CHURCH OF SCIENTOLOGY OF CALIFORNIA, Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
No. 85-7324.
United States Court of Appeals,
Ninth Circuit.
Argued and Submitted Aug. 8, 1986.
Decided July 28, 1987.
On appeal from revocation of church's tax exempt status by Internal Revenue
Service, the Tax Court, 83 T.C. 381, affirmed commissioner's assessment of
tax deficiencies and late filing penalties and church appealed. The Court of
Appeals, Tang, Circuit Judge, held that: (1) significant sums of church money
inured to benefit of church's founder and his family thus constituting
inurement to private individual, and thus, church was not entitled to tax
exempt status; (2) notice of deficiency sent by Internal Revenue Service was
not unconstitutional, though there was some evidence of religious animus, where
overwhelming weight of evidence indicated that Internal Revenue Service
determined that church did not conform to requirements for tax exempt status
based upon exhaustive and responsible investigations; (3) 1967 revocation
letter sent by Internal Revenue Service was not constructively revoked; and
(4) late filing penalties were valid.
Affirmed.
[1] INTERNAL REVENUE
In order to qualify for tax exemption, church must show that it is organized
and operated exclusively for religious or charitable purposes. 26
U.S.C.A. ss 501, 501(c)(3).
[2] INTERNAL REVENUE
In order for organization to pass operational test in order to obtain tax
exempt status, it must engage primarily in activities which accomplish one or
more of exempt purposes, organization's net earnings may not inure to benefit
of private shareholders or individuals, organization must not expend
substantial part of resources attempting to influence legislation or political
campaigns, and organizations seeking exemption from taxes must serve valid
public purpose and confer public benefit. 26 U.S.C.A. s 501(c)(3).
[2] INTERNAL REVENUE
In order for organization to pass operational test in order to obtain tax
exempt status, it must engage primarily in activities which accomplish one or
more of exempt purposes, organization's net earnings may not inure to benefit
of private shareholders or individuals, organization must not expend
substantial part of resources attempting to influence legislation or political
campaigns, and organizations seeking exemption from taxes must serve valid
public purpose and confer public benefit. 26 U.S.C.A. s 501(c)(3).
[3] INTERNAL REVENUE
Organization loses tax exempt status if even small percentage of income inures
to private individual. 26 U.S.C.A. s 501(c)(3).
[4] INTERNAL REVENUE
Organization's net earnings, which may not inure to benefit of private
individual in order to retain tax exempt status, includes more than gross
receipts minus disbursements as shown on books of organization; only those
ordinary expenses necessary to operation of organization are not included in
net earnings. 26 U.S.C.A. s 501(c)(3).
[4] INTERNAL REVENUE
Organization's net earnings, which may not inure to benefit of private
individual in order to retain tax exempt status, includes more than gross
receipts minus disbursements as shown on books of organization; only those
ordinary expenses necessary to operation of organization are not included in
net earnings. 26 U.S.C.A. s 501(c)(3).
[5] INTERNAL REVENUE
Payment of reasonable salaries to church officials does not constitute
inurement so as to defeat church's tax exempt status, but payment of excessive
salaries will result in finding of inurement as will distributions or
unaccounted for diversions by one who has complete and unfettered
control over organization's resources. 26 U.S.C.A. s 501(c)(3).
[6] INTERNAL REVENUE
Excessive compensation by organization to private individual and potential for
abuse, even absent showing of actual abuse, will constitute inurement
sufficient to destroy tax exempt status of organization. 26 U.S.C.A. s
501(c)(3).
[7] INTERNAL REVENUE
Taxpayer has burden to establish that it is entitled to tax exempt status;
this is particularly true in situations where there is great potential for
abuse created by one individual's control of church; church must come forward
with candid disclosure of facts bearing on exemption application and doubts
will be resolved in favor of government.
[8] INTERNAL REVENUE
For purposes of determining whether church's net income inured to benefit of
church's founder and family, combined salaries of $20,249, $49,648 and $115,680
in three different tax years were not excessive.
[9] INTERNAL REVENUE
Financing church operation through sale of religious literature does not
necessarily violate requirements for tax exemption; furthermore, church may
pay author reasonable compensation in form of royalties for literary works.
26 U.S.C.A. s 501(c)(3).
[10] INTERNAL REVENUE
Royalty payments made by church to its founder on sales of books, recordings
and electronic devices, were excessive, and thus supported determination that
church's net income inured to benefit of individual, where founder used church
to generate copyrighted literature and market his products, church policy
mandated that any book on subject be copyrighted in name of founder, and number
of publications copyrighted by founder were actually written by church
employees.
[11] INTERNAL REVENUE
Church's founder's control over large amount of church's assets compelled
finding that church's proceeds inured to benefit of private individual, though
some evidence was presented that funds were not missing, where fact that funds
were present was not inconsistent with finding that founder had unfettered
control over millions of dollars in money which originated with church.
[12] INTERNAL REVENUE
"Debt repayments" to church's founder by church, which were based upon
percentage of church's total receipts inured to personal benefit of founder and
thus, church's claim to tax exempt status was defeated.
[13] FEDERAL COURTS
Normally, determination of party's "actual motive" is type of mixed question of
law and fact which appellate court reviews for clear error; however, when
questions of motive implicate constitutional rights, review is de novo.
[13] FEDERAL COURTS
Normally, determination of party's "actual motive" is type of mixed question of
law and fact which appellate court reviews for clear error; however, when
questions of motive implicate constitutional rights, review is de novo.
