CHURCH OF SCIENTOLOGY OF CALIFORNIA, Petitioner
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3352-78.
United States Tax Court
Filed September 24, 1984.
Petitioner, a Church incorporated in the State of California, was granted tax-
exempt status in 1957 under sec. 501(c)(3), I.R.C. 1954. In 1967 respondent
sent petitioner a letter revoking its exemption following audit of petitioner's
records which was in part sparked by litigation involving the tax-exempt status
of an affiliated Church of Scientology. Subsequent to issuing the letter of
revocation, respondent conducted several audits of petitioner's records for
various tax years and also reviewed the tax status of several affiliated
churches. Petitioner was also investigated by several intelligence groups which
respondent specially formed during 1969 through 1975 to investigate taxpayers
allegedly selected by essentially political criteria. During the period that
petitioner's taxes were under administrative review, petitioner conspired to
prevent the IRS from determining and collecting taxes due from petitioner and
affiliated churches. Petitioner sold religious services, books, and artifacts
according to a fixed fee schedule through its branch churches and franchises.
Petitioner's profits from these sales were not less than $1,494,617.53 in
1970, $881,131.18 in 1971, and $1,707,287.17 in 1972. Petitioner maintained
large cash reserves in a sham corporation and in a bogus trust controlled by
key church officials including petitioner's founder. HELD, petitioner was not
the victim of selective enforcement of the tax laws since the notice of
deficiency was based on valid regulatory considerations. HELD FURTHER, various
other asserted constitutional rights of petitioner not violated. HELD FURTHER,
petitioner was not operated exclusively for an exempt purpose under sec.
501(c)(3), I.R.C. 1954, since petitioner had a substantial commercial purpose,
since its net earnings benefited key Scientology officials, and since it had
the illegal purpose of conspiring to impede the IRS from collecting taxes due
from petitioner and affiliated churches and thus its activities, dictated at
the highest level, violated well-defined public policy.
*382 ROBERT H. HARRIS, CHRISTOPHER COBB, MICHAEL WELLS, and PETER YOUNG,
specially recognized, for the petitioner.
MARTIN D. COHEN, for the respondent.
Petitioner, the Church of Scientology of California (California Church or
Church), was incorporated as a non-profit corporation in the State of
California in 1954. In 1957 respondent recognized petitioner as an organization
described in section 501(c)(3) [FN1] exempt from Federal income taxes under
section 501(a). In 1967 respondent revoked petitioner's tax-exempt status.
Following an extensive audit of petitioner's records for the years 1971-1974,
respondent, by notice of deficiency dated December 28, 1977, determined
deficiencies in petitioner's Federal income taxes and additions to tax as
Addition to tax
Taxable year Deficiency under sec. 6651(a)
1970 $581,245.29 $145,311.32
1971 70,881.48 17,720.37
1972 498,332.10 124,583.02
*383 The controversy in this case is simply stated: Petitioner claims it is
exempt from taxation and respondent claims it is not. Subsumed within this
simple controversy, however, are numerous and complex subsidiary issues
including several challenges to the constitutionality of section 501(c)(3). The
questions presented for resolution in this case are:
1) Is the notice of deficiency null and void because respondent never issued a
final letter of revocation of exempt status?
2) Is the notice of deficiency or the letter revoking petitioner's tax-exempt
status based upon political animus or hostility to the religion of Scientology
in violation of the First and Fifth Amendments?
3) To the express conditions in section 501(c)(3) for exempting religious
organizations from taxation violate the First Amendment because they tax
4) Do the express conditions in section 501(c)(3) for exempting religious
organizations from taxation violate the First Amendment because the Government
has no compelling interest in taxing religious income?
5) Are the express conditions in section 501(c)(3) for exempting religious
organizations overbroad provisions because they restrict commercial activity in
aid of religion which is affirmatively protected by the free exercise clause?
6) Are the express and implied statutory conditions for exempting religious
organizations from taxation unduly vague in violation of the First and Fifth
7) Does section 501(c)(3) violate the establishment clause of the First
Amendment because its enforcement advances some religions and inhibits others?
8) Does section 501(c)(3) violate the establishment clause because its
enforcement results in excessive Government entanglement in church affairs?
9) Does the First Amendment's protection for religious organizations relieve
petitioner of the burden of proof in this case and require respondent to assume
*384 10) Is the statutory scheme prohibiting some tax-exempt organizations
but not others from using their net earning to benefit private interests
arbitrary and capricious?
11) Does the application of common law charitable trust doctrine to churches,
requiring their conformity to fundamental public policy standards evidenced by
criminal or civil statutes, violate the free exercise clause of the First
Amendment because there are less restrictive ways of regulating church-
12) Does the retroactive application of public policy standards derived from
the common law of charitable trusts to petitioner's operations deprive
petitioner of due process of law in violation of the Fifth Amendment?
13) May respondent, consistent with fairness, be heard to argue after the
start of trial the new position that the United Kingdom Church of Scientology
(United Kingdom Church) is a branch of petitioner?
14) During the years 1970, 1971 and 1972 did petitioner's activities include a
substantial commercial purpose?
15) During the taxable years in issue, did any part of petitioner's net
earnings inure to the benefit of any private shareholder or individual?
16) During the taxable years in issue, did petitioner's activities violate
common law standards of public policy applicable to charities and incorporated
in section 501(c)(3)?
17) If petitioner is not exempt from taxation, can the determinations in
respondent's notice of deficiency be upheld?
18) Is petitioner liable for additions to tax under section 6651(a) for
willfully failing without reasonable cause to file corporate income tax
returns (Forms 1120) in 1970, 1971 and 1972?
FINDINGS OF FACT
Some of the facts have been stipulated. They represent a miniscule part of the
record. In some instances, the stipulated facts were contradicted by the
remainder of the record. We, therefore, decline to incorporate in toto the
stipulations of fact in our findings. Instead we have made our own findings
giving weight to the stipulations only where their trustworthiness was not
discredited by the remainder of the record.
*385 Petitioner, the Church of Scientology of California, was incorporated
on February 18, 1954, as a non-profit corporation in the State of California.
When the petition herein was filed, petitioner's principal place of business
was located at 5930 Franklin Avenue, Los Angeles, California. Petitioner was
one of many Churches of Scientology organized worldwide. During the tax years
at issue, 1970-1972, it was considered the 'Mother Church' of all Churches of
Scientology in the United States.
The parties have stipulated that petitioner was organized exclusively for
religious purposes and that petitioner has satisfied the organizational
requirements found in section 1.501(c)(3)-1(b), Income Tax Regs. The Court
adopts this stipulation and finds that petitioner was organized to propagate
the faith of Scientology, a religion founded by L. Ron Hubbard, through such
means as the indoctrination of the laity, the training and ordination of
ministers, the creation of congregations and the provision of support to
affiliates and similar organizations.
Scientology teaches that the individual is a spiritual being having a mind and
a body. Part of the mind, called the 'reactive mind' is unconscious. It is
filled with mental images that are frequently the source of irrational
behavior. Through the administration of a Scientology process known as
'auditing,' an individual, called a 'preclear,' is helped to erase his reactive
mind and gain spiritual competence. A trained Scientologist known as an
'auditor' administers the auditing. He is aided by an electronic device called
an 'E-meter' which helps the auditor identify areas of spiritual difficulty for
the preclear by measuring skin responses during a question and answer session.
Scientology teaches that spiritual awareness is achieved in stages. The
religion defines different levels of awareness and prescribes the requisite
auditing to achieve each level. L. Ron Hubbard researched and developed the
spiritual awareness levels and the courses to train auditors. During the
docketed years L. Ron Hubbard continued this research. A chart entitled
'Classification Gradation and Awareness Chart of Levels and Certificates'
depicts levels of spiritual awareness *386 and corresponding auditor
training requirements in effect in 1970.
One of the tenets of Scientology is that anytime a person receives something,
he must pay something back. This is called the doctrine of exchange.
Petitioner's branch churches applied this doctrine by exacting a 'fixed
donation' for training and auditing.
Scientology is an international religion and during the docketed years there
were numerous Churches of Scientology around the world. These Churches were
organized along hierarchical lines according to the level of services (training
and auditing) they were authorized to provide. Churches which delivered
Scientology services at the lowest levels were called 'franchises' and later
'missions.' Churches which delivered auditing (also referred to as 'processing
') through Grade IV and training through Level IV as depicted on the
Classification Gradation and Awareness Chart were known as 'Class IV Orgs.'
Saint Hill Organizations and Advanced Organizations offered intermediate and
higher level services. A branch of petitioner known as 'Flag' offered the
highest level training and auditing.
Petitioner's branch churches were opened daily and nightly to provide auditing
and training. Petitioner's ministers also officiated at weekly Sunday services
and performed services such as marriages, baptism and funerals.
The parties stipulated to seven divisions. They are:
1) San Francisco Organization (SFO) 2) Los Angeles Organization (LAO) 3)
American Saint Hill Organization (ASHO) 4) Advanced Organization of Los
Angeles (AOLA) 5) Flag Operations Liaison Office (FOLO or FOLO WUS) (prior to
June 6, 1972 known as United States Liaison Office (USLO)) 6) Flag 7) United
States Guardian Office (USGO)
In addition to these seven stipulated divisions, we find that Scientology
Churches and organizations in the United Kingdom (hereinafter collectively
referred to as the United Kingdom *387 Church) were part of the California
Church. Furthermore, the Operation Transport Corporation, Ltd. (also known as
Operation Transport Services, OTC or OTS), a noncharitable Panamanian
corporation, had no true, independent existence apart from petitioner's Flag
A. THE STIPULATED DIVISIONS
The San Francisco Organization (SFO) and the Los Angeles Organization (LAO)
were both 'Class IV organizations.' As such they were authorized to conduct
training through Class IV and auditing through Grade IV as depicted on the
Classification Gradation and Awareness Chart. They were open 7 days a week for
training and auditing and related activities. The American Saint Hill
Organization (ASHO) located in Los Angeles, like SFO and LAO, provided auditing
and training but at higher levels. ASHO also published and distributed
Scientology books, prerecorded tapes, and E-meters throughout the United
States. The staff at ASHO were mostly members of the Sea Organization, an elite
order of Scientologists. The Advanced Organization of Los Angeles (AOLA)
provided high levels of auditing and training to persons who had completed
services at a Class IV organization. The staff at AOLA were mostly Sea
Organization members and the parishioners came from all over the United States
The Flag Operations Liaison Office (FOLO), located in Los Angeles, was an
administrative unit of the California Church. [FN2] It did not provide
religious services except to the staff. FOLO relayed administrative advice
emanating from Flag, the headquarters of the California Church, to other
branches of the California Church and to other Scientology Churches. The staff
at FOLO played a significant role in promoting the growth and development of
Scientology by providing training to staff from other organizations, by
supervising the implementation of new programs developed at Flag, and by
providing administrative assistance to new organizations. FOLO also relayed
funds from other branches of the California Church and from other churches to
Flag. The staff at FOLO were members of the Sea *388 Organization. Other
Scientology Churches in the United States and abroad had counterpart FOLO
Flag was the highest division of the California Church. It provided spiritual
leadership. It also acted as petitioner's administrative center. During the
taxable years, the Flag division was headquartered aboard a ship, the Apollo,
which cruised the Mediterraneen Sea and docked in various countries along its
shores. L. Ron Hubbard, his wife, Mary Sue, and their family lived on the
Apollo with other members of the ship's crew and staff. All staff and crew were
Sea Organization members. Flag also had two outposts: The Tangier Reception
Center (TRC) and the Mission European Agency (MEA). MEA served as a relay point
for personnel, deliveries, and communications going to Flag, and TRC, among
other things, housed the overload of students who came to Flag for training.
Flag activities fell into three general areas, each conducted by a separate
organization within Flag. The Flagship Organization was responsible for all
nautical functions--sailing, maintenance and port relations. The Flag
Administrative Organization provided religious and administrative training and
auditing at the highest levels. The majority of the students who came to Flag
for training were staff members sent from petitioner's other divisions or from
other Churches of Scientology. Students lived aboard the ship or stayed at TRC.
After completing their course work they generally returned to their local
The Flagship Bureau was petitioner's management body. This management function
was fulfilled in a variety of ways which are only briefly recounted here.
First, petitioner's other divisions and other Churches sent reports on a
regular basis to Flag. These reports supplied information, often in statistical
form, about the organizations' operations. Flag staff, on the basis of their
review of these reports, issued policy letters, directives and other kinds of
administrative advice geared to improving local church operations. Second, Flag
personnel researched and developed programs and techniques for improving the
administration of local organizations. Finally, Flag sent teams of individuals
specially trained in management techniques 'on mission' to help other units or
churches which were experiencing difficulties.
