Opinion ID: 491560
Heading Depth: 2
Heading Rank: 2

Heading: Inurement

Text: 27 Congress conferred tax exemption on churches and other organizations in recognition 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). 28 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. 29 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. 30 The heart of Sec. 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). 31 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). 32 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 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. 4 33 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. 34 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. 35 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. 36 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. 37 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. 38 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. 39 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 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. 40 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. 41 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. 42 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. 43 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. 44 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).. 45 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. 46 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. 47 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. 48 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.