[14] CRIMINAL LAW
Standard applied by Court of Appeals in reviewing cases of alleged
discriminatory prosecution is that others are not generally prosecuted for same
conduct and that decision to prosecute this defendant was based upon
impermissible grounds such as race, religion or exercise of constitutional
rights.
[15] INTERNAL REVENUE
Notice of deficiency sent by Internal Revenue Service to church was not
unconstitutional, though there was some evidence of religious animus against
church, where overwhelming weight of evidence indicated that Internal Revenue
Service concluded that church did not conform to requirements for tax exempt
status based upon exhaustive and responsible investigation. 26 U.S.C.A. s
501(c)(3).
[16] INTERNAL REVENUE
Revocation letter of 1967 regarding church's tax exempt status was not
constructively revoked by fact that Internal Revenue Service settled case
against church pertaining to tax deficiency for 1965 through 1967 by
stipulation, where although Internal Revenue Service abandoned its attempt to
collect taxes for those years, it did not abandon its 1967 determination that
church was no longer eligible for tax exempt status as evidenced by fact that
stipulation expressly stated that concession was without prejudice with respect
to any other taxable year.
[17] INTERNAL REVENUE
Taxpayer carries burden to show reasonable cause for failing to file required
tax return.
[18] INTERNAL REVENUE
Church's unilateral doubts about effectiveness of revocation letter sent by
Internal Revenue Service was not reasonable cause for its failure to file
proper tax return nor was its alleged reliance on advice of tax professionals
where Internal Revenue Service expressly instructed church to file tax
return. 26 U.S.C.A. s 6651(a)(1).
*1312 Christopher Cobb, Pasadena, Cal., Richard Riley, Washington, D.C. and
Eric Lieberman, New York City, for petitioner-appellant.
Steven Frahm, Washington, D.C., for respondent-appellee.
Lee Boothby, Berrien Springs, Mich. and Gerald McNally, Jr., Glendale, Cal.,
for amicus-curiae.
Appeal from a Decision of the Tax Court of the United States.
Before TANG and BRUNETTI, Circuit Judges, and JAMESON, [FN*] District Judge.
FN* Honorable William J. Jameson, Senior United States District Judge,
District of Montana, sitting by designation.
TANG, Circuit Judge:
The Church of Scientology (Church) appeals a judgment of the Tax Court which
affirmed the Commissioner's assessment of tax deficiencies and late filing
penalties against the Church for the years 1970, 1971 and 1972. At issue is
whether the Commissioner properly revoked the Church's tax exempt status.
I.
The Church was incorporated as a nonprofit corporation in the State of
California in 1954. In 1957, the Commissioner recognized it as a tax exempt
organization under s 501(c)(3) of the Internal Revenue Code of 1954. [FN1]
The Commissioner revoked the Church's tax exempt status in 1967. The letter of
revocation stated that the Church was "engaged in a business for profit," and
was "operated in a manner whereby a portion of [its] earnings inure[d] to the
benefit of a private individual," and was "serving a private, rather than a
public interest." The letter instructed the Church to file federal income tax
returns. The IRS subsequently published a notice of revocation in the Internal
Revenue Service bulletin, and removed the Church from the Service's official
roster of organizations eligible to receive tax deductible charitable
donations. The Church did not file income tax returns for the years 1970
through 1972, instead, it submitted Form 990, information returns. On December
28, 1977, after auditing the Church's records, the IRS sent a Notice of
Deficiency for the years 1970, 1971, and 1972. The IRS calculated the
deficiency to be $1,150,458.87 and imposed an additional $287,614.71 in late
filing penalties. [FN2]
FN1. Codified as amended at 26 U.S.C. s 501(c)(3) (1982).
FN2. The IRS may impose a penalty in addition to the tax for failure to
file tax returns under 26 U.S.C. s 6651(a).
On March 28, 1978, the Church filed suit in United States Tax Court
challenging the Commissioner's determination of tax deficiency. In an
extensive opinion, the Tax Court substantially upheld the determination of the
Commissioner. 83 T.C. 381 (1984). It held that the Church did not qualify
for exemption from taxation under ss 501(a) & 501(c)(3) because: (1) the
Church was operated for a substantial commercial purpose; (2) its earnings
inured to *1313 the benefit of L. Ron Hubbard, his family, and OTC, a
private non-charitable corporation controlled by key Scientology officials;
and (3) it violated well defined standards of public policy by conspiring to
prevent the IRS from assessing and collecting taxes owed by the Church. The
Court also upheld the validity of the Notice of Deficiency. [FN3] Finally, the
Court upheld the penalties for failure to file tax returns.
FN3. However, the Court found that the IRS erred in including payments
from the United Kingdom Church in the Church's income because it found that
the United Kingdom Church was a branch of the Church, and that the
payments were internal transfers of funds.
II.
During the years in question, the Church of Scientology of California was the
"Mother Church" of the many Scientology churches around the country. The
Church propagated the Scientology faith, a religion founded by L. Ron Hubbard,
through such means as the indoctrination of laity, training and ordination of
ministers, creation of congregations, and provision of support to affiliated
organizations.
Scientology teaches that the individual is a spiritual being having a mind and
body. Part of the mind, called the "reactive mind" is unconscious and filled
with mental images that are frequently the source of irrational behavior.