*389 L. Ron Hubbard officially resigned his position as executive head of
the California and other Churches of Scientology in 1966. Despite his official
resignation various charts of petitioner depicting management functions during
the docketed years continued to place him in the top position. He also held the
rank of Commodore, the highest rank in the Sea Organization, which was an elite
fraternity of Scientologists. He kept control over the California Church policy
by authoring numerous policy letters and by allowing others to go out in his
behalf. He also wrote other types of policy directives including Flag Orders,
L. Ron Hubbard Executive Directives, and Orders of the Day. He made important
decisions affecting Church administration, transferring U.S. Pubs from the
Denmark Church to ASHO and disbanding the Executive Council Worldwide which had
overseen the day-to-day operations of the Church. He supervised the activities
of the Franchise Office. Staff consulted with him before inagurating major
plans and whenever an operation of the Church was foundering.
L. Ron Hubbard's control over petitioner's financial affairs was particularly
notable and was longstanding. In the years immediately preceding the taxable
years, L. Ron Hubbard was a signatory on all Churches of Scientology bank
accounts including petitioner's. His approval was required for all financial
planning. He was the sole 'trustee' of a major Scientology fund into which
petitioner made substantial payments. He decided to open Swiss bank accounts
for petitioner and to put them in the name of OTC. He sent a Flag executive to
AOLA to revamp its financial operations. He authorized the purchase of a ranch
in Ensenada, Mexico and wrote a check for $80,000 on one of petitioner's Zurich
accounts for its purchase. His control continued during the docketed years. He
remained a signatory on petitioner's bank accounts including the OTC accounts.
His approval was required for financial planning. He authorized the removal of
huge sums of money from petitioner's Swiss bank accounts maintained in the name
Apart from his executive duties, L. Ron Hubbard also engaged in research and
writing and supervised auditing.
During the docketed years L. Ron Hubbard was served by an executive group
variously known as the Commodore's Staff *390 Aides, the Aides Council, and
the International Board of Scientology Organizations. Mary Sue Hubbard was the
senior person on the Aides Council. The Aides Council had seven other members,
one to oversee the planning for each division on the Scientology Org. Board.
The Org. Board is a theoretical model or blueprint of the organization of a
Scientology Church. All Scientology Churches around the world were organized
along similar lines. The Org. Board shows that each Scientology Church was
organized to have seven divisions and that each division carried on a specific
function. Division 1, called the HCO Division, was responsible for
communications. Division 2, called the Dissemination Division, was responsible
for the dissemination of Scientology literature, materials, and services.
Division 3, called the Treasury Division, was responsible for finances.
Division 4, called the Technical Division, was responsible for training and
auditing. Division 5, called the Qualifications Division, was responsible for
quality control in the delivery of services. Division 6, called the
Distribution Division, was responsible for public relations and Division 7, the
Executive Division, was responsible for managing the organization and
coordinating the programs and policies of the other divisions on the
Scientology Org. Board. A member of the Aides Council called a 'CS-1, CS-2,'
etc., depending on the area of divisional responsibility, was in charge of the
overall planning for each division. In sum, the Aides Council helped L, Ron
Hubbard manage petitioner's operations and plan for Churches of Scientology
around the world.
The CS-3 on the Aides Council was in charge of a Flag Banking Officer network.
Each Scientology Organization offering advanced services had a Flag Banking
Officer (FBO) who banked the organizations funds, reviewed and approved its
weekly financial plan and generally monitored its financial affairs. The FBO's
primary responsibility was to insure his church's solvency. The FBO was also
responsible for collecting and sending to Flag weekly sums for support and
training. The FBO network was international. During the taxable years in issue,
the following branches of petitioner's stipulated divisions had an FBO: AOLA,
ASHO, USLO, and Flag. A precise description of the FBO chain of command does
not emerge from the record. However, it is clear that the top officials of the
FBO network were the Flag FBO, the Staff Banking *391 Officer (SBO), and the
CS-3, all posted at Flag. The continental FBOs operated over the local FBOs,
under the authority of the top officials of the network. At least during 1969,
and perhaps during the docketed years, the FBO International, posted at AOLA,
also exercised mid-level leadership.
The United States Guardian Office (USGO) located in Los Angeles was in charge
of petitioner's external affairs. Its chief responsibility was to safeguard
petitioner's institutional well-being. Towards this end it performed a number
of functions. It handled petitioner's relations with other organizations
including governmental bodies and agencies. It also handled legal matters for
petitioner and other Churches of Scientology in the United States. It performed
accounting services for petitioner and prepared petitioner's tax returns. It
informed the public on a national level about the works and doctrines of
Scientology and documented unfavorable or inaccurate public comment on
Scientology. During the docketed years, the United States Guardian Office had
five divisions: Legal, Public Relations, Finance, Intelligence and Technology.
The United States Guardian Office was part of an international network of
Guardian offices and Guardian personnel. The highest ranking Guardian was Mary
Sue Hubbard, L. Ron Hubbard's wife. She held the position of Commodore Staff
Guardian (CSG). Although Mary Sue Hubbard lived on the Apollo and was the
senior Guardian, the senior Guardian office, called the Guardian Office
Worldwide, was part of petitioner's United Kingdom operations. Jane Kember, the
Guardian Worldwide, headed the office. In addition to USGO and the Guardian
Office Worldwide, the Guardian network consisted of Guardian personnel attached
to other branches of the California Church and other Churches of Scientology.
B. UNITED KINGDOM CHURCH
The notice of deficiency issued on December 28, 1977 did not treat the United
Kingdom Church as a branch of petitioner. It did not include the accounts of
the United Kingdom Church, and specific transactions between the two Churches
were treated as transactions between separate entities. Thus, payments made by
the United Kingdom Church to petitioner's Flag branch were shown as income to
petitioner and not as internal transfers of funds. Respondent's pretrial
pleadings and memoranda, reflecting the notice of deficiency, also
*392 treated the United Kingdom Church as a separate entity from petitioner.
The trial of this case began on November 10, 1980 and lasted 10 weeks spread
out over the course of a year. [FN3] The relationship between petitioner and
the United Kingdom Church was first raised during the third week of trial, on
December 11, 1980, immediately after petitioner rested its case-in-chief.
Respondent raised the issue when he sought to introduce into evidence certain
checks representing franchise payments drawn by the Calgary Scientology Mission
and variously made payable to the Church of Scientology of California or the
Church of Scientology of California, WW. Since Worldwide, or its abbreviation
'WW', was a name used by the United Kingdom Church, respondent sought to show
by these checks and other evidence that the United Kingdom Church was a branch
of petitioner. On December 12, 1980, the second day of respondent's case,
respondent again pressed the Court to hear evidence relating to the United
Kingdom Church. Respondent disavowed any intention of seeking an increase in
the notice of deficiency by reason of the United Kingdom Church's income.
However, respondent urged the Court to entertain the matter on the limited
issue of petitioner's entitlement to tax-exempt status. Respondent proffered
three theories of relevance. First, the franchises managed by the United
Kingdom Church were a commercial operation. Second, petitioner's attempt to
conceal the corporate status of the United Kingdom Church was one more link in
the chain of activities making up petitioner's conspiracy to obstruct the
Internal Revenue Service (IRS or Service). Third, L. Ron Hubbard possibly
benefited from the money deposited in the Worldwide franchise accounts.
As the trial progressed, respondent, on February 9, 1981 and again on April 9,
1981, stated his intention to reduce the scope of his reliance on matters
relating to the United Kingdom Church so that on April 9, 1981 respondent said
he planned to use the matter solely as it was relevant to proving petitioner
conspired to obstruct the IRS. However, respondent quickly retracted this
decision the following day. On July 20, *393 1981, the first day of the
seventh week of trial, this Court ruled that respondent could present evidence
relating to the United Kingdom Church's activities and corporate status under
three theories of relevance: commercialism, inurement and conspiracy.
Petitioner began its rebuttal case on August 17, 1981. With continuances
petitioner completed rebuttal on November 12, 1981. During rebuttal, petitioner
presented documentary and testimonial evidence directed toward refuting loss of
tax-exempt status as a result of the United Kingdom Church's operations.
Respondent knew that his claim that the United Kingdom Church was a branch of
petitioner made the determination in the notice of deficiency, treating
payments from the British Church to OTC as Flag income, erroneous. He was aware
that his new position would therefore necessitate a hearing under Rule 155 to
recompute the notice of deficiency. Respondent consistently disavowed any
intention to use the income from the United Kingdom Church to increase the
notice of deficiency.
By the end of 1974, respondent's files contained documents from various
sources identifying the United Kingdom Church as a branch of petitioner. One
such document was a report entitled 'Enquiry Into the Practice and Effects of
Scientology' (Foster Report) prepared for the House of Commons in the United
Kingdom on December 21, 1971 by Sir John G. Foster, K.B.E., Q.C., M.P. The
report quoted part of a letter from British Scientologists which stated:
The main activities of Scientology in the United Kingdom are carried on by the
Church of Scientology of California (non-profit Corporation in California
registered under Part X of the Companies Act) with its branches at St. Hill
Manor, London, Brighton, and Swansea. (Foster Report at 26.)
The report also reprinted in full a policy letter written by L. Ron Hubbard
explaining the financial considerations which led the California Church to take
over the United Kingdom Scientology organization and detailing the history of
the transfer. The files of the IRS also contained balance sheets for the fiscal
years ended April 5, 1967 and April 5, 1968, which the California Church had
filed with the Registrar of Companies in the United Kingdom in order to conduct
its operations there. The balance sheets were headed:
*394 CHURCH OF SCIENTOLOGY OF CALIFORNIA
A company incorporated in the State of California, U.S.A. and registered
under Part X of the Companies Act 1948 on 29th March 1966 and not having a
In March 1975 respondent audited the Church of Scientology of Hawaii (Hawaii
Church). This audit was immediately followed by a year-long audit of the
California Church's 1971-1974 tax years. During these audits respondent
reviewed letters, checks, receipts, and disbursement vouchers, some bearing
such names as Church of Scientology of California UK, Church of Scientology of
California WW, Church of Scientology Worldwide, Publications Org. WW, or HCO WW
as a name on the letterhead or as the endorsement or payee. A few letters and
receipts bore petitioner's name in bold print on the letterhead and the words
'a non-profit corporation in U.S.A. Registered in England' in fine print across
A few documents prepared by the IRS show that some of respondent's employees
knew that the United Kingdom Church was a branch of petitioner. The chief of
respondent's Foreign Operations Division in a memorandum to the chief of the
Audit Division, Honolulu District Office, dated November 18, 1966 stated:
The Hubbards attempted to organize a British corporation as a religious non-
profit organization, but the British tax authorities refused to grant the
corporation tax free status. They then organized the Los Angeles corporation
and they now carry on their British operations as a part of that corporation.
Respondent's representative in London reviewed the documents petitioner filed
with the Registrar of Companies in Great Britain. In a memorandum dated
November 18, 1974, transmitting these documents to respondent's Refund
Litigation Division, he concluded that the accounts of the United Kingdom
Church could be incorporated with petitioner's for tax purposes. At least two
other reports prepared by respondent's representatives show knowledge that the
California Church was registered to conduct operations in Great Britain. One of
these reports was distributed to a Scientology Task Force in December 1974. A
report prepared by Service personnel after auditing the Hawaii Church in March
1975 tentatively concluded that the Publication Org. WW, a Scientology
*395 organization operating in the United Kingdom, was a division of the
Lewis J. Hubbard, Jr. served as respondent's advisory on Scientology matters
from middle or late 1974 until July 1977. During this period Lewis Hubbard held
the position of Staff Assistant to the Associate Chief Counsel (Litigation).
Lewis Hubbard directly oversaw the exempt function audit of the Hawaii Church
which took place in March 1975 (Hawaii audit) and served as the National Office
advisor during the year-long audit of petitioner's 1971-1974 tax years (1971-
1974 audit). Before overseeing the Hawaii audit Lewis Hubbard read a few
documents which either explained that the United Kingdom Church was a branch of
petitioner or perhaps made passing reference to this fact. He read the Foster
Report. He saw petitioner's certificate of incorporation which it filed with
the Registrar of Companies in the United Kingdom in order to operate there. He
also skimmed one transmittal memorandum dated November 18, 1974 from
respondent's London representative which opined that the United Kingdom
Church's accounts could be incorporated with petitioner's for tax purposes.
However, Lewis Hubbard did not recall reading that portion of the memorandum.
During the Hawaii audit, Lewis Hubbard questioned Joel Kreiner, a Church lawyer
and high-ranking Guardian official, about the status of the United Kingdom
Church. Kreiner told Lewis Hubbard that petitioner incorporated the United
Kingdom Church but it operated separately and independently. After overseeing
the Hawaii audit, Lewis Hubbard authored a report in which he tentatively
concluded that the Publication Org. WW was a division of the California Church.
