Rev. Rul. 89-74

1989-1 C.B. 311, 1989-21 I.R.B. 21.

                       Internal Revenue Service

                                 Revenue Ruling

           SUBSTANTIAL UNDERSTATEMENT PENALTY: 'MAIL ORDER' CHURCHES

                            Published: May 22, 1989

Section 6661. - Substantial Understatement of Liability, 26 CFR 1.6661-5: Items relating to tax shelters.

(Also Sections 170, 262, 501:  1.170A-1, 1.262-1, 1.501(c)(3)(1.)

  Substantial understatement penalty: 'mail order' churches. 'Churches' such as those described in Rev. Ruls. 78-232 and 81-94 are 'tax shelters' for purposes of the substantial understatement penalty imposed by section 6661 of the Code. Rev. Ruls. 78-232 and 81-94 amplified.

ISSUE

  Are 'churches' such as those described in Rev. Rul. 78-232, 1978-1 C.B. 69, and Rev. Rul. 81-94, 1981-1 C.B. 330, 'tax shelters' within the meaning of section 6661 of the Internal Revenue Code?

FACTS

  In Rev. Rul. 78-232, the taxpayer, claiming to be a duly ordained minister, formed a 'church.' The original members of the church consisted of the taxpayer, the taxpayer's spouse and two minor children, and a few family friends. The taxpayer was employed full-time by a state government, and continued in this employment after the church was formed. The taxpayer's salary checks were received by the taxpayer and deposited into the church's bank account. The funds from the church bank account, however, were primarily used to furnished the taxpayer with lodging, food, clothing, and other living expenses in a manner comparable to that which the taxpayer previously enjoyed.

  In Rev. Rul. 81-94, a professional nurse formed a 'church' and became its minister by purchasing a 'certificate of ordination' and a church charter from an organization selling such certificates and charters. Pursuant to a vow of poverty, all the nurse's assets, including a house and an automobile, were transferred to the church. In addition, the nurse's wage income was deposited into the church bank account. In return, the church assumed all the nurse's existing liabilities, such as the home mortgage and all outstanding credit card balances. The church also provided the nurse with a full living allowance sufficient to maintain or improve the nurse's standard of living and permitted the nurse to use the house and automobile for personal purposes.

LAW AND ANALYSIS

  Section 501(c)(3) of the Code provides for the exemption from federal income tax of organizations organized and operated exclusively for religious or charitable purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual. Section 1.501(c)(3)-1(d)(1)(ii) of the Income Tax Regulations provides that an organization described in section 501(c)(3) must serve a public rather than a private interest. For example, such an organization cannot be organized or operated for the purpose of benefiting certain designated individuals or the creator or the creator's family.

  Sections 170(a)(1) and 170(c) of the Code provide a deduction for any  'charitable contribution.' A 'charitable contribution' is defined to include a contribution or a gift to or for the use of an organization organized and operated exclusively for religious or charitable purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

  Section 262 of the Code provides, in general, that no deduction shall be allowed for personal, living, or family expenses.

  Section 6661(a) of the Code imposes a penalty if there is a substantial understatement of income tax. The penalty is equal to 25 percent of the underpayment attributable to such understatement.

  Section 6661(b)(1) of the Code provides that a substantial understatement exists if the understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000 ($10,000 in the case of certain corporations).

  Section 6661(b)(2)(B) of the Code provides that the amount of the understatement shall be reduced by the portion of the understatement which is attributable to (i) the tax treatment of any item by the taxpayer if there is or was substantial authority for such treatment, or (ii) any item with respect to which the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return.

  In the case of any understatement attributable to a tax shelter, section 6661(b)(2)(C)(i) of the Code provides that the taxpayer must be able to show that there is or was substantial authority for the tax treatment taken AND that the taxpayer reasonably believed that the tax treatment was more likely than not the proper tax treatment. That section further provides that the adequate disclosure exception in section 6661(b)(2)(B)(ii) does not apply to any item attributable to a tax shelter.

  Section 6661(b)(2)(C)(ii) of the Code and the underlying regulations define the term 'tax shelter,' for purposes of section 6661, to mean a partnership or other entity (such as a corporation or trust), any investment plan or arrangement, or any other plan or arrangement, if the principal purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of federal income tax.

  Section 1.6661-5(c) of the regulations provides that an item of income, gain, loss, deduction or credit will be considered a 'tax shelter item' if the item is directly or indirectly attributable to the principal purpose of a tax shelter to avoid or evade federal income tax.

  Rev. Proc. 89-11, 1989-6 I.R.B. 2, provides, in section 4(a)(4), that merely disclosing 'the name of an organization to which the taxpayer makes a donation and the amount of the donation (for which a charitable contribution deduction is claimed) will not constitute adequate disclosure for purposes of section 6661 of the Code if the taxpayer receives a substantial benefit for the donation shown.' This revenue procedure has no applicability, however, if the organization to which the donation is being made is a 'tax shelter' under section 6661(b)(2)(C)(ii), since the adequate disclosure exception does not apply in such cases.

  In Tweeddale v. Commissioner, 92 T.C. No. 31 (March 22, 1989), the petitioner claimed on his individual income tax return that his income was exempt from tax because he was a 'minister' in the Basic Bible Church of America. For the purchase price of $1200, the petitioner received a letter certifying him to be a minister of the Basic Bible Church, a certificate of ordination, a certificate of Doctor of Divinity, a letter from the 'Archbishop' of the Church outlining the minister's obligations and duties, and a vow of poverty. Petitioner attached the documents to his individual income tax return for 1983. The court concluded that the principal purpose for establishing the ministry was tax avoidance and that the ministry was a tax shelter for purposes of section 6661 of the Code. Accordingly, the adequate disclosure exception to the penalty did not apply.

  Rev. Rul. 78-232 holds that the amount of the salary checks deposited by the taxpayer in the church bank account is not deductible as a charitable contribution under section 170 of the Code on two alternative grounds. First, the contribution is not a 'charitable contribution' within the meaning of section 170 because the transfer was made with the expectation of procuring a benefit in return. Second, the church is not an organization described in section 170(c) because it was operated for the private purposes of the taxpayer and not exclusively for religious or other charitable purposes.

  Rev. Rul. 81-89 holds that the church is not an exempt organization under section 501(c)(3) of the Code because it was operated to serve the private interests of the taxpayer rather than a public interest and therefore was not operated exclusively for religious or charitable purposes. The church was merely a vehicle for handling the taxpayer's personal financial transactions.

  The churches in Rev. Rul. 78-232 and Rev. Rul. 81-94 were formed for the principal purpose of avoiding federal income taxes. These churches thus come within the definition of 'tax shelter' under section 6661 of the Code.

HOLDING

  'Churches' such as those described in Rev. Rul. 78-232 and Rev. Rul. 81-94 are 'tax shelters' within the meaning of section 6661 of the Code. Therefore, in the case of any understatement of income tax attributable to such a church, the adequate disclosure exception in section 6661(b)(2)(B)(ii) is not available to reduce such a taxpayer's understatement of income tax for purposes of applying the substantial understatement penalty.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 78-232 and Rev. Rul. 81-94 are amplified.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Vincent Surabian of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Surabian on (202) 566-4680 (not a toll-free call).

Rev. Rul. 89-74, 1989-1 C.B. 311, 1989-21 I.R.B. 21.