Through the administration of a process known as "auditing" a parishioner,
called a "pre-clear," is helped to erase his or her reactive mind and gain
spiritual awareness. Auditing is administered individually by a trained
"auditor." The auditor poses questions to the pre-clear and measures the
latter's response with an electronic device call an "E-Meter" that is attached
to the skin. The E-Meter assists in the identification of spiritual
difficulty. Scientology teaches that spiritual awareness is achieved in
stages. A disciple achieves different levels of awareness through additional
auditing. The religion also offers courses to train auditors.
Scientology teaches that people should pay for whatever of value they
receive. This is called the "Doctrine of Exchange." Toward the realization of
this doctrine, branch churches exacted a "fixed donation" for training and
auditing. Fixed donations were not based on ability to pay and with few
exceptions, services were not given for free.
Scientology is an international religion with numerous churches around the
world. In the 1970's, these churches were organized along hierarchical lines
according to the level of services they were authorized to provide. Churches
that delivered services at the lowest levels were called "franchises" and
later "missions." "Class IV orgs" delivered auditing through "grade IV" and
training through "level IV." "St. Hill organizations" and "advanced
organizations" offered intermediate and higher level services. The branch
known as "Flag" offered the highest level of training and auditing.
The California Church consisted of several divisions. The San Francisco
Organization and the Los Angeles Organization were both class IV
organizations. The American St. Hill Organization was located in Los Angeles
and offered intermediate auditing and training. The Advanced Organization of
Los Angeles provided high levels of auditing and training to persons who had
completed services at a class IV organization. The Flag Operations Liaison
Office, located in Los Angeles, was an administrative unit of the California
Church.
In addition to auditing and training, the Church provided assistance to
prisoners, ex-offenders, the elderly, the mentally ill and drug addicts. On
occasion the Church assisted the poor and the sick. The Church performed
christenings, funerals and wedding ceremonies free of charge, and conducted
regular Sunday services. The Church's chaplain provided marriage and family
counseling free of charge. The Church also provided free, a specialized form
of auditing geared to help people in crisis.
Flag was the highest division of the California Church. It provided spiritual
leadership. It also acted as the Church's administrative center. The Flag
division was headquartered aboard the ship Apollo, *1314 which cruised the
Mediterranean Sea and docked in various countries along its shores. L. Ron
Hubbard, his wife, Mary Sue, and their family lived aboard the Apollo with
other members of the ship's crew and staff. Besides performing the highest
levels of auditing and training, Flag staff members performed a variety of
management functions. The Church's other divisions and other Scientology
churches sent reports on a regular basis to Flag. These reports supplied
information, often in statistical form, about the organization's operations.
Flag staff, on the basis of the review of these reports, issued policy letters,
directives, and other kinds of administrative advice geared to improving local
church operations. Flag personnel also researched and developed programs for
improving the administration of local churches. Flag sent teams of specialists
to help other units or churches experiencing management difficulties.
The Church derived income from four sources: (1) auditing and training; (2)
sales of Scientology literature, recordings and E-meters; (3) franchise
operations; and (4) management services. Franchise operators were required to
remit ten percent of gross income to the Church. The Church offered its
managerial services to branch organizations around the world for a fixed fee.
One of the policy directives of the Church was to "MAKE MONEY". The Church
frequently engaged in aggressive promotion of its products and services. This
promotion included market surveys and advertisements. In addition, the Church
trained staff members in salesmanship techniques.
L. Ron Hubbard officially resigned his position as executive head of the
California and other Scientology churches in 1966. Despite his official
resignation, the Tax Court found that he continued to exert significant control
over the Church by making policy statements, directives, and orders. In
addition, his approval was required for all financial planning. He was the
sole trustee of a major Scientology trust fund into which the Church made
substantial payments. He or Mary Sue Hubbard were signatories on many Church
bank accounts.
During the tax years at issue, L. Ron Hubbard and Mary Sue Hubbard received
salaries from the California Church and its affiliate, the United Kingdom
Church, in the following amounts:
1970 1971 1972
California Church
L. Ron Hubbard $ 4,932 $ 9,368 $ 35,000
Mary Sue Hubbard $ 3,017 $ 2,430 $ 25,000
United Kingdom Church
L. Ron & Mary Sue
Hubbard Combined $12,300 $37,850 $ 55,680
--------------------------
TOTAL $20,249 $49,648 $115,680
During these years, L. Ron Hubbard, Mary Sue Hubbard and their four children
resided for the most part aboard the Apollo. While aboard ship, the Church
provided the Hubbards with free lodging, food, laundry, medical services and
vitamins.
The Church made royalty payments to L. Ron Hubbard for sales of his books,
tapes and E-meters. The royalties amounted to ten percent of the retail
price. The Church, for example, made $104,618.27 in royalty payments to
Hubbard in 1972. Additionally, Church policy required that all work pertaining
to Scientology and Dianetics be copyrighted to L. Ron Hubbard. As the result
of this policy, a number of publications copyrighted by L. Ron Hubbard were
actually written by others. For example, Ruth Mitchell wrote the book Know
Your People and Peter Gillum wrote the book How to be Successful.
Additionally, a series of books called the OEC series contained policy letters,
some written by L. Ron Hubbard and others written by paid employees of the
Church. L. Ron Hubbard received royalty payments on the sale of all of these
publications.
During the 1960's, Scientology organizations around the world were required to
pay directly to L. Ron Hubbard, ten percent of their income. These payments
were termed "debt repayments" because they were designed to compensate Hubbard
for his work in originating the Scientology religion. The Tax Court concluded
*1315 that during 1971-1972 the Church continued to make debt repayments to
Hubbard.