Following the 1971-1974 audit, Revenue Agent Eugene Endo, on the advice of
Lewis Hubbard, changed some wording in a draft of his report of the audit. The
original version said that the audit disclosed that petitioner had seven
branches and then listed them. The final version again stated that petitioner
had seven branches but inserted the phrase 'California's submission outlined
the seven branches as follows: :' before listing them.
On most occasions when the subject arose, petitioner misled respondent about
the legal status of the United Kingdom Church. In 1967 respondent asked
petitioner to list its subordinate churches. Petitioner's reply letter did not
mention *396 the United Kingdom Church. [FN4] Again, during the 1971-1974
audit, respondent twice asked petitioner to list its divisions. Petitioner did
not mention the United Kingdom Church. Petitioner was dissatisfied with
respondent's report of the audit and so wrote its own report correcting what it
viewed to be respondent's errors. Petitioner's version did not list the United
Kingdom Church as a branch church. On the first day of trial petitioner and
respondent filed Stipulation of Facts (Set Number 3) listing the divisions of
the Church. The United Kingdom Church was not listed. [FN5] During the 1971-
1974 audit, respondent asked for an explanation of several FOLOs including the
FOLO in the United States (FOLO WUS) and the FOLO in the United Kingdom (FOLO
UK) and was told that FOLO WUS was part of petitioner but FOLO UK was part of
an overseas Church. Also when respondent asked for a list of petitioner's bank
accounts, none of the United Kingdom accounts were listed in petitioner's
response. The Church's report of the 1971-1974 audit, in discussing the United
Kingdom Church's alleged debt repayment to OTC, named several British
Scientology organizations and stated they were 'part of the corporate entity of
the UK Church.' Prior to trial, respondent subpoenaed the records of the United
Kingdom Church bank accounts used to deposit franchise payments. Objecting to
the subpoena, petitioner in open court said:
The accounts referred to there are not accounts of the Church of Scientology
of California and they are not in its custody and control. It is true that the
accounts bear the name Church of Scientology of California Worldwide but they
are actually accounts of the United Kingdom Church of Scientology which until
two years ago, as I understand it, was incorporated as the Church of
Scientology of California but never, ever was a part of the Church of
Scientology of California that's involved in this case.
Those accounts have had nothing to do with the Church of Scientology of
California involved in this case.
The United Kingdom Church was formally organized as a branch of petitioner in
1966 when the assets of the Scientology organizations in the United Kingdom
were conveyed to petitioner *397 which then registered to do business in the
United Kingdom as a foreign corporation under the Companies Act of 1948, 11
Geo. 6, Ch. 38. Tax considerations partly motivated the transfer. British
authorities would not grant tax-exempt status to local Scientology
organizations. Petitioner therefore took over the assets of those organizations
so that they could carry on under petitioner's tax-exempt mantle.
The United Kingdom Church purported to have its own board of directors.
Anthony Dunleavy, a high-ranking church official who served as a Commodore
Staff Aide during the docketed years, testified about his tenure on the board
preceding the docketed years. He gave three different versions of his term on
the board, changing dates as he was confronted with conflicting documentary
evidence. By the end of his testimony he had completely changed his initial
statement regarding the dates of his tenure. He was also evasive about who were
the prior members of the board. At first he claimed not to know who they were.
Then confronted by one of respondent's exhibits, he claimed his memory was
refreshed and listed the prior members. Testimony about board membership during
the docketed years was also conflicting, one Church witness naming one set of
members and another Church witness naming a different set except for one common
member. A few board minutes were placed in evidence. Two of these are
captioned 'Church of Scientology of California' and refer in their text to
officers of the United Kingdom Church as 'Directors of the Church of
Scientology of California.' The Franchise Office was a major division of the
United Kingdom Church. The board of the United Kingdom Church did not have
final authority for its management. Diana Hubbard, L. Ron Hubbard's daughter
and a Commodore Staff Aide, had the final authority.
The California Church and the United Kingdom Church shared responsibility for
the franchises. The California Church issued the franchise charters, [FN6] gave
them some legal advice, *398 served occasionally as an intermediate
collection point for franchise payments and ultimately established franchise
policy. For its part, the United Kingdom Church collected weekly tithes and
operating reports, distributed policy letters, and gave day-to-day operating
United Kingdom Church officials were signatories on the California Church's
accounts and vice versa. Mary Sue Hubbard was authorized to sign checks on
virtually all the United Kingdom Church accounts, including Church of
Scientology of California Rubric Worldwide Account Number 292236 at the Swiss
Bank Corporation in Zurich, Switzerland where franchise tithes were deposited.
Denzil Gogerly, who by all accounts was a member of the board of directors of
the United Kingdom Church during the docketed years, was sole signatory on
petitioner's accounts. He signed checks on SFO's and USGO's accounts. Jane
Kember, the highest ranking official in the United Kingdom Church's Guardian
Office, was also a sole signatory on petitioner's accounts. Herbie Parkhouse,
the Deputy Guardian of Finance in the United Kingdom Guardian Office, issued
checks on the United States Guardian Office account.
The Guardian Offices of both churches were also interconnected. Mary Sue
Hubbard at Flag was the chief executive for both offices. Furthermore,
sometimes both offices collaborated and jointly issued policy directives on
behalf of L. Ron Hubbard or the California board of directors.
For part of the docketed years the United Kingdom Church tithed to the United
States Churches of Scientology Trust. The trustors of this purported trust were
all Scientology Churches in the United States. Petitioner was a trustor.
The United Kingdom Church had several divisions. These were: Worldwide; the
Hubbard College of Scientology, St. Hill; the Hubbard College of Scientology
St. Hill Foundation; Advanced Organization United Kingdom; London Day; London
Foundation; Plymouth; Brighton; and Swansea. Worldwide in turn had several
departments: the Executive Council Worldwide, the Franchise Office Worldwide,
the Guardian Office Worldwide, and the Flag Operation Liaison Office, United
Kingdom (FOLO UK). In 1971 the United Kingdom Church underwent some
reorganization. The Executive Council Worldwide was officially disbanded. The
Hubbard College *399 of Scientology, St. Hill merged with the Hubbard
College of Scientology St. Hill Foundation. The FOLO UK split off from
C. OPERATION TRANSPORT CORPORATION, LTD.
The Operation Transport Corporation, Ltd., was a L. Ron Hubbard and
petitioner. It's board of directors lacked bona findes. Panamanian corporation
incorporated by L. Ron Hubbard, Mary Sue Hubbard and Leon Steinberg on February
17, 1968. It was not organized as a non-profit corporation. No shares of stock
OTC was a sham corporation controlled by L. Ron Hubbard, Mary Sue Hubbard and
Leon Steinberg were the original directors of OTC. They resigned immediately
after the corporation's formation and were replaced by Brian Livingston, Joyce
Popham and Barry Watson. All three of these individuals were Flag employees.
Joyce Popham was the secretary to L. Ron Hubbard's personal aide. Barry Watson
and Brian Livingston were Class-10 auditors and served on the Aides Council.
During the docketed years, these three individuals performed only one board
function. Sometime in the summer of 1972 they approved L. Ron Hubbard's
decision to transfer approximately $2 million from OTC bank accounts in
Switzerland to Apollo. That they even performed this function is questionable
since there are no minutes of the board meeting adopting a resolution
authorizing the transfer. A signature card for petitioner's account number 6919
at the Crocker-Citizens National Bank in Los Angeles, California underscores
the lack of substance of the OTC board of directors. It certifies that on
November 18, 1968 the board of directors of the 'O.T.S., Advanced Organization
Church of Scientology of California' authorized the signatories listed on the
card to sign checks on behalf of the corporation.
OTC purportedly performed banking services for Flag. However, the record shows
that OTC had no offices, officers, or employees and that Flag employees were
actually the ones who handled all of petitioner's financial activities. During
the docketed years petitioner deposited Flag division funds in accounts
maintained in the name of OTC. The signatories on the OTC accounts were all
Flag employees. Except for Joyce Popham, who apparently never wrote a check,
they had no connection with OTC. Besides keeping the checkbooks, Flag
*400 officials, not OTC personnel, directed the flow of funds into and out
of OTC accounts, receipted money for the support of Flag operations and
controlled and managed Flag expenditures. Furthermore, Flag officials did not
differentiate between Flag and OTC invoices and disbursement vouchers when they
recorded Flag receipts and expenses.
L. Ron Hubbard and Mary Sue Hubbard controlled OTC funds. L. Ron Hubbard
initiated the practice of depositing Flag funds in OTC bank accounts. Sometime
before the Apollo went to Corfu in August 1968, he directed a Flag official to
travel to Zurich, Switzerland to open bank accounts in the name of OTC. At that
time two numbered accounts were opened. They were account number 295,728 and
account number 295,728.1. During the taxable years in issue the major share of
OTC funds were banked in those accounts. There were other OTC accounts. L. Ron
Hubbard was a signatory on all the major OTC accounts. In the summer of 1972,
L. Ron Hubbard authorized the transfer of approximately $2 million in cash from
OTC accounts 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.
To avoid harassment, Flag officials on board the Apollo were instructed to
tell strangers they were employed by OTC and that OTC was a management company.
This cover story was first used in March 1969 when the Apollo was suddenly
asked to leave Corfu, Greece. It was formalized in a Flag Order dated December
D. THE SEA ORGANIZATION
The Sea Organization was a fraternal organization of elite Scientologists. Its
membership consisted of persons who dedicated their lives to work fulltime for
Scientology. Sea Organization members signed a 'contract of employment'
pledging to work for the Sea Organization for a billion years. Sea Organization
members were frequently sent on missions to Scientology organizations
throughout the world to handle problems interfering with the effective
administration of the organization and the delivery of Scientology services.
Organizations mostly or entirely staffed by Sea Organization members were
called 'Sea Org. Orgs.' The following divisions of petitioner were Sea Org.
Orgs.: Flag, ASHO, AOLA, and *401 FOLO. The leadership of the Sea
Organization came from petitioner's Flag Division.
California Church officials administered the Church in accordance with written
policy directives called 'issues.' There were several different kinds of issues
classified by a combination of factors including author, period of
effectiveness, and designated audience. The most important issue was called a
Hubbard Communications Office Policy Letter (HCO PL or policy letter). These
issues were usually written by L. Ron Hubbard. Sometimes, however, they were
written by a high-ranking Scientologist with L. Ron Hubbard's approval or the
approval of the Aides Council (also known as the International Board). Policy
letters set basic administrative policy. They took precedence over all other
types of issues. Each policy letter was dated and had a legend showing its
designated area of distribution on the upper left-hand corner of the first
page. Policy letters were intended to remain in full force and effect until
officially cancelled or modified by another policy letter.
Initially policy letters were distributed individually in looseleaf form or in
packets called 'hat-packs.' Beginning in 1970 a Scientology organization in
Denmark began to compile the policy letters and publish them by subject matter
in a comprehensive set of volumes called the Organization Executive Course or
'OEC.' The project took years to complete. Individual volumes were published as
they were completed. By 1974 petitioner published the complete nine volume
work. Most of the policy letters in the OEC series contain information about
Church administrative practices but some contain instructions on religious
practice. As previously found, a typical Scientology church has seven operating
divisions. The OEC volumes are organized so that volumes 1 through 7 of the
series each contain policy letters relating to the management, operation and
activities of a corresponding division of a Scientology church. Volume 0 of the
OEC series is an introductory volume. It contains policy letters describing
basic staff duties and responsibilities and the rudiments of Church structure
and organization. The Management Series volume contains policy letters relating
to data collection, public *402 relations, personnel practices, operational
control, finances, executive duties, and the establishment of churches. The OEC
series does not contain every policy letter. The OEC volumes indicate in
brackets when a policy letter has been formally cancelled or amended. Some HCO
PLs fell into desuetude without being officially cancelled. [FN7]
There were other types of policy issues besides policy letters governing
petitioner's administrative practices. In addition to writing policy letters,
L. Ron Hubbard also wrote executive directives called L. Ron Hubbard Executive
Directives (LRH EDs). These communicated short-range orders and directions and
described current projects and programs. They were generally written for a
limited audience such as a specific organization, region or staff position. LRH
EDs were only valid for a year and then they automatically expired. Guardian
Orders were another type of issue. They set policy for the Guardian Offices and
Guardian staff of the Churches of Scientology including petitioner. Guardian
orders were issued by the authority of Mary Sue Hubbard or Jane Kember, the
Guardian Worldwide Guardian Orders did not expire automatically. Flag Orders
set policy for Scientology Sea Organizations including the following divisions
of petitioner: Flag, FOLO, ASHO, and AOLA. Most Flag Orders were written by L.
Ron Hubbard or with his approval. Flag Orders did not automatically expire at
the end of a fixed period.
