IRS Finds Loophole to Get Church Records

By Raul Rivera

The IRS has found a way of getting church records without having to comply with Section 7611. In Topeka, Kansas, a case brought to light significant challenges involving the interaction of church and federal regulations. At the center of this situation is Pastor Richard Kloos and his congregation at God’s Storehouse (GSH). According to court records, the IRS investigation raised concerns about whether God’s Storehouse functioned primarily as a thrift store business rather than as a church. This aspect of the audit probes into the nature of the organization's activities and their alignment with its declared religious purpose, which is central to its tax-exempt status.

Unlike many religious organizations that apply for 501(c)(3) status, God’s Storehouse has declared itself tax-exempt under Section 508(c)(1)(A). I do not know the reason why pastor Kloos chose to rely on Section 508 for his church’s tax-exempt status. However, it reflects a widespread, yet incorrect, belief among some that section 508 grants exemption by constitutional right, supposedly rendering such entities immune to IRS audits. Again, I want to reiterate that I am not aware of why Pastor Kloos chose not to apply for 501(c)(3) status.

What I want to emphasize is that there is a common misconception that churches that do not apply for 501(c)(3) status are immune from IRS audits due to a constitutional provision of tax exemption. However, this belief is far from the truth.

Adding a layer of complexity to pastor Kloos’ case, there are some who claim that Pastor Kloos's political engagement—marked by his 2020 campaign that resulted in unseating the longest-serving member of the Kansas Legislature—might have also sparked the IRS's interest. As he gears up for reelection in 2024, alongside his wife, Pennie Kloos, who is also campaigning for a state legislative seat in Topeka, the intertwining of his religious leadership and political aspirations raises questions about potential motivations behind the IRS's scrutiny.

Section 7611 defines a detailed structure for IRS audits of churches, imposing strict restrictions on the agency's ability to carry out inquiries and examinations. It specifies the exact process for examining "church records" and sets clear guidelines on the timing and methodology of these audits. Additionally, Section 7611 authorizes the IRS to audit any entity that operates as a church, whether it is officially incorporated, unincorporated, or merely self-identified as such. This includes churches that rely on Section 508.

In Pastor Kloos’ case, The IRS ran into the limitations of Section 7611 and relied on a loophole workaround to obtain church records. Pursuant to 26 U.S.C. §7609, the IRS summoned the church’s bank (Kaw Valley Bank) to obtain the church’s banking records. Pastor Kloos and his church (GSH) claimed the summons was invalid because, before its issuance, the IRS failed to satisfy requirements applicable to church tax inquiries and examinations under section 7611.¹

A three-judge panel of the U.S. Court of Appeals upheld the IRS’s approach, confirming that the agency’s actions to subpoena bank records from God’s Storehouse align with federal law by reasoning that section 7609 is not subject to section 7611 in that the IRS can get the church’s records through third party holders (like banks, accountants, etc.)  by using other statutes that permit such actions.  This decision emphasizes that the specific IRS requirements for initiating church taxation inquiries do not pertain to third-party summons such as those sent to Kansas banks.²

The law needs a fix

To effectively address the loophole in Section 7611, an amendment could introduce a 'comprehensive coverage clause' that explicitly extends the protective measures of this section to all federal tax statutes, including Section 7609. This clause would require that any IRS attempt to access church records through third-party entities like banks must first comply with the rigorous procedural safeguards outlined in Section 7611. Specifically, it would mandate a demonstrable substantiation of reasonable suspicion, articulated in a detailed notice to the church, and a mandatory waiting period for the church to respond, thereby preserving the integrity of church audits and upholding the original protective intent of Section 7611. This approach would create a uniform standard for handling church records, ensuring that their confidentiality and the church's autonomy are not compromised by indirect methods of inquiry.

In the meantime . . .

While we await potential legislative amendments to Section 7611, churches must navigate the existing legal framework with caution. Keep in mind that churches not formally recognized under 501(c)(3) but claiming tax exemption under Section 508(c)(1)(A) have always been susceptible to IRS scrutiny through mechanisms like Section 7609, which allows the IRS to access financial records through third parties. This means that while direct audits on churches are tightly regulated, indirect inquiries can still pose significant risks.