In 1968, L. Ron Hubbard, Mary Sue Hubbard, and Leon Steinberg incorporated a
Panamanian corporation called Operation Transport Corp., Ltd. (OTC). OTC was a
for-profit corporation. Shortly after the corporation's formation, Hubbard,
Mary Sue Hubbard and Steinberg resigned and were replaced by three Flag
employees. During the years in question, the new directors performed only one
function. In the summer of 1972, they approved L. Ron Hubbard's decision to
transfer approximately two million dollars from an OTC bank account in
Switzerland to the Apollo. The money was stored in a locked file cabinet to
which Mary Sue Hubbard had the only set of keys.
Between 1971 and 1972, the Church made payments in excess of three and a half
million dollars to OTC. During these years, the Church also made payments
totaling nearly $175,000 to the Central Defense and Dissemination Fund.
According to the Church, these payments were placed in the United States Church
of Scientology Trust of which L. Ron Hubbard was the sole trustee. The trust
funds were deposited in several Swiss bank accounts. L. Ron Hubbard and Mary
Sue Hubbard were signatories of the accounts and L. Ron Hubbard kept the trust
checkbooks.
III.
A. Tax Exemption
[1] Internal Revenue Code s 501 exempts certain organizations from
taxation. Section 501(c)(3) exempts:
corporations and any community chest, fund, or foundation, organized and
operated exclusively for religious ... purposes, ... no part of the net
earnings of which inures to the benefit of any private shareholder or
individual....
To qualify for exemption, a church must show that it is (1) organized, and (2)
operated, exclusively for religious or charitable purposes. Hall v.
Commissioner, 729 F.2d 632, 634 (9th Cir.1984).
The Church strenuously argues that the trial court failed to recognize it as a
bona fide religion. This argument goes to whether the Church meets the
organizational test. Neither the Commissioner, nor the Tax Court, nor this
court questions that the Church of Scientology of California was organized for
a bona fide religious purpose. The only question before the court, is whether
the Church met the second requirement for tax exempt status, the operational
test.
[2] Four elements compose the operational test. First, the organization
must engage primarily in activities which accomplish one or more of the exempt
purposes specified in s 501(c)(3). Treas.Reg. s 1.501(c)(3)-
1(c)(1); Church by Mail, Inc. v. Commissioner, 765 F.2d 1387, 1391 (9th
Cir.1985). Second, the organization's net earnings may not inure to the
benefit of private shareholders or individuals. Treas.Reg. s 1.501(c)(3)-
1(c)(2); Church by Mail, 765 F.2d at 1391. Third, the organization must
not expend a substantial part of its resources attempting to influence
legislation or political campaigns. Treas.Reg. s 1.501(c)(3)-1(c)(3);
Church by Mail, 765 F.2d at 1391. Courts have imposed a fourth element.
Organizations seeking exemption from taxes must serve a valid public purpose
and confer a public benefit. Bob Jones University v. United States, 461
U.S. 574, 585-92, 103 S.Ct. 2017, 2025-29, 76 L.Ed.2d 157 (1983). If an
organization fails to comply with any one of these four elements, it will fail
the operational test and lose its eligibility for tax exempt status.
Harding Hospital, Inc. v. United States, 505 F.2d 1068, 1072 (6th Cir.1974).
We conclude that the Church failed to establish that "no part of the net
earnings ... inures to the benefit of any private shareholder or
individual...." 26 U.S.C. s 501(c)(3). Because we may affirm the Tax Court
on this ground, we do not reach the questions of whether the Church operated
for a substantial commercial purpose or whether it violated public policy.
B. Inurement
Congress conferred tax exemption on churches and other organizations in
recognition *1316 of the benefit society derives from the activities of
these organizations. Harding Hospital, 505 F.2d at 1071; Founding
Church of Scientology v. United States, 412 F.2d 1197, 1199, 188 Ct.Cl. 490
(1969), cert. denied, 397 U.S. 1009, 90 S.Ct. 1237, 25 L.Ed.2d 422 (1970).
The government leaves funds in the hands of charitable organizations rather
than taxing them and spending the funds on public projects. Implicit in this
purpose is that charities must promote the public good to qualify for tax
exemption. Presbyterian and Reformed Publishing Co. v. Commissioner, 743
F.2d 148, 153 (3d Cir.1984).
[3] Section 501(c)(3) embodies this policy. Churches are eligible for
tax exempt status only if no part of their net earnings inure to the benefit of
private individuals. Each phrase of the statute has significance. The term
"no part" is absolute. The organization loses tax exempt status if even a
small percentage of income inures to a private individual. Founding Church,
412 F.2d at 1200; Spokane Motorcycle Club v. United States, 222 F.Supp.
151, 153 (E.D.Wash.1963). The sole beneficiary of the church's activities must
be the public at large. Founding Church, 412 F.2d at 1199.
[4] Courts have construed broadly the term "net earnings". Hall, 729
F.2d at 634. "Net earnings" includes more than gross receipts minus
disbursements as shown on the books of the organization. Harding Hospital,
505 F.2d at 1072. Only those ordinary expenses necessary to the operation of
the church are not included in net earnings. Founding Church, 412 F.2d at
1200.
[5] The heart of s 501(c)(3) tax exempt status is the phrase "inures to
the benefit." Payment of reasonable salaries to church officials does not
constitute inurement. Bubbling Well Church of Universal Love v.
Commissioner, 670 F.2d 104, 105 (9th Cir.1981). However, payment of excessive
salaries will result in a finding of inurement. Id. Inurement can also
result from distributions other than the payment of excessive salaries. See
Founding Church, 412 F.2d at 1200 (ten percent of gross income of affiliated
Scientology organizations paid to L. Ron Hubbard); General Contractors'
Ass'n of Milwaukee v. United States, 202 F.2d 633 (7th Cir.1953) (reports and
surveys furnished to members); Spokane Motorcycle Club, 222 F.Supp. 151
(goods, services, and refreshments given to members). Unaccounted for
diversions of a charitable organization's resources by one who has complete and
unfettered control can constitute inurement. Parker v. Commissioner, 365
F.2d 792, 799 (8th Cir.1966), cert. denied, 385 U.S. 1026, 87 S.Ct. 752, 17
L.Ed.2d 674 (1967); Kenner v. Commissioner, 318 F.2d 632 (7th Cir.1963).
Finally, the regulations define "private shareholder or individual" broadly as
any person "having a personal and private interest in the activities of the
organization." 26 C.F.R. 1.501(a)-1(c).
[6] While we remain solicitous of Congress' intent to confer tax exempt
status on religious organizations, this court has previously affirmed the
denial of tax exemption where church income inures to private individuals. In
Church by Mail, the Commissioner denied the Church's application for tax
exempt status. Two individuals, Reverend Ewing and Reverend McElrath, ran a
church that mailed printed sermons to several million homes. They also owned
Twentieth Century Advertising Agency which provided the Church's printing and
mailing services. We found that the salaries paid to Reverend Ewing and
Reverend McElrath by the Church and Twentieth Century were excessive. We
rejected the Church's argument that the income paid by Twentieth Century should
not be included because Twentieth Century, a for-profit company, simply
funneled church income to Reverends Ewing and McElrath. 765 F.2d at 1393.
Similarly, in Hall, we held that William and Lorna Hall were not entitled to
a charitable donation deduction for money donated to the Church of the United
Brotherhood (CUB). CUB failed to qualify as a charitable organization because
its major purpose was to funnel rental income to the Halls. 729 F.2d at
634. In Bubbling Well Church, we upheld the Tax Court's denial of the
Church's application *1317 for tax exempt status. Three members of one
family were the sole employees and voting directors of the Church. The Church
paid a substantial portion of its income to the three family members. We held
that the Church failed to carry its burden to prove that the salary and
benefits paid to the family members were reasonable. 670 F.2d at 106.
These cases emphasize that excessive compensation and potential for abuse, even
absent a showing of actual abuse, will constitute inurement. [FN4]
FN4. We recognize that not every instance in which payments are made to
private individuals will result in inurement. See e.g., Presbyterian
and Reformed Publishing Co. v. Commissioner, 743 F.2d 148 (3d Cir.1984).
In Presbyterian and Reformed Publishing, the Third Circuit reversed the
Tax Court's denial of tax exempt status because the publishing company paid
nothing more than reasonable salaries to the founder's family and
employees.
The finding of the Tax Court that a portion of the Church's net earnings
inured to the benefit of L. Ron Hubbard, his family, and OTC, a private for-
profit corporation, is a factual finding. See Bubbling Well Church, 670
F.2d at 106; cf. Church By Mail, 765 F.2d at 1390 (whether Church is
operated for a non-exempt purpose is a factual finding). We review this
finding for clear error. Bubbling Well Church, 670 F.2d at 106.
[7] The taxpayer has the burden to demonstrate that it is entitled to tax
exempt status. Church by Mail, 765 F.2d at 1391. This is especially true
in situations where there is a great potential for abuse created by one
individual's control of the church. See Bubbling Well Church, 670 F.2d at
105. The Church must come forward with candid disclosure of the facts bearing
on the exemption application. Id. Doubts will be resolved in favor of the
government. Harding Hospital, 505 F.2d at 1071.
In finding that a portion of the Church's net earnings inured to the benefit
of L. Ron Hubbard, his family and OTC, the court isolated two indicia of
inurement, overt and covert. The overt indicia included salaries, living
expenses, and royalties. The covert indicia included "debt repayments" and L.
Ron Hubbard's unfettered control over millions of dollars of Church assets.
The court concluded that these indicia, when viewed in light of the self-
dealing associated with them, coupled with the Church's failure to carry its
burden of proof and to disclose the facts candidly, proved conclusively that
the Church was operated for the benefit of L. Ron Hubbard and his family.
The Church challenges the overt indicia of inurement on the ground that the
salaries, expenses and royalties, were reasonable. It notes that the court did
not find them unreasonable, considered separately. The Church questions the
logic of the finding that several reasonable payments add up to inurement.
[8] The Church paid L. Ron Hubbard and Mary Sue Hubbard combined salaries
of $20,249 in 1970, $49,648 in 1971 and $115,680 in 1972. We cannot say that
these salaries were excessive.
In addition to Hubbard's salary, the Church paid for all of the Hubbards'
living and medical expenses aboard the cruise ship Apollo. These expenses
amounted to about $30,000 per year. Because it is unnecessary to our decision,
we express no opinion on whether supporting a Church's founder and his family
aboard a yacht cruising the Mediterranean constitutes a reasonable Church
expense.
[9][10] The Church also paid substantial royalties to L. Ron Hubbard for his
books, recordings and E-meters. Churches, especially less established ones,
rely on the distribution of church literature to propagate their beliefs.
Financing church operations through the sale of religious literature does not
necessarily violate the requirements for tax exemption. See Presbyterian
and Reformed Publishing Co., 743 F.2d at 158-59. Furthermore, a church may pay
the author reasonable compensation in the form of royalties for his literary
works. However, the payments in this case, cross the line between reasonable
and excessive. Here, the evidence indicates that Hubbard used the Church to
generate copyrighted literature and market his products. Scientology policy
mandated that *1318 any book on Dianetics and Scientology be copyrighted in
the name of L. Ron Hubbard. Pursuant to this policy, a number of publications
copyrighted by L. Ron Hubbard were actually written by Church employees.
Furthermore, the Church encouraged its staff members to market aggressively his
products. We agree with the Tax Court that the royalty payments support a
finding of inurement.
[11] The Church argues that the evidence does not support the Tax Court's
finding of covert inurement. However, the record reveals that L. Ron Hubbard
had unfettered control over millions of dollars in Church assets. The
Church transferred several million dollars to OTC during 1970-72. These
payments were designated as "charter mission expenses." L. Ron Hubbard and
Mary Sue Hubbard controlled OTC funds. Sometime during 1972, OTC transferred
approximately two million dollars from OTC bank accounts in Switzerland to the
Apollo. The finding that OTC was a sham corporation is sustained. During the
tax years in question OTC funneled millions of dollars of Church assets to L.
Ron Hubbard. See Church by Mail, Inc., 765 F.2d at 1393; Hall, 729
F.2d at 634.
The record also supports the Tax Court's conclusion that L. Ron Hubbard had
unfettered control over Church of Scientology Trust Fund assets. The Church
deducted payments of $28,930.34 in 1970, $67,892.40 in 1971, and $77,986.62 in
1972 to the Central Defense and Dissemination Fund. According to the Church,
these payments were made to the United States Church of Scientology Trust. L.
Ron Hubbard was the sole trustee of the Trust during the years in question.
Trust funds were deposited in several Swiss bank accounts. L. Ron Hubbard and
Mary Sue Hubbard were two of the three signatories on the Trust accounts. L.
Ron Hubbard kept the Trust checkbooks. In 1972, over a million dollars was
withdrawn from the Trust accounts in Switzerland and brought aboard the Apollo
where it was kept in a locked file cabinet. Mary Sue Hubbard had the only keys
to the cabinet.
The Church disputes that control over assets compels a finding of inurement.
It argues that every Sunday morning pastors all over America collect money from
parishioners and hold that money for Church uses. It asserts that OTC funds
were used for expenses associated with operation of the Apollo and in providing
banking services for Flag. Witnesses testified that the Church used Trust
monies to defend Scientology against attack and to propagate the religion.
Finally, the Church argues that the three million dollars brought aboard the
Apollo from the OTC and Trust accounts remained on the Apollo during the years
in question. It cites the testimony of a Trust accountant who counted the cash
aboard the Apollo and testified that none of it was missing.
We find these arguments unpersuasive. Unlike the typical Saturday or Sunday
when parishioners donate their money to the church, here the Church transferred
millions of dollars to bank accounts controlled by a private individual who had
no official responsibility for managing church assets. Although witnesses
testified that the money was used for Church purposes, the Church presented
little documentation to show that the majority of Trust or OTC money was
actually spent on bona-fide Church activities. Finally, the self-serving
testimony of a Church employee that the three million dollars remained in the
Apollo safe proves nothing. The fact that there were three million dollars in
the safe on the day the Church accountant checked, is not inconsistent with the
Tax Court's finding that L. Ron Hubbard had unfettered control over millions of
dollars in money that originated with the Church. The Church failed to come
forward with testimony from key individuals such as L. Ron Hubbard and Mary Sue
Hubbard and failed to present the documentation necessary to trace the source
and use of OTC and Trust monies. In sum, the Church failed to carry its burden
of proof in a situation where "the potential for abuse created by the
[founder's] control of the Church required open and candid disclosure of facts
bearing on the exemption application." Bubbling Well Church, 670 F.2d at
105.
*1319 The Tax Court found that Church income inured to the benefit of L.
Ron Hubbard in a "grand scale" in the form of "debt repayments." During the
1950's, Hubbard was paid a portion of the gross income of Scientology
congregations, franchises and organizations. Founding Church, 412 F.2d at
1199. This compensation scheme was called the "proportional pay plan." During
the 1960's these tithes became known as "Founding Debt Payments" (sometimes
also called "LRH RR" or "LRH 10").
[12] Although the form changed, the payments continued through the years at
issue in this case. Church records indicate that between October 9, 1972 and
December 28, 1972, it made debt repayments totaling $19,324.41. A policy
letter dated September 7, 1972 entitled "Repayment or Due Money Collected for
LRH Personally" set out a program to reimburse Hubbard for past use of
Hubbard's personal income and capital; research and development of the
technology of Dianetics and Scientology; and the use of Hubbard's goodwill and
high credit rating. The letter establishes the post of "LRH accounts officer"
to monitor collection of debt repayments.
The Church argues that the Tax Court's finding of continued debt repayments is
clearly erroneous. The policy letter establishing the post of "LRH accounts
officer" was canceled two days after it was promulgated. According to the
Church, the only credible evidence of payments were the checks issued between
October and December 1972. It contends that these payments, even though
invoiced in the Church's records as "Per HCO Policy Letter 7 Sept. 72", "LRH
Repayments," and "Founding Debt Payment," were actually deposited in an OTC
bank account for the benefit of the Church. Finally, even if the evidence is
believed, argues the Church, it accounts for only a four-month period and is
insufficient to support revocation of tax exemption for all three years.
These arguments are unavailing. Even though the payments were called debt
repayments, the Church produced no evidence of bona fide indebtedness. The
typical indicia of a debt are a sum certain payable over a specific period of
time at a stipulated rate of interest. Here, the evidence indicates a
continuing obligation to make uncertain payments based on a percentage of the
Church's total receipts. In enforcing federal tax laws, courts look to the
substance of a transaction rather than its form. Commissioner v. Court
Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945). These
payments more closely resemble tithes to L. Ron Hubbard than debt repayments.
It makes no difference whether the $19,000 was the tip of the iceberg, as the
Tax Court concluded, or the total of all debt repayments made by the Church.
No part of the Church's income could inure to L. Ron Hubbard if it was to
maintain tax exempt status. Founding Church, 412 F.2d at 1200. Even if the
money went into an OTC account, it inured to the benefit of L. Ron Hubbard
because he had unrestrained and unaccounted for access to that account. See
Parker, 365 F.2d at 799. The Church failed to come forward with credible
proof that the funds were actually spent on behalf of the Church. Bubbling
Well Church, 670 F.2d at 106.
In sum, we hold that significant sums of Church money inured to the benefit of
L. Ron Hubbard and his family during the tax years 1970, 1971 and 1972.
Although neither the salaries nor the living expenses necessarily constituted
evidence of inurement, the cumulative effect of Hubbard's use of the Church to
promote royalty income, Hubbard's unfettered control over millions of dollars
of church assets, and his receipt of untold thousands of dollars worth of "debt
repayments" strongly demonstrate inurement. We find no clear error.
C. Validity of Notice of Deficiency
The Church mounts two attacks on the notice of deficiency. First, it alleges
that the notice was void because the 1967 revocation letter was
unconstitutional. Second, it contends that the notice was void or voidable due
to administrative defects.
*1320 1. Constitutional Challenge
[13] The Church asserts that the IRS was motivated by hostility towards
Scientology as a religion in issuing the 1967 letter revoking the Church's tax
exempt status. The first amendment imposes an obligation of neutrality on the
government in its dealings with religious organizations. See Sherbert v.
Verner, 374 U.S. 398, 402, 83 S.Ct. 1790, 1792, 10 L.Ed.2d 965 (1963). The
question of whether the Commissioner was motivated by religious animus turns on
subjective intent. Normally, the determination of a party's "actual motive" is
the type of mixed question of law and fact which we review for clear error.
United States v. McConney, 728 F.2d 1195, 1203 (9th Cir.) (en banc), cert.
denied, 469 U.S. 824, 105 S.Ct. 101, 83 L.Ed.2d 46 (1984). However, when
questions of motive implicate constitutional rights, we review de novo. See
Standard Oil Co. of California v. Arizona, 738 F.2d 1021, 1023 (9th
Cir.1984), cert. denied, 469 U.S. 1132, 105 S.Ct. 815, 83 L.Ed.2d 807
(1985); McConney, 728 F.2d at 1203.
As proof of the Commissioner's enmity, the Church cites a record of harassment
dating back to 1958. Essentially, the Church contends that it was singled out
for revocation. In 1959, the IRS revoked the tax exempt status of the Founding
Church. In 1963, Food and Drug Administration agents raided the Founding
Church and seized E-meters and Scientology literature on the grounds of "false
or misleading labeling." Founding Church of Scientology v. United States,
409 F.2d 1146, 1148 (D.C.Cir.1969). The Church alleged that in the mid-60's
the Department of Justice targeted all Scientology churches for revocation of
tax exempt status. Memoranda and correspondence in IRS files contained
statements antagonistic to the Church. IRS agents called Scientology a
"medical quackery," a "threat to the community, medically, morally and
socially," a "prey on the public pocketbook," and similar epithets. Between
1969 and 1975 the IRS established three special intelligence units to collect
information about taxpayers and to monitor their compliance with tax laws. All
three units collected information on the Church and other groups such as the
Black United Front, the New Left Movement and the Welfare Rights Organization.
Despite these facts, the record bears out the trial court's conclusion that
the IRS revoked the Church's exemption based upon legitimate agency concerns.
The IRS examined the Church's records in 1965 and again in 1966. On July 29,
1966, the IRS sent a letter to the Church stating that it was considering
revocation of its tax exempt status because: (1) the Church's income inured to
the benefit of Scientology practitioners; (2) the Church's activities were
commercial; and (3) the Church was serving the private interest of L. Ron
Hubbard and Scientology practitioners. The agency then held two protest
conferences and finally issued a formal letter of revocation on July 18, 1967
stating the same three grounds of revocation. During 1969 and 1970, the IRS
examined the Church's records for the taxable years 1964-67 and, in a second
audit, the years 1968 and 1969. In 1974, the IRS mailed a notice of deficiency
to the Church for the taxable years 1965 through 1967. The Church filed the
petition in the Tax Court for the 1965 deficiency and in late 1976 the IRS
settled the case by conceding the petitioners' tax exempt status for that year
without prejudice to any other year. In 1975 and 1976 the IRS audited the
California Church for the taxable years 1971 through 1974. The agents examined
between 200 and 300 cartons of records containing approximately two million
documents. Based on the findings of that audit, the parties attempted
settlement negotiations. Finally, in December of 1977, the IRS issued a notice
of deficiency for the tax years 1970, 1971 and 1972.
[14] Even examining the IRS's actions under the selective prosecution
standard--a standard which is arguably too stringent for review of a mere
revocation of tax exempt status--we cannot hold that there is any impropriety
in this revocation. See Karme v. Commissioner, 673 F.2d 1062, 1064 (9th
Cir.1982). The standard we apply in cases of alleged discriminatory
prosecution is:
*1321 (1) That others are generally not prosecuted for the same conduct;
(2) The decision to prosecute this defendant was based upon impermissible
grounds such as race, religion or the exercise of constitutional rights.
Id.
[15] The Church has not shown discriminatory selection even under the
stringent criminal standard. The IRS has revoked the tax exempt status of many
other churches. See e.g., Presbyterian and Reformed Publishing Co., 743
F.2d 148 (reversing the IRS's revocation); Bethel Conservative Mennonite
Church v. Commissioner, 746 F.2d 388 (7th Cir.1984) (reversing IRS's
revocation); Church of Gospel Ministry, Inc. v. United States, 640 F.Supp.
96 (D.D.C.1986) (upholding the IRS's revocation). Nor has the Church proven
the second prong. Although there is evidence of religious animus, the
overwhelming weight of the evidence indicates that the IRS concluded that the
Church did not conform to the requirements of section 501(c)(3) based upon
exhaustive and responsible investigation. Accordingly, we reject the Church's
argument that the notice of deficiency was unconstitutional.
2. Administrative Defects
The IRS revoked the Church's tax exempt status by letter dated July 18, 1967.
After fruitless negotiations, the IRS issued a notice of deficiency to the
Church on June 7, 1974 covering the years 1965 through 1967. The Church argues
that, because the IRS settled the case by stipulating that the Church owed no
deficiency for 1965, the revocation letter was constructively revoked. Thus,
argues the Church, the 1977 notice of deficiency, relating to the years 1970
through 1972, was void because the Church was still a recognized tax exempt
organization. The Church cites A. Duda & Sons Cooperative Ass'n v. United
States, 504 F.2d 970 (5th Cir.1974).
[16] We disagree with the Church's analysis. Although the IRS abandoned its
attempt to collect taxes for the years 1965 through 1967, it never abandoned
its 1967 determination that the Church was no longer eligible for tax exempt
status. In fact, the stipulation expressly stated that the concession was
"without prejudice to [the Church] or [the Commissioner] with respect to any
other taxable year...." A. Duda & Sons is inapposite. In that case, the
Commissioner expressly conceded that the grounds for revocation were
erroneous. 504 F.2d at 975. In this case, the Commissioner never made such
a concession; in fact today we hold that one of the stated grounds, inurement,
was valid. In sum, we hold that the 1967 revocation letter was not
constructively revoked.
D. Validity of Late Filing Penalties
The Commissioner imposed an additional penalty on the Church in the amount of
$287,615 for failing to file a corporate tax return for the years in
question. Internal Revenue Code s 6651(a)(1) reads in pertinent part:
In case of failure ... to file any return ... on the date prescribed
therefor ..., unless it is shown that such failure is due to reasonable cause
and not due to willful neglect, there shall be added to the amount required to
be shown as tax on such return 5 percent of the amount of such tax if the
failure is for not more than 1 month, with an additional 5 percent for each
additional month or fraction thereof during which such failure continues, not
exceeding 25 percent in the aggregate.... (emphasis added)
The regulations provide that, to demonstrate reasonable cause a taxpayer must
show that it "exercised ordinary business care and prudence and was
nevertheless unable to file the return within the prescribed time...." 26
C.F.R. s 301.6651-1(c)(1). What elements constitute reasonable cause is a
question of law which we review de novo. United States v. Boyle, 469 U.S.
241, 105 S.Ct. 687, 692 n. 8, 83 L.Ed.2d 622 (1985).
[17][18] The Church argues that the IRS waived its right to impose the
penalty because it accepted the Church's Form 990 and even extended the time
for filing. This waiver, argues the Church, constitutes *1322 "reasonable
cause" for failing to file corporate returns. The taxpayer carries the burden
to show reasonable cause for failing to file the required return. Funk v.
Commissioner, 687 F.2d 264, 266 (8th Cir.1982). The IRS expressly revoked the
Church's tax exempt status in the July 18, 1967 letter which instructed the
Church thereafter to file federal tax returns. We agree with the Tax Court
that "[the Church's] unilateral doubts about [the revocation letter's]
effectiveness are not 'reasonable cause' for its failure to file a proper
return." 83 T.C. at 526.
Secondly, the Church argues that its reliance on the advice of tax
professionals that the Form 990 would be acceptable, constitutes reasonable
cause. The Supreme Court recently held that a taxpayer's failure to file a
timely return, in reliance upon an attorney's advice did not constitute
"reasonable cause" under s 6651(a)(1). Boyle, 105 S.Ct. at 693-94.
Likewise, we hold that a taxpayer's failure to file the proper form, in
reliance upon an attorney's advice is not "reasonable cause" where the IRS has
expressly instructed the taxpayer to file a tax return.
IV.
We affirm the Tax Court decision upholding the Commissioner's revocation of
the Church of Scientology of California's tax exempt status on the ground that
a portion of its income inured to the benefit of L. Ron Hubbard and others. We
reject the Church's argument that the notice of deficiency was constitutionally
and administratively defective. Finally, we uphold the Commissioner's
imposition of a penalty on the Church for failure to file the proper returns.