Another type of issue was the Order of the Day (OOD). The commanding officer
of every church unit was supposed to write an OOD daily. This form of issue was
used to communicate newsworthy events, to promulgate daily schedules, and to
publicize plans and directions for current programs and projects. The first
section of the Flag Order of the Day was reserved for communications from L.
The front piece of each volume in the OEC contains a partial disclaimer
stating that the policy letters 'should be construed only as a written report
of * * * (L Ron Hubbard's) research and not as a statement of claims made by
the Church or the author.' Despite this disclaimer the California Church
clearly adopted and utilized the policy letters. Each California Church
*403 staff member had a folder of materials called a 'hatpack' describing
the duties of his position and the place his position occupied in the
organization's structure. The hatpack contained policy letters. Staff members
were expected to read the hatpack materials and were quizzed on their contents.
Sometimes the failure to follow a policy letter inspired a quiz on the hatpack
materials. California Church members also studied policy letters in work-
training courses they were encouraged to take. One course, the OEC course
offered by most of petitioner's branch churches, was entirely devoted to the
study of the OEC volumes. It required 2- 1/2 weeks of study for each volume.
The Franchise Office Worldwide distributed policy letters to franchise holders
for use in running the missions, and Flag distributed them to the local
churches for guidance. In the Flag Division every crew member received and was
required to read the Flag OOD and Flag Orders.
One of the guiding principles of Scientology is that most organization
problems arise from the failure to follow policy. True policy was strictly
limited to the written policy found in the official issues such as HCO PLs,
Flag Orders and Executive Directives. California Church members were taught
that if a directive was not in writing based on official policy, it was not to
be believed. California Church officials were expected to know the contents of
HCO PLs and to follow them. One high ranking official referred to policy
letters on an average of once a day for guidance. The failure to follow policy
was an offense for which a California Church member could be disciplined
particularly if the failure resulted in monetary loss or bad publicity. There
is no evidence in the record that this happened. California Church officials
did not always robotically implement policy. If a particular policy was
questionable, staff consulted higher officials, usually in writing, to
determine a more favorable course of action. Franchise holders providing
services to the public had more freedom to disregard policy directives than
On January 2, 1957 respondent recognized petitioner as an organization
described in section 501(c)(3) exempt from income tax under section 501(a).
Petitioner's tax-exempt status was reconfirmed on November 16, 1964. In August
1965 respondent *404 examined petitioner's records for the taxable year 1963
and concluded that petitioner was a church; that petitioner received income by
selling books and E-meters and by providing spiritual counseling and training;
and that petitioner paid royalties to the L. Ron Hubbard Trustee Account for
the use of Scientology books and materials. After the examination, respondent
again confirmed the tax-exempt status of the California Church.
In 1966 respondent again reviewed petitioner's tax status by examining
petitioner's Annual Information Returns (Forms 990-A) for 1964 and 1965. The
record does not disclose what concerns prompted the examination. Following the
examination, respondent sent petitioner a letter on July 29, 1966 recommending
revocation of petitioner's tax-exempt status. The letter stated three bases for
the recommendation: (1) the California Church's income was inuring to the
benefit of Scientology practitioners; (2) the Church's activities were
commercial; and (3) the Church was serving the private interests of L. Ron
Hubbard and Scientology practitioners. The California Church was accorded the
right to protest the recommendation and to submit documents in support of its
protest. An informal conference was held in the Los Angeles District Office and
the proposed revocation was affirmed. A conference was then held in the
National Office on June 15, 1967 and again the proposed revocation of exemption
was sustained. One month later on July 18, 1967 respondent issued a formal
letter of revocation which repeated the same three grounds of revocation as had
been stated in the original recommendation. Respondent published the revocation
in the Internal Revenue Bulletin and removed petitioner from its cumulative
list of organizations qualifying under section 170 for deductible charitable
contributions. Petitioner was advised that it was required to file Federal
income tax returns.
Sometime in the fall of 1966 the Department of Justice asked respondent to
review the tax status of several Scientology churches including petitioner. The
request was made as the Department of Justice prepared to defend a case against
the Founding Church of Scientology (Founding Church) in the United States Court
of Claims. In that case, the Founding Church sued for refund of its Federal
income taxes which it had paid after its tax-exempt status had been denied. The
*405 exemption was denied on the grounds that the Founding Church was
organized and operated as a commercial venture benefiting private interests and
that Scientology did not serve a religious purpose. [FN8] Believing that
respondent's recognition of the tax-exempt status of other Churches of
Scientology was inconsistent with the defense of the Founding Church case, the
Department of Justice asked respondent to investigate the matter and rescind
recognition of all similar Churches of Scientology prior to the trial of the
Founding Church case.
In response to this request respondent reviewed the tax status of several
Scientology churches in addition to petitioner whose tax status was already
under review. In the spring of 1967, as the trial of the Founding Church case
approached, pressure to expedite proceedings relating to these churches
increased. In some cases, denial or revocation of exemption was proposed.
However, the record is silent with respect to what, if any, final adverse
action was taken against these churches, besides petitioner, prior to the trial
of the Founding Church case. Years later the tax status of some of these
Scientology churches was still under administrative review.
During 1966 and 1967 a few of respondent's agents spoke critically of
Scientology or circulated reports calling it a medical quackery; evil; a threat
to the community, medically, morally and socially; a pseudo-religious
organization; a grab-bag of philosophical voodooism; and a prey on the public
pocketbook. These comments were not made by agents in respondent's Exempt
Organizations Division--the division charged with reviewing petitioner's tax
status. However, agents in respondent's Exempt Organizations Division were
privy to memoranda containing these comments and to materials critical of
Although petitioner was advised that it was required to file Federal income
tax returns (Forms 1120), it refused to do so and continued to file Annual
Information Returns (Forms 990). During 1969 and 1970 Revenue Agent Woodrow
(Woody) Wilson examined petitioner's records for the taxable years 1964-1967 to
determine petitioner's tax liability and review its *406 tax status. A
second agent Robert Cluberton tried to audit petitioner's records for the
taxable years 1968 and 1969. Petitioner resisted this second audit claiming a
right to be free from successive audits until its protest of the 1964-1967
audit, including the denial of its tax-exempt status, was finally resolved.
On June 7, 1974 respondent mailed a notice of deficiency to petitioner for the
taxable years 1965 through 1967. The deficiencies were:
TYE Dec. 31-- Deficiency
1965 ....... $2,614.19
1966 ........ 5,041.03
1967 ....... 13,946.30
Petitioner filed a timely petition in the Tax Court for the 1965 deficiency.
In late 1976 respondent settled the case by conceding petitioner's tax-exempt
status for that year but without prejudice to any other year. Respondent also
decided not to litigate any cases against petitioner prior to the 1968 taxable
year and closed the 1966 and 1967 tax years on the basis of 'no change.'
Returning to 1974, respondent, by the end of the year, was occupied with a
number of Scientology matters. [FN9] Representatives of the California Church,
respondent and the Department of Justice met at a conference in Washington,
D.C. on February 14, 1975 to try to settle some of these matters without
resorting to litigation. No agreement about substantive issues was reached, but
the representatives did establish a procedure for handling some of the ever
mounting tax matters. First, the parties would temporarily suspend litigation.
Second, respondent would examine the Hawaii Church to determine whether it
qualified as a tax-exempt organization. Third, the ruling with respect to the
Hawaii Church would govern all Churches of Scientology organized and operated
in a similar fashion. Fourth, respondent would examine the California
*407 Church and any other church that differed from the normal pattern and
determine what effect, if any, these differences in operation or organization
had on the organization's qualification for tax-exempt status. [FN10]
The audit of the Hawaii Church was an exempt function audit covering the tax
years 1965 and 1966 through 1974. The audit lasted approximately 2 weeks.
Following the audit of the Hawaii Church the IRS asked the Church and several
similarly situated churches to submit determination applications, Forms 1023.
This was done and the IRS set up a special group to process the applications.
The Hawaii Church received a favorable ruling and so did several other Churches
The audit of the California Church (1971-1974 audit) followed the Hawaii
audit. The examination began in June 1975 and continued through July 1976
covering the taxable years 1971 through 1974. Three experienced agents [FN11]
worked full time on the audit. Under IRS policy, cases involving a church are
classified as sensitive cases and automatically referred to the National
Office. Thus, from time to time the agents received advice and guidance from
Lewis Hubbard, an attorney in the National Office of respondent's Chief
The agents examined between 200 and 300 cartons of records, containing
approximately 2 million documents. The audit covered the following topics: (1)
petitioner's sources of income; (2) petitioner's corporate structure; (3) the
purposes of the California Church as stated in corporate documents; (4) the
administration of the Scientology trust fund; (5) compensation and benefits
paid or bestowed upon L. Ron Hubbard and his family; (6) the purposes and
amounts of petitioner's expenditures; (7) certain aspects of Church
administration including banking practices, recordkeeping and the
implementation of policy; and (8) Scientology religious beliefs and practices.
At the outset of the 1971-1974 audit, no thought was given to what procedure
would be used to obtain a ruling on the audit. As the audit drew to a close,
the National Office and the *408 District Office jointly decided that the
technical advice procedure was best since it afforded the California Church an
opportunity to comment on the facts and issues raised by the audit. [FN12]
In accordance with the technical advice procedure, Agent Eugene Endo prepared
a draft report of the audit. The draft report covered the following topics: (1)
a description of Scientology religious beliefs; (2) a description of
petitioner's corporate charter, by-laws and amendments thereto; (3) a
description of petitioner's pricing and sales policies; (4) an explanation of
the different memberships in petitioner; (5) an account of petitioner's
charitable and community activities; (6) a description of petitioner's
promotion methods; (7) a discussion of the role of policy letters in the
administration of petitioner's affairs; (8) a description of petitioner's
banking practices and management activities; (9) an analysis of petitioner's
income and certain expenses by Church branch; (10) an explanation of the
royalties paid to L. Ron Hubbard; (11) a description of OTC's relationship to
petitioner; (12) documentation of petitioner's failure to substantiate OTC
expenditures on behalf of petitioner; (13) an analysis of financial gains
accruing to OTC from currency conversions; and (14) a history and description
of the United States Churches of Scientology Trust.
The technical advice procedure was never fully implemented. The California
Church took matters into its own hands and sent the National Office Agent
Endo's draft report (Service audit report) which it had been given for comment
as a matter of courtesy before Agent Endo had a chance to complete it. The
Church also sent the National Office a copy of its own report (Church audit
report). The Church audit report *409 was written in the style of the
Service audit report in goodly measure adopting verbatim the text of the
Service audit report. However, there were textual differences, some noted and
explained in footnotes. According to Church officials, the purpose of the
Church audit report was to present a fair and accurate version of the
California Church's tax position. The National Office refused to accept this
'end-run' and referred the matter back to the Los Angeles District Office.
In accordance with the technical advice procedure, the examining agent and
Church officials met in the district office in October 1976 and tried to reach
agreement on a statement of facts and issues to present to the National Office.
Agent Endo reviewed the Church audit report, signified his agreement with the
factual content of certain footnotes in the Church audit report, but complete
agreement was never reached. [FN13] There remained significant differences in
the texts and the footnotes of both reports. The matter was then referred to
the National Office. [FN14] In January 1977 Church and Service representatives
met in the National Office to discuss the reports. Respondent never issued a
technical advice memorandum.
During 1977 petitioner and respondent engaged in settlement negotiations.
These negotiations were discussed in detail by counsel at a pretrial hearing
held on petitioner's Motion to Render the Notice of Deficiency Nugatory and for
Other Relief. At the conclusion of the hearing, the Court made findings about
the conduct of the settlement talks. The Court found (1) that there was a bona
fide dispute between the parties which was the subject of negotiations; (2)
that the notice of deficiency incorporates these legitimate grounds of
dispute; (3) that respondent was forced to issue the notice of deficiency to
protect the Government's interest in the revenue since petitioner would not
consent to extending the statute of limitations which was about to expire
before a settlement could be reached; and (4) that good-faith settlement
negotiations continued after the notice of deficiency was issued. The
*410 Court ultimately found that the determinations were at least
sufficiently reasonable to render the notice of deficiency valid and therefore
denied petitioner's motion.
During negotiations the parties came close to reaching a settlement of their
disputes over income inuring to OTC's benefit from currency conversions and
over alleged debt repayments from the Danish Kingdom and United Kingdom
Churches. Significant differences remained on at least three other issues: (1)
petitioner's recordkeeping system; (2) petitioner's reporting obligations; (3)
petitioner's failure to satisfy respondent that it was not implicated in
criminal activity to impede the IRS from performing its lawful functions.
Respondent's last offer was made on December 20, 1977. The scope of the offer
was limited to settlement of petitioner's 1970-1972 taxable years.
The notice of deficiency was drafted by Agent Endo. It was drafted sometime in
November, 1977 as the statute of limitations for the taxable years in issue was
about to expire. The notice was issued on December 28, 1977.
On March 5, 1980 this Court ruled that compliance with public policy is a
requirement for exemption from tax under section 501(c)(3). In a Memorandum Sur
Order dated April 1, 1980, this Court defined the scope of the public policy
requirement by stating 'this requirement is limited to compliance with well
defined public policy--such as may be reflected in a criminal or civil
statute.' Respondent's Trial Memorandum, filed October 3, 1980, catalogued a
series of petitioner's acts, policies and procedures which respondent intended
to prove to show petitioner's failure to comply with public policy. These acts,
policies and procedures included: (1) conspiracy to impede and obstruct the
Internal Revenue Service under 18 U.S.C. section 371; (2) abuse of the role
of religious confidant by auditors; (3) the infliction of psychic harm
including the loss of moral judgment through brainwashing accomplished by
auditing and other practices and procedures; (4) the use of blackmail and
intimidation to implement petitioner's 'fair game' policy; (5) the involuntary
dissolution of marriages and family ties through the enforcement of
petitioner's 'disconnect' policy; (6) involuntary detention and false
imprisonment; (7) the making of false statements to immigration authorities in
violation of 18 U.S.C. section 1544; (8) the *411 removal of large
amounts of currency from the United States without disclosure; (9) the false
registration of petitioner's fleet as private yachts used for pleasure when in
fact they were used for paramilitary training and commercial activities; and
(10) the drastic punishment of staff and members. By letter ruling dated
October 30, 1980, the Court precluded respondent from offering proof on many of
these issues and narrowed the evidence it would entertain on the remaining
issues to 'ACTS against others that violated civil or criminal law or were
contrary to well-defined public policy.' Respondent's Trial Memorandum also
stated two other major issues to be tried in addition to the public policy
issue: (1) whether part of the California Church's net earnings inured to the
benefit of L. Ron Hubbard and his family; and (2) whether petitioner engaged in
commercial activities such that it was not operated exclusively for religious
Respondent also contended, in a letter to petitioner in connection with
petitioner's Motion to Render the Notice of Deficiency Nugatory and for Other
Relief, that (1) the Church's methods are akin to brainwashing; (2) the Church
employs tactics which are harmful to society; (3) petitioner is a cult; (4)
Scientology operations are partially a profit-making scheme; and (5) Church
policies and practices endanger the moral and physical health of citizens and
create trouble in families. [FN15]
During the years 1969 through 1975 respondent formed and maintained special
intelligence units to collect information about certain taxpayers, apparently
selected by essentially political criteria, to monitor their compliance with
the tax laws. Two of these units, the Special Service Staff (at first called
the 'Activist Organization Committee') and the Intelligence Gathering and
Retrieval Unit, were part of respondent's National Office. The third unit, the
Case Development Unit, was part of the Los Angeles District Office. All three
collected information about petitioner.
In July 1969 the IRS established the Special Service Staff (SSS) to insure
that dissident groups were not violating the tax laws. The SSS gathered the
centralized information about *412 taxpayers, frequently selected because of
their political activism, and disseminated this information to the district
office having jurisdiction over the particular taxpayer. As a result of SSS
operations, dissident groups were subject to more rigorous scrutiny for their
compliance with the tax laws. Also, all exempt organizations which were
scrutinized by the SSS were subject to special procedures for obtaining
approval of their applications for exemption from taxation.
Initially the SSS selected 77 organizations to monitor. On October 8, 1969 an
additional 22 organizations were targeted. These included the Founding Church
of Scientology. After the Founding Church was selected, the SSS received some
information about Scientology churches including petitioner. [FN16] When the
SSS ceased functioning in 1973, it had amassed close to 3,000 files on
organizations and approximately 8,500 files on individuals.
In 1973 respondent established a national intelligence program called the
Intelligence Gathering and Retrieval Unit (IGRU). This program differed from
other intelligence operations in that the IGRU gathered general intelligence
unrelated to a specific investigation of a specific allegation. Agents were
free to determine whom and what to investigate provided their investigations in
some way related to IRS investigative jurisdiction. In a number of districts,
IGRU agents collected intelligence having little relationship to enforcement of
the tax laws.
The Los Angeles District unit of IGRU classified petitioner as a 'tax
register.' In 1975 certain IGRU files in St. Louis were destroyed. One file
labeled 'subversives' contained materials only about Scientology. [FN17] The
IGRU was disbanded in mid-1975.
Between 1968 and 1974 the Case Development Unit staffed by two special agents
in respondent's Los Angeles Office gathered information they collected
concerned petitioner's religious operations and financial activities. Their
files, *413 however, contained a few reports linking petitioner or
Scientology with criminal activity including homicide, blackmail, guerrilla
training, break-ins, drug trafficking and the transportation of illegal
Over slightly more than a decade, respondent examined petitioner's records
four times. In 1965 respondent audited petitioner's 1963 tax year and, in 1969,
petitioner's 1964-1967 tax years. Between 1971 and 1973 Agent Cluberton
unsuccessfully tried to examine Church records for 1968 and 1969. The most
comprehensive audit began in June 1975. It lasted approximately 1 year and
covered petitioner's 1971-1974 tax years. Three or four agents worked full time
and others worked as needed. The auditors received and reviewed between two and
three million records. Most of these were original financial records such as
invoices, disbursement vouchers and cancelled checks since the California
Church did not keep business journals or books of account. The examiners also
reviewed policy issues, membership fees and descriptions, contracts for
services and employment, organizational charts, Scientology newsletters and
dissemination pieces, and similar records illustrating petitioner's
organization, activities and financial practices. The agents also inspected
petitioner's premises at three or four locations.
Respondent collected information about Scientology and petitioner. An index
prepared by the IRS in 1974 shows that respondent had over 6,000 documents
relating to Scientology in its files. Many of these documents were prepared by
the IRS and related to specific audits, investigations or lawsuits.
Approximately 2,000 of these documents were policy letters similar in kind, if
not identical, to the ones contained in the OEC volumes. Other documents
transmitted information from confidential sources on such diverse topics as
their personal experiences in the Church of Scientology, Scientology financial
activities, the administration of Scientology churches and the names of
Scientology members. Respondent's files also contained newspaper articles about
Scientology and pamphlets, magazines and newsletters published by Scientology
organizations, and a few books and brochures describing Scientology doctrine
*414 The trial of this case lasted 51 days, spread over 12 months. Many
matters were covered: petitioner's corporate and management structure,
petitioner's fee structure, petitioner's banking practices, petitioner's
dissemination practices, petitioner's relationship to OTC, the administration
of the Scientology trust fund, IRS antipathy toward Scientology; petitioner's
efforts to obstruct the IRS, and Scientology beliefs and practices. Petitioner
called three witnesses -- Joyce Isaacson, Herbert Richardson, and Renee
Norton -- to provide background information about Scientology beliefs and
practices. On cross-examination respondent inquired of these witnesses whether
Dianetics formed part of the religious doctrine of Scientology and whether the
E-meter was used apart from auditing to conduct security checks as a condition
of employment. [FN18]
During the trial, respondent tried to prove that some of petitioner's
activities served a commercial purpose. Respondent tried to prove that
petitioner sent staff on missions to branch churches to increase profits, that
petitioner developed new courses and awareness levels for commercial reasons,
and that petitioner used commercial techniques to promote Scientology in order
to make money.
During the trial, respondent used policy issues to examine witnesses on such
subjects as petitioner's corporate and management structure, petitioner's
financial activities and petitioner's efforts to obstruct the IRS. Respondent's
reliance on policy issues generated collateral examination on the extent to
which policy issues had to be obeyed. while following this line of inquiry,
respondent questioned witnesses, past and present members of Scientology, with
respect to whether they were disciplined for failing to follow policy.
Respondent also inquired into petitioner's system of discipline and ethics in
pursuing his inquiry into petitioner's treatment of IRS personnel.
*415 CHURCH FINANCES
Petitioner mainly 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. Of these four areas, the
largest percentage of petitioner's income came from auditing and training. By
petitioner's own admission, auditing and training sales accounted for the
following percentages of total income:
AOLA ASHO LAO SFO UK
1971 91 68 85 81 70
1972 94 50 91 86 70
Petitioner exacted what it called a 'fixed donation' for its auditing and
training courses. With few exceptions, these services were never given for
free. [FN19] Auditing sessions were offered in fixed blocks of time called
'Intensives.' By petitioner's own admission the general rate of the fixed
donation for auditing was as follows:
12 1/2-Hour intensive ......... $625
25-Hour intensive ............ 1,250
50-Hour intensive ............ 2,350
75-Hour intensive ............ 3,350
100-Hour intensive ..... [FN20]4,250
At Flag, the fixed donations were 3 to 4 times higher. Additionally,
petitioner offered two specialized types of auditing for a higher fixed
Integrity Processing-- $750 per 12 1/2-Hour intensive
Expanded Dianetics-- $950 per 12 1/2-Hour intensive
*416 Petitioner offered its parishioners a 5-percent discount on the rate
of fixed donation if the donation was well in advance of the service.
Petitioner also offered 1-year members and lifetime members a 10-percent and
20-percent discount, respectively, on services. Apart from these discounts,
branch churches were not allowed to deviate from standard prices. [FN21]
There was a special fee arrangement for most staff members. In order to become
a staff member, a prospective employee had to sign an employment contract. The
terms of most employment contracts varied from week-to-week employment to
periods of 2- 1/2 or 5 years. Sea Organization staff members pledged to work
for a billion years. Contracted staff members, except the week-to-week
employees, were given free or discounted training and auditing. If, however, a
staff member breached his employment contract by leaving petitioner's employ
prior to the contract's expiration, the former staff member, termed a
'freeloader,' was contractually obligated to pay petitioner a sum equal to the
full cost of all services received or liquidated damages of $5,000. In order to
enforce this policy an organization that sent a staff member for training to a
higher organization was required to have the staff member sign a note in the
amount of $5,000 before commencing training. The signing of the $5,000 note was
intended to prevent a staff member from leaving after receiving higher
training. HCO PL December 14, 1969, 3 OEC 241, entitled 'ORG Protection,'
required that 'Such a Note * * * must be legally binding in that, if he breaks
his Contract, he is automatically in debt to the org for $5,000.' In order to
insure collection of such amounts, petitioner paid its agents a 10-percent
commission for each freeloader debt collected in full. *417 No effort was
made by petitioner to collect freeloader debts in court.
Individual applicants for training and auditing were required to execute two
documents. Under the first document, entitled the 'Pledge of Offering,' the
applicant pledged a specified amount as an offering to petitioner in exchange
for a limited amount of training or auditing directed toward the attainment of
a specified state of spiritual awareness.
Additionally, the applicant was required to execute a second document,
entitled a 'Legal Contract for Auditing and Training.' Under this document, the
applicant declared that he or she was a proper applicant for training, which
entailed among other things that the applicant was of legal age, that he or she
did not have any medical illness, that he or she did not have a record of
institutionalization, that he or she did not have a criminal record, and that
he or she was not addicted to drugs or alcohol. Furthermore, pursuant to this
contract, the applicant waived all rights of action against petitioner L. Ron
Hubbard arising from the receipt of the designated services except the right to
request a refund within 3 months of the last day of the services rendered.
Petitioner promoted Scientology services through free lectures, congresses,
free personality testing, handouts and advertisements placed in newspapers and
magazines and on the radio. Petitioner geared promotional activities to be
responsive to community concerns after taking surveys to ascertain community
needs and desires.
Two categories of staff-registrars and Field Staff Members--had the job of
establishing contact with the public to stimulate interest in Scientology
services. Registrars in the public division of petitioner's branch churches
kept track of new people who showed an interest in Scientology. The registrars
were trained in salesmanship. They encouraged new people to purchase
introductory Scientology courses. Once a new person showed a commitment to
Scientology through the purchase of a major Scientology service, responsibility
for his progress was turned over to registrars in the dissemination division of
petitioner's branch churches who monitored each parishioner's training and
auditing progress through a central file system. This second group of
registrars had the duty of *418 contacting people listed in the central
files by mail or in person and urging them to take higher Scientology services.
In addition to the actions of the registrars, petitioner used another group of
people known as Field Staff Members (FSMs), who also contacted individuals in
an effort to interest them in Scientology. These FSMs operated on a commission
basis. They were paid an amount equal to 10 percent of the fixed donation for
each person they successfully enrolled in a Scientology service. Additionally,
the FSMs received awards in the form of scholarship money for Scientology
courses based on their ability to make commissions.
Petitioner earned money from the sale of books, E-meters and recordings.
According to petitioner during the taxable years 1971 and 1972, AOLA, ASHO, SFO
and LAO alone generated in excess of $400,000 and $500,000, respectively, from
the sale of these items. By petitioner's admission, sales of these items
accounted for the following percentages of total income:
AOLA ASHO LAO SFO UK
1971 1 24 10 16 3
1972 5 49 7 14 3
ASHO PUBS, a division of ASHO, from 1971 onwards published and distributed
these items. As a distributor, it sold these items to other churches and
missions of Scientology as well as commercial bookstores for resale.
The major portion of the books distributed by ASHO PUBS were copyrighted by L.
Ron Hubbard. Through the year 1972, L. Ron Hubbard's collected works on
Dianetics, Scientology and closely related topics included two multi-volume
encyclopedic series and more than 50 other books and publications. [FN22] L.
Ron Hubbard also recorded more than 3,000 lectures dealing with Scientology
technology, administration and policies between the years 1950 and 1972. Tapes
for 509 of such lectures were regularly available to the public. Additionally,
petitioner sold E-meters which L. Ron Hubbard invented and on which he had a
Petitioner had an elaborate system of prices and discounts for books. In 1959
petitioner used the following formula to *419 price its books: It took the
printing cost and multiplied by 5. In 1965 this formula underwent a slight
change. The basic formula, 5 times the printing cost, stayed the same but to
this figure petitioner added 2 times the cost of postage to the furthest
church. This formula established a minimum price. During the docketed years,
the list price of books sold by petitioner through its bookstore ranged from a
low of $2 to a high of $225 or $300 for the OEC series. [FN23] Books could not
be given away. They had to be sold. Books sold to Scientology members were
discounted by 10 percent. Books sold to other Scientology churches, including
branches of petitioner, were discounted by 40 percent. Books sold to commercial
bookstores were also discounted in accordance with the following schedule:
1 Book ........... 25%
2 - 9 Books ...... 33/13 [sic]
10 - 49 Books .... 40
50 - 99 Books .... 41
100 - 249 Books .. 42
250 - 499 Books .. 43
500 Books ........ 45
The retail price of an E-meter during the tax years at issue was around $200;
however, discounts were available in accordance with the following schedule:
1. On individual purchases without any membership, full price, no discount.
2. International Membership holders -- 20% discount.
3. Bulk sales (10-40 meters) -- 35% discount.
4. Bulk sales (50 or more meters) -- 40% discount.
5. All contracted staff -- 40% discount.
Petitioner's third souce of income came from its franchise operations.
Petitioner's Franchise Programme was first introduced in the early part of
1959. Under the Franchilse Programme, interested auditors were granted
franchises which authorized them to use the names 'Applied Philosophy',
'Scientology', and 'Dianetics', along with the copyrights associated therewith,
in a certain district or territory. Additionally, *420 franchise holders
were granted 40 percent discounts on their purchases of books that they could
later resell to the public. In exchange, the franchise holder agreed (1) to
remit 10 percent of his or her gross income to HCO WW, and (2) to abide by the
policies governing franchises. The rates franchise holders could charge for
processing and courses were set by L. Ron Hubbard and made known to the
franchise holders in the form of policy letters. Franchises were strictly
forbidden from providing any free services.
In order to obtain a franchise, an interested person had to first file an
application for an interim franchise. Initially, these franchises were granted
directly by L. Ron Hubbard; however, during the tax years at issue, the
franchises were issued to the applicant by petitioner as agent for L. Ron
A principal objective of the Franchise Programme was to involve members of the
public and push them up to upper level orgs, such as St. Hill, AOLA, ASHO and
Flag. [FN24] To this end, franchise holders were only permitted to offer lower
level courses and were encouraged to send their students to the higher level
orgs for more advanced training. For each student which the franchise holder
successfully referred to petitioner, he received a Field Staff Commission equal
to 10 percent of the amount the student spent at the higher level
In conducting the Franchise Programme, petitioner placed a heavy emphasis on
statistics and the regular payment of the required 10 percent of gross income
to HCO WW. In this regard, the franchise holders were required to keep a set of
books and records and to submit weekly reports of the franchise holder's
activities, along with their weekly remittance of the required 10 percent of
gross income. Franchise holders who failed to submit the required 10 percent of
gross income on a regular basis ran the risk of losing their franchise.
During the tax years at issue, the franchises were administered by the
Franchise Office Worldwide, which was directed by the Franchise Offer. As part
of his responsibilities, the Franchise Officer sent the franchise holders
policy letters pertinent to running their franchises and collected the 10
*421 percent payments from each franchise. These payments were then reported
on the books of petitioner's United Kingdom Church under the designation
'Tithes.' The record is not clear how much income the Franchise Programme
generated. By petitioner's own records, the income from its franchising
operations during the tax years in question was as follows:
1970 ....... $288,672
1971 ........ 307,809
1972 .. [FN25]435,960
Petitioner's Flag Bureau generated a fourth source of income through the
provision of management services to Scientology organizations around the world,
including branches of petitioner. Flag collected a variety of statistics from
each local church and organization and used this data to develop programs for
improving local church administration. When a local church experienced
difficulty, Flag sent staff on assignments, called 'missions,' to help manage
the situation. The purposes of such missions were varied and included
straightening out financial mismanagement, increasing gross income, clarifying
job responsibilities, attracting new parishioners, and insuring excellence in
the delivery of services. Flag concentrated its attention on the organizations
that made the greatest contribution to Flag's financial support. The fee for
these management services was 10 percent of the corrected gross income of the
organizations and franchises that were not obligated to pay 10 percent to
Flag collected statistics to track Scientology's worldwide growth and
expansion as well as individual and local church productivity. These statistics
were reviewed by Flag and used as a basis for the development of programs,
policies and procedures to increase the organization's growth and expansion. As
a basis for these statistics, each local church was required to follow a
standard method for reporting statistics to petitioner's Flag Bureau. Required
statistics included measures of output for each division within a church. This
statistic was called the 'Gross Divisional Statistic,' or 'GDS,' and was
specific to each division; for example, the GDS of the Dissemination Division
was gross income, while the GDS of the *422 Treasury Division was the amount
of credit collected and the amount of bills paid. Each church had an
organizational Information Center (OIC) which graphed and posted divisional
statistics. The OIC also transmitted certain statistics to Worldwide on a
weekly basis. Worldwide then transmitted (via Telex) accumulated statistics to
Flag, where they were graphed and posted in the Control Information Center
(CIC) and on the wall outside the Flag Treasury Division. These graphs
reflected overall Scientology income, Flag income, and LRH Comm. Statistic
Revised income, [FN26] as well as other income figures. In addition, each Flag
staff member had a graph of his job statistic posted next to his desk.
One of petitioner's articulated goals was to make money. This was expressed in
HCO PL March 9, 1972, MS OEC 384, which enumerated the Governing Policy of
Finance as follows:
A. MAKE MONEY
B. Buy more money made with allocations for expense (bean theory).
C. Do not commit expense beyond future ability to pay.
D. Don't ever borrow.
E. Know different types of orgs and what they do.
F. Understand money flow lines not only in an org but org to org as customers
G. Understand EXCHANGE of valuables or service for money (P/L Exec Series 3
H. Know the correct money pools for any given activity.
I. Police all lines constantly.
J. MAKE MONEY.
K. MAKE MORE MONEY.
L. MAKE OTHER PEOPLE PRODUCE SO AS TO MAKE MONEY.
A small sack of beans will produce a whole field of beans. Allocate only with
that in mind and demand money be made. * * *
Petitioner often used business terminology to describe its operations.
Churches were referred to as 'orgs.' Church missions were called 'franchises'
until 1971 when their designation in the United States was officially changed
to 'mission.' However, even after the name change, petitioner continued to
refer to the administrator of the missions as the Franchise Officer. Fees for
auditing were called 'prices' *423 rather than 'fixed donations,' and
petitioner frequently said its services were 'purchased,' 'bought,' or 'sold'
rather than 'donated,' 'offered,' or 'contributed.' HCO PL May 23, 1969 (Issue
III), 0 OEC 91-93, describing 134 measures to take to insure Church solvency,
exemplifies these patterns of speech. It states in part:
90. DEPARTMENT 17 (DEPT OF PUBLIC REHABILITATION): SELLS SCIENTOLOGY TO
GOVERNMENTS AND BROAD SOCIAL STRATAS (SIC).
92. Makes Scientology popular and the thing to do. * * *
107. DEPARTMENT 20 (DEPT OF ACTIVITIES): Guides in new body traffic. * * *
109. Sees that the Introductory Lecture and nonclassed courses use no words
that will be misunderstood and MAKES PEOPLE WANT TO BUY TRAINING AND PROCESSING
and offers it. * * *
124. DEPARTMENT 22 (DEPT OF FIELD RECRUITMENT, ESTABLISHMENT AND RECORDS):
Recruits, appoints and establishes FSMs, Groups and Franchises. * * *
128. Gets all commissions owed promptly paid to ENCOURAGE EARNING MORE
129. DEPARTMENT 23 (DEPT OF FIELD TRAINING): Trains the FSMs and Franchise
holders and MAKES THEM FINANCIALLY SUCCESSFUL.
130. TREATS THE WHOLE DEPARTMENT ACTIVITY AS SALESMEN ARE HANDLED BY ANY OTHER
BUSINESS ORG. (Emphasis added.)
This policy letter is not an isolated phenomenon. Even during the trial of
this case, the testimony of petitioner's church witnesses was heavily
punctuated with business terminology.
Petitioner performed charitable works. It provided assistance to prisoner's
ex-offenders, the elderly, the mentally ill, and drug addicts. It helped form
Narcanon, a drug-rehabilitation program. It organized a job referral service
for ex-offenders and it developed an educational program called Applied
Scholastics. On oCCsion, it also assisted the poor and sick.
*424 Petitioner performed christenings, funerals, and wedding ceremonies
free of charge. Petitioner's chaplains provided free marriage and family
counseling. Petitioner also provided a specialized form of auditing free of
charge called 'ARC break' auditing. This service was geared to help people in
In his notice of deficiency, respondent determined that petitioner's seven
stipulated divisions (SFO, LAO, FOLO, ASHO, AOLA, USGO, and Flag) had the
following consolidated net incomes during the docketed years:
Income 1970 1971 1972
Gross receipts ................. $2,249,013.08 $3,301,143.73 $3,134,391.00
Advance payments ............... 373,222.37 788,704.96 1,198,763.86
Flag income .................................... 263,557.47 240,932.55
Payment Danish Kingdom Church .................. 77.92 53,609.76
Payment United Kingdom Church .................. 76,497.24 161,018.38
-------------- -------------- --------------
Total income ............. 2,622,235.45 4,429,981.32 4,788,715.55
Per Form 990 ................... 2,438,646.65 4,242,124.02 4,178,876.05
Trust .......................... (28,930.34) (67,892.40) (77,986.62)
Charter Mission (disallowed) ... (982,415.39) (1,143,928.02) (1,400,015.99)
Flag expenses .................................. 1,238,466.30 1,036,108.56
-------------- -------------- --------------
Total allowable expenses . 1,427,300.92 4,268,769.90 3,736,982.00
Net income ............... 1,194,934.53 161,211.42 1,051,733.55
Petitioner does not contest the accuracy of these figures, but does disagree
with the tax treatment accorded them by respondent.
Petitioner collected advance payments from parishioners for auditing and
training services of $373,222.37 in 1970, $788,704.96 in 1971 an $1,198,763.86
in 1972. These were payments from people for whom no services were rendered
during the year the payments were received. It was petitioner's policy to
refund advanced payments upon request at any time before the services were
taken. There is no evidence in the record that petitioner kept the advance
payments segregated or placed restrictions on the use of these funds.
Petitioner used the cash method of accounting for its receipts except it
treated advance payments as liabilities.
*425 The Charter Mission expenses represented amounts transferred by
petitioner to OTC during the tax years. Petitioner deducted these payments as
expenses on its Forms 990. Respondent disallowed the deduction on the grounds
that the payments were not a business expense but constituted an internal
transfer of funds to the Flag Division. On brief, petitioner does not contest
Petitioner 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
petitioner these were payments to the United States Church of Scientology
Trust (the Trust).
Petitioner alleged that the Trust originated in 1962. However, there was no
trust document during the docketed years. The Trust was first memorialized by
Declaration of Trust on June 25, 1973. L. Ron Hubbard was the sole trustee of
the Trust during the docketed years.
During the docketed years no investments were made with trust funds. They were
deposited in several Swiss bank accounts: Rubric Trustee Account No. 272,893.6,
Church of Scientology of California Trustee Account No. 285,222, Church of
Scientology of California Trustee Account No. 285,222.1, L. Ronald Hubbard
Trustee Account No. 272,893.2 and L. Ronald Hubbard Trustee Account No.
272,893.3 at the Swiss Bank Corporation in Zurich, Switzerland. Funds were also
deposited in Account No. 015867.226 at the Swiss-Israeli Trade Bank, Geneva,
Switzerland. L. Ron Hubbard, Mary Sue Hubbard and Denzil Gogerly (a United
Kingdom Church official who administered the Trust) were all sole signatories
on the trust accounts. L. Ron Hubbard kept the trust checkbooks. Member
churches were required to remit 10 percent of their total income to the Trust
on a weekly basis.
In 1972, 4,222,015 Swiss francs ($1,119,678) [FN27] was withdrawn from the
trust accounts in Switzerland. petitioner's worksheets originally showed this
withdrawal as an inter-account transfer to OTS. This is crossed out and in
different handwriting the transaction is shown as cash held. According to
petitioner, this money was brought aboard the Apollo where it *426 was kept
in a locked file cabinet until 1975. Mary Sue Hubbard had the only keys to the
Membership in the Trust was restricted to churches of Scientology in the
United States. However, the Trust was administered in England by Denzel
Gogerly, a United Kingdom Church official, and the United Kingdom Church tithed
to the Trust until sometime in 1971. Financial statements for the Trust
covering the docketed years were belatedly prepared in 1973. They were prepared
in South Africa. They were prepared for the benefit of ten churches of
Scientology in the United States although the Declaration of Trust recites only
five member churches.
According to the financial statements finally prepared in 1973, the trust
accounts had the following net proceeds and accumulated funds for the docketed
Year ended Net proceeds funds
Dec. 31, 1970 $86,170.80 $812,134.51
Dec. 31, 1971 254,084.71 930,400.08
Dec. 31, 1972 376,837.18 1,307,237.26
July 18, 1973 691,106.02 1,998,343.08
The purported purpose of the Trust was the defense of Scientology. During the
docketed years there was only one disbursement for such purpose in the amount
of $9,290.47. USGO expended substantially greater amounts for legal fees.
The United Kingdom Church was a branch of petitioner. According to
petitioner's records, the United Kingdom Church earned the following profits:
1970 1971 1972
Total receipts $892,783 $2,017,850 $1,815,509
Less: Total expenses (593,102) (1,221,433) (998,937)
--------- ----------- -----------
Net income 299,681 796,417 816,572
It was petitioner's policy to build large cash reserves and to deduct payments
to these cash reserves as business expenses. These reserves were mainly held in
OTC bank accounts. The year-end balances of the OTC bank accounts are shown in
the following table:
[Note: The following TABLE/FORM is too wide to be displayed on one screen.
You must print it for a meaningful review of its contents. The table has been
divided into multiple pieces with each piece containing information to help you
assemble a printout of the table. The information for each piece includes: (1)
a three line message preceding the tabular data showing by line # and
character # the position of the upper left-hand corner of the piece and the
position of the piece within the entire table; and (2) a numeric scale
following the tabular data displaying the character positions.]
******** This is piece 1. -- It begins at character 1 of table line 1. ********
OTC BANK ACCOUNTS
YEAREND (DEC. 31) BALANCE
Bank number 1970 1971
(1) Swiss Bank 295,728 $1,721,748.46 $1,653,475.50
(2) Swiss Bank 295,728.1 25,757.85 50,723.24
(3) Swiss Bank 295,728.2 --- 98,743.80
(4) Banque 081,920.4 --- 110,852.06
(5) du 10,5616.2 --- 1,330.93
(6) Exterieur 90,1924.0 --- 36,289.48
(7) " 90,1928.0 --- 8,425.93
(8) " 217.734.2 --- 11,937.44
(9) " 02.03.C.05616.5 --- ---
(10) Banco de 93,7470 20,577.44 1,433.57
(11) Banco 15,855 --- 7,697.29
(12) Banco 23,718 --- 52,356.93
(13) 1st 20,48.007 --- 9,565.87
(14) Banco de Ellen Kayman 742.59 ---
(15) Banco de 917290 2,340.66 ---
(16) Banco 8631 1,814.72 ---
------------------ --------------- --------------- ---
Total 1,772,981.72 2,042,831.54
******* This is piece 2. -- It begins at character 78 of table line 1. ********
*427 During the tax years at issue, L. Ron Hubbard and Mary Sue Hubbard
received salaries from petitioner in the following amounts.
1970 1971 1972
L. Ron Hubbard $4,932 $9,368 $35,000
Mary Sue Hubbard 3,017 2,430 25,000
------ ------ -------
Total 7,949 11,798 60,000
Additionally, according to petitioner's own records, L. Ron Hubbard and Mary
Sue Hubbard received 5,125.11.4 pounds in fees from the United Kingdom Church
in 1970, 15,770.67 pounds in 1971, and 23,199.90 pounds in 1972. [FN29] Using
the *428 conversion rate of 2.4 suggested by petitioner's witness, these
amounts translate into $12,300.27 in 1970, $37,849.61 in 1971, and $55,679.76
in 1972. Thus, by petitioner's own admission, L. Ron Hubbard and Mary Sue
Hubbard received salary payments from petitioner totaling $20,249.27 in 1970,
$49,647.61 in 1971, and $115,679.76 in 1972.
In addition to the outright salary payments detailed above, during the years
at issue, L. Ron Hubbard, Mary Sue Hubbard, and their four children resided for
the most part aboard the Apollo. While aboard ship, petitioner paid the
Hubbard's living expenses which included free lodging, food, laundry, and
medical services. In 1970 Flag expended $31,720 for the benefit of the Hubbard
L. Ron Hubbard received royalty payments in connection with petitioner's sale
of books and E-meters. These royalties were paid by ASHO and were computed on
the basis of 10 percent of the retail price of the publications and E-meters
distributed by ASHO PUBS. Parenthetically, we note that the retail price of
these items was determined by a formula developed by L. Ron Hubbard. Beginning
in August of 1971, all such royalties were paid on a weekly basis, while back
royalties attributable to periods prior to that time were paid intermittently
on later dates.
The amounts of royalties paid by ASHO to the account of L. Ron Hubbard during
the years 1971 and 1972 were as follows:
1971 .. $10,649.22
1972 .. 104,618.27
Additionally, as of April 29, 1972, there were unpaid back royalties of
$17,187.70 for the year 1971 which, along with all back royalties, were paid to
L. Ron Hubbard by the end of 1974. The majority of ASHO PUB's sales of E-meters
and books upon which royalties were paid to the account of L. Ron Hubbard were
to other Scientology churches including branches of petitioner.
It was a long-standing policy of petitioner that all works pertaining to
Scientology and Dianetics had to be copyrighted to L. Ron Hubbard. As a 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 *429 to Be Successful';
however, both books were copyrighted by L. Ron Hubbard. Additionally, there are
many policy letters contained in the OEC series that were actually written by
paid employees of petitioner with L. Ron Hubbard's approval. Nevertheless,
despite the fact that L. Ron Hubbard did not personally author the entire nine-
volume set, he did receive royalty payments on the sale of this publication.
Petitioner expended funds to protect L. Ron Hubbard's patents and copyrights.
Sometime in the 1960s, Scientology organizations around the world began paying
L. Ron Hubbard 10 percent of their income in the guise of debt repayment. These
payments were variously referred to as 'LRH 10,' 'LRH RR,' AND 'LRH COMM.
STATISTIC (STAT.) REVISED.' THE RECORD IS PAMPERED WITH REFERENCES TO THESE
ALLEGED DEBT REPAYMENTS IN FBO CORRESPONDENCE AND POLICY LETTERS PREDATING THE
DOCKETED YEARS. IT IS CLEAR FROM THESE DOCUMENTS THAT THERE WAS NO SET AMOUNT
OF DEBT WHICH HAD BEEN NEGOTIATED BETWEEN L. RON HUBBARD AND PETITIONER OR ANY
OTHER ORGANIZATION BUT RATHER A CONTINUING OBLIGATION TO MAKE PAYMENTS BASED ON
Petitioner continued to funnel debt repayments to L. Ron Hubbard during the
docketed years. Between October 9, 1972 and December 28, 1972, USLO, also
called FOLO, receipted $19,324.41 in debt repayment from Scientology
organizations throughout the United States and Canada including branches of
petitioner. On petitioner's invoices (records of receipt), these payments were
designated 'LRH Repayments,' 'Founding Debt Payment' or 'Per HCO Policy Letter
7 Sept. 72.'
Petitioner, its agents, and others willfully and knowingly conspired to
defraud the United States by impairing, obstructing, and defeating the lawful
functions of the IRS in the determination, assessment, and collection of income
taxes due from petitioner and from other Scientology organizations and
officials. The conspiracy began in 1969 and continued until approximately July
7, 1977 when the FBI, pursuant to a warrant, searched petitioner's premises for
evidence of the conspiracy and related crimes.
There is a written record documenting most of this conspiracy, some of it in
official Church publications, some in confidential *430 orders issued by
petitioner's Guardian Office, and some in correspondence between Scientology
officials. Prior to and during the course of the conspiracy, L. Ron Hubbard
issued policy letters and directives depicting the IRS as a danger to
Scientology, and threatening to make the IRS swim in circles. During 1969
personnel in petitioner's FBO network corresponded about plans to protect
petitioner's tax-exempt status by forging records to conceal petitioner's
relationship with OTC. Two confidential orders formulated by petitioner's
Guardian Office in 1972 and 1974, respectively, outlined plans to thwart IRS
investigations into the tax status of Churches of Scientology by burglarizing
Government offices and stealing Government documents. Reports sent to
petitioner's Guardian Office describe compliance with the confidential Guardian
Order issued in 1974.
In 1969 the IRS began an audit of petitioner's records to determine
petitioner's tax liability for the years 1963 through 1967. In the same year
top officials on petitioner's staff in the FBO network grew concerned that
petitioner's large payments to OTC, a foreign corporation not holding tax-
exempt status, would jeopardize petitioner's tax-exempt status. To disguise
these payments as debt repayment and to conceal the OTC sham, a cover story was
developed. [FN30] The theme of the coverup story was that OTC was a corporation
which provided training and consultation services to petitioner for a fee.
Petitioner planned several measures to implement this cover and some of them
were actually executed.
*431 On May 25, 1969 Vicki Polimeni, SBO and high-ranking official in the
FBO network, by dispatch orchestrated a plan to disguise payments AOLA and
other Advanced Organizations in Denmark and the United Kingdom made to OTC as
debt repayment. She ordered the FBO at AOLA and various other Advanced
Organizations to prepare and backdate weekly statements showing that each
Advanced Organization was making expenditures ON BEHALF OF OTC. [FN31] The FBOs
were directed to make these statements using Flag bill folders and Flag
summaries. However, the Polimeni dispatch directed the FBOs not to mention Flag
on the prepared statement. A mock statement itemizing Advanced Organization
expenditures on behalf of OTC was included in the dispatch as an example.
[FN32] The dispatch further explained that at the same time the FBOs were
preparing the statements, the SBO and others at Flag would prepare billings
from OTC to the Advanced Organizations using the statements to substantiate the
billings. The purpose of these statements and billings was to manufacture
evidence to show to the IRS which would disguise Advanced Organization payments
to OTC as debt repayment for services OTC had allegedly rendered. In fact OTC,
by petitioner's own admission, did not perform services for petitioner of the
type described in the mock statement.
As part of the coverup plan, the FBO International wrote the FBO at AOLA on
May 29, 1969 informing him that changes would have to be made to AOLA's
disbursement vouchers and invoices to OTC dating back to August 1968 to make
them support petitioner's tax story. (Petitioner's branch churches used
disbursement vouchers to record payments and invoices to record receipts.) On
June 1, 1969 the FBO International also directed the FBO AOLA to prepare new
signature cards and change the drawer's name on checks for account number 6919
used by AOLA but periodically maintained in the name of OTC at the Wilshire-
Westlake Office of *432 the Crocker-Citizens National Bank in Los Angeles.
This was done. Signature cards for this account show that between August 2,
1968 (when the account was established) and August 13, 1969 the account was
periodically held in the name of OTS or OTC, in combination with petitioner's
name or AOLA's name. However, beginning on August 14, 1969, account number 6919
was held in AOLA's name with no mention of OTC. Sometime in 1969 the drawer's
name was also changed on checks for account number 6919 from OTS to Church of
Scientology of California Advanced Organization of Los Angeles Reserve Account.
During the docketed years, petitioner advocated and practiced the use of
obstructionist tactics to thwart IRS investigations of petitioner and
affiliated churches. In 1970 petitioner's tax returns for the taxable years
1964 through 1967 were under audit. In June or July of that year Martin
Greenberg, the Church's accountant, told an assembled group of Scientologists
[FN33] that he purposely made the audit difficult. He said he gave the examiner
boxes of original records, disbursement vouchers and invoices in no semblance
of order with the intent of so hopelessly overwhelming and confusing the
examiner that he would be forced to give up the examination and accept
petitioner's version of the facts. In April 1972 Mr. Greenberg instructed a
member of the financial staff at an affiliated Church of Scientology to use
similar tactics if IRS agents ever came to her church to examine records. She
was told to give the IRS agent a bunch of records in a box in no semblance or
order, to place the agent in a dark, small, out-or-the-way room, to refuse to
give practical assistance like locating records, and to notify petitioner's
Guardian Office immediately of the agent's presence. Henning Heldt,
petitioner's vice president and the Deputy Guardian Finance in petitioner's
Guardian Office, gave this staff member similar instructions.
For approximately two years from May 1971 through February 1973, IRS Agent
Robert Cluberton tried unsuccessfully to audit petitioner's 1968 and 1969 tax
returns. [FN34] Part of the *433 audit's lack of success was attributable to
the IRS's failure to pursue vigorously the audit and part to petitioner's
refusal to cooperate. [FN35] Petitioner never allowed agent Cluberton access to
its financial records. On February 9, 1973 agent Cluberton served an
administrative summons on Henning Heldt, vice-president and director of
petitioner. The summons specified records and documents to be produced and
allowed a 10-day return. Heldt did not comply. On February 20, 1973 Heldt
appeared at the Los Angeles IRS office and handed Cluberton a letter stating he
had resigned as an officer of the California Church and therefore did not have
control of its records. Notwithstanding his resignation, Heldt continued to
exercise control over petitioner's financial records. By letter dated June 12,
1973 he authorized the Crocker-Citizens National Bank to release certain bank
statements to the bearer of the letter.
On or about October 26, 1971, petitioner filed an informational return, Form
990, for the taxable year 1970; on or about August 21, 1972, for 1971; and on
or about October 12, 1973, for 1972. All three informational returns were
prepared and signed by Martin Greenberg, certified public accountant. Reverend
Mulligan as president co-signed the 1970 return; Craig Beeney as secretary and
vice-president, respectively, co-signed the 1971 and 1972 returns. The returns
were signed under penalty of perjury. They do not contain financial information
for the United Kingdom Church of OTC.
During and after the docketed years, petitioner's Guardian Offices in the
United States and the United Kingdom planned and executed a scheme to
infiltrate the IRS, seize records pertaining to Scientology-related tax matters
pending before the IRS, and conceal petitioner's connection to these covert,
illegal activities. During this period the highest ranking Guardian was Mary
Sue Hubbard who held the position Commodore Staff Guardian. Jane Kember, the
Guardian Worldwide, was just under her in rank. In the United States during the
years 1970-1972, the highest ranking official in the *434 Guardian Office
was Robert Thomas, the Deputy Guardian United States (DG US). His senior staff
and their positions from 1970-1972 were as follows:
James Mulligan .. Deputy Deputy Guardian [FN36]
Joel Kreiner .... Deputy Guardian Legal
Craig Beeney .... Deputy Guardian Technology
Henning Heldt ... Deputy Guardian Finance
Arthur Maren .... Deputy Guardian Public Relations
Terry Milner .... Deputy Guardian Intelligence [FN37]
Martin J. Greenberg, whose title was CPA US, was an adjunct of the United
States Guardian Office during these years. He was petitioner's accountant.
Henning Heldt reviewed his work. By the end of 1972 the USGO had 40 staff
members. James Mulligan, Craig Beeney and Henning Heldt also served as officers
and directors of petitioner during the docketed years. Their positions and
dates of service were:
James Mulligan .. Director and president
(Jan. 1, 1970--Sept. 3, 1973)
Henning Heldt ... Director and vice president
(Feb. 23, 1971--Feb. 16, 1973)
Craig Beeney .... Director and secretary
(Feb. 23, 1971--Apr. 13, 1973)
In April 1972, petitioner's Guardian Office formulated a three-prong plan
designed to stop what it perceived to be an IRS attack on Scientology. The plan
was developed in response to several unfavorable tax rulings revoking the tax-
exempt status of Churches of Scientology in the United States. The plan called
for three separate intelligence operations: Operation Search and Destroy,
Operation Random Harvest, and Operation Paris. The purpose of Operation Search
and Destroy was to identify organizations and individuals furnishing
information to the IRS and secure information about them covertly and overtly
which could be used to discredit or 'Dead Agent' them. This plan appears to
have been a continuation of an earlier program since the Intelligence Bureau of
the Guardian Office was already in possession of files taken from
organizations *435 providing information to the IRS. [FN38] Care was to be
taken to prevent the Church of Scientology from being connected to the covert
component of the operation.
The purpose of Operation Random Harvest was to document criminal activity on
the part of the IRS. The purpose of the third intelligence program, Operation
Paris, was to identify IRS personnel handling Scientology tax matters and to
investigate their backgrounds and activities. A segment of the plan called for
recruiting a 'plant' to develop social and professional contacts with IRS
personnel and develop a cover to hide his affiliation with the Church of
Scientology. Significant information gleaned from Operation Paris was to be
forwarded to the Intelligence Bureau of the Guardian Office. The Deputy
Guardian Intelligence (DG Int US) was placed in charge of this project.
The Guardian Office later developed another plan to infiltrate the IRS and
appropriate documents. The plan is memorialized in Guardian Order 1361 dated
October 21, 1974. The plan was developed in response to the IRS's continuing
investigation of Scientology tax matters which petitioner viewed as an attack.
Part of this investigation covered petitioner's tax returns for 1964-1969. The
purpose of the plan was to root out damaging reports considered to be false in
the IRS files so that the IRS would forget about Scientology and direct its
attention elsewhere. The plan called for infiltrating IRS offices in Los
Angeles, Washington, D.C., and London; stealing files on Scientology and L. Ron
Hubbard; and developing a suitable cover story to disguise how the information
was obtained. The Deputy Guardian Information, U.S. ('DG Info US') was in
charge of implementing most of the plan.
Pursuant to Guardian Order 1361, the IRS offices in Washington, D.C., were
burglarized and documents relating to petitioner and other Scientology churches
were taken and forwarded to petitioner's Guardian Office. At one point
Scientology operatives had difficulty gaining access to IRS intelligence files.
They tried to solve this problem by having petitioner's attorney, Joel Kreiner,
a witness in this case, make a Freedom of Information request for these
documents believing the request would lead the IRS to place the filed in a
*436 central location for processing where they would be more accessible.
Operatives gained inside information about the 1971-1974 audit by monitoring
the offices of Lewis Hubbard and his assistant and then successor, Stephen
Friedberg. Their offices were monitored over a period of several months while
the 1971-1974 audit was in progress. At one point during this period,
operatives reported they had gained access to all of the materials on
Scientology kept in Lewis Hubbard's office including Chief Counsel's files.
They also gained possession of Stephen Friedberg's handwritten daily notes
which contained occasional references to the examiner's activities.
On December 11, 1979 several ranking officials in petitioner's hierarchy were
convicted in the United States District Court for the District of Columbia of
conspiracy to obstruct justice and to obstruct a criminal investigation in
violation of 18 U.S.C. section 371. They were Mary Sue Hubbard, the
Founder's wife and second in the executive chain-of-command during the docketed
years; Henning Heldt, petitioner's vice-president and Deputy Guardian Finance
during the docketed years; Duke Snider, petitioner's president from late 1975
through May 10, 1976 and USGO official; Gregory Wilardson, a USGO intelligence
official in the post-docketed years; and Richard Weigand, also a USGO
intelligence official in the post-docketed years. On the same day Mitchell
Hermann a/k/a Mike Cooper, a Guardian official employed by the Church of
Scientology in the District of Columbia, was convicted of conspiring to steal
Government documents including ones pertaining to the 1971-1974 audit. [FN39] A
year later, on December 19, 1980, Jane Kember and Morris Budlong were convicted
in the United States District Court for the District of Columbia of
burglarizing the Exempt Organizations Division of the National Office of the
IRS on three occasions in 1976 while the 1971-1974 audit was in progress. Jane
Kember, the Guardian Worldwide, was the highest ranking official in the United
Kingdom Church during the docketed years. Morris Budlong was an official in the
Guardian Office Worldwide in the post-docketed years.
In the spring of 1975, Guardian Office personnel came aboard the Apollo and
engaged in a project to falsify petitioner's *437 financial records. The
project was undertaken in anticipation of an IRS audit.
From June 1975 through July 1976 the IRS audited petitioner's records bearing
on its 1971-1974 tax returns. Following the audit, petitioner prepared a Church
audit report and maneuvered to have it serve as the operative statement of
facts to accompany a request for technical advice. Thereafter petitioner and
respondent entered into settlement negotiations which continued even after the
notice of deficiency was issued.
The California Church did not keep books or journals to record its financial
transactions. The examiners, therefore, worked from original records--checks,
disbursement vouchers and invoices. The California Church also gave the
examiners tax workpapers for the years 1971 and 1972 in lieu of general ledgers
or books of entry. During the course of the audit the examiners received over
300 cartons of records containing by conservative estimate two million
documents. The boxes were labeled by type of record and by year; for example,
'1971 disbursement vouchers,' but the labels did not always correspond with the
materials inside. The records were generally not in chronological order. The
checks were detached from their stubs. It took three or four examiners from one
to two weeks just to organize 49 boxes of records from the San Francisco
Organization. The Church's workpapers were not always prepared in accordance
with generally accepted accounting principles and were insufficient to
establish the information the California Church was required to report on its
During the audit the examiners tried to fathom the relationship between
petitioner and OTC. Several times they asked for canceled checks from the bank
accounts OTS maintained on behalf of the California Church. They were told
these might take several weeks to produce since foreign banks did not return
cancelled checks as a matter of course. The California Church concealed from
the examiners that it regularly received debit advices from the foreign banks
in lieu of cancelled checks, and it never produced the cancelled checks. As a
result, docketed-year disbursements totaling over $3 million from the Rubric
General Account No. 295,728 on which L. Ron Hubbard was a signatory were never
explained. The auditors made numerous requests for records to verify
*438 that OTC expenditures claimed to be made on petitioner's behalf were
actually expended on petitioner for an exempt purpose. The California Church
did not comply with some of these requests. In one instance the California
Church failed to substantiate a schedule of approximately 300 claimed
expenditures. The schedule was pared down to 20 items. The IRS never received
adequate documentation, e.g., cancelled checks or third party bills, to
substantiate even these 20 items.
During the audit and the ensuing negotiations, petitioner repeatedly
represented that OTC was a separate corporation from petitioner. Petitioner
represented that OTC was formed in 1968 to render financial services to the
Flag Division aboard the Apollo. Petitioner represented that OTC was a trusted
agent receiving and banking petitioner's funds and then expending them on
petitioner's behalf to support Flag operations. Petitioner represented that OTC
personnel performed these financial services. Petitioner further represented
that at the start of the agency relationship force of circumstances led
petitioner to deposit its funds in existing OTC bank accounts, a practice which
continued through the taxable years in issue. Petitioner also represented that
in 1972 over $2 million in cash belonging to OTC was transferred to the Apollo
and kept in OTC's custody until the end of 1974 when it was credited to
petitioner as partial payment of a debt OTC owed petitioner.
All of these representations were false. OTC was in form, but not in fact, a
separate entity from petitioner. Petitioner's personnel and not OTC personnel
kept the OTC checkbooks, directed the flow of funds into and out of OTC
accounts, receipted money for the support of Flag operations and controlled and
managed Flag expenditures. The OTC bank accounts were in reality opened and
maintained by petitioner. [FN40] Only petitioner's personnel were signatories
on the accounts. [FN41] Mary Sue Hubbard and L. Ron Hubbard were sole
*439 signatories on the accounts. The $2 million in cash that was brought to
the Apollo in 1972 in reality belonged to petitioner and not OTC. The cash was
withdrawn from a Swiss bank account upon L. Ron Hubbard's authority,
transferred to the Apollo by Flag employees, and kept in a file cabinet in a
strongroom to which only Mary Sue Hubbard had keys.
Throughout most of th course of the conspiracy, the California Church
knowingly concealed the status of the United Kingdom Church as an operating
branch of petitioner. The Forms 990 filed by petitioner for the years 1970-1972
did not consolidate or include the receipts, disbursements, assets or
liabilities of the United Kingdom Church. Church submissions to the IRS made
during the audit and intended to describe petitioner's corporate structure made
no mention of the United Kingdom Church. Throughout the audit, petitioner's
representatives referred to Scientology activities in the United Kingdom by
such names as U.K. Church, U.K., United Kingdom Churches, Worldwide Church in
England, and United Kingdom Scientology Organizations. They never used the
term 'U.K. Branch' or 'Church of Scientology of California--U.K. Branch' or a
term of like import although they did furnish some records which incidentally,
e.g., in letterheads, disclosed the United Kingdom Church's corporate status.
The Church audit report cast the United Kingdom Church as a separate corporate
entity. An affidavit of petitioner's president dated November 9, 1980, in
support of a motion to quash a subpoena to produce bank records from accounts
maintained by the United Kingdom Church denied the accounts belonged to the
A stipulation in this case filed November 10, 1980 listed seven of
petitioner's