Churches should ensure they are following all applicable federal tax laws. One effective way to do this is by securing formal 501(c)(3) status, which may provide clearer protections by making a public record of the church's activities, programs, doctrines, and initial financial standing. This transparency can be beneficial, in that before initiating an inquiry, the IRS can review the church’s 501(c)(3) application, potentially finding the answers they need and concluding their investigation at that stage.

501(c)(3) status offers better protection

In light of the complexities surrounding federal tax compliance, there is no better time than now to apply for 501(c)(3) status. At startCHURCH, we are the leaders assisting churches with this crucial process. Trusted by thousands of churches nationwide, we have a 100% success rate in obtaining approvals. Our expertise in church-specific language and jargon enables us to clearly translate your church's vision into terms the IRS can understand and appreciate. Secure your church’s future, and take advantage of our proven expertise today. Contact us at 770-638-3444 to get started!

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1. The case is God's Storehouse Topeka Church v. United States, No.23-3063, (10th Cir. Apr. 9, 2024)
   
   In November 2020, Richard Kloos was elected to the Kansas State Senate. During his run, his campaign purchased yard signs that included the words “Founder of God's Storehouse” below his name. The State of Kansas Governmental Ethics Commission vetted and preapproved those signs. According to Richard Kloos, GSH did not “create, purchase, display, distribute, or in any way contribute to any yard signs associated with” his campaign. Kloos further claims GSH did not “intervene in or support [his] campaign for Kansas Senate.”3

   In February 2021, the IRS assigned Kesroy Henry to investigate whether it should initiate a church tax inquiry into GSH for the 2019 and 2020 tax years. In June, Henry issued a Notice of Church Tax Inquiry (“Inquiry Notice”) to GSH after he secured approval from the TE/GE Commissioner.5 The Inquiry Notice informed GSH of four concerns: (1) it potentially operated as a thrift store instead of a church, (2) it may have improperly intervened in a political campaign, (3) its coffee shop may incur liability for unrelated business income tax,6 and (4) the wage payments to the Klooses may incur liability for unpaid employment taxes. Although the Inquiry Notice also requested GSH's responses to a series of questions, it did not request any documents. Nevertheless, GSH responded to the questions and provided copies of documents.

   GSH's responses and documents did not assuage Henry's concerns about GSH's tax-exempt status and potential tax liability. Accordingly, in September of 2021, he obtained approval from the TE/GE Commissioner to initiate a church tax examination.7 Henry then issued to GSH a Notice of Church Tax Examination (“Examination Notice”). The Examination Notice informed GSH about the IRS's continued concerns. It also described church records and activities Henry might need to examine and offered to conduct a pre-examination conference. The following month, GSH's representative met with IRS personnel for the pre-examination conference. Because that conference did not resolve the IRS's concerns, the IRS notified GSH that it would move forward with an examination. Consistent with this determination, a few days later, Henry sent GSH a request for documents, including copies of its bank statements for a two-year period. GSH objected to producing those statements on the grounds the request was overly broad. Although GSH did not provide the requested bank statements, it did provide an extensive list of documents.

   In December 2021, the IRS notified GSH it intended to contact third parties and informed GSH of its right to request a list of people the IRS contacted. In February 2022, the IRS issued a §7609 third-party summons to Kaw Valley. IRS requested bank records for all accounts in GSH's name for the period January 1, 2019, to December 31, 2020. IRS also served a copy of the summons on GSH.

2. IRS argued §7611 was not relevant to the validity of the third-party summons it issued to Kaw Valley. Instead, §7609, together with the decision in United States v. Powell, 379 U.S. 48 (1964), governed the validity of that summons. “The district court denied GSH's petition, concluding (1) the provisions of §7611 do not apply to §7609 third-party summonses; and (2), even if the provisions of §7611 did apply to §7609 third-party summonses, IRS complied with the requirements of §7611(a)(2). Like the district court, we hold the plain language of §7611 makes clear it does not apply to §7609 third-party summonses. Accordingly, it is unnecessary to decide whether the TE/GE Commissioner is an appropriate high-level Treasury official. Exercising jurisdiction pursuant to 28 U.S.C. §1291, this court affirms the district court's denial of GSH's petition to quash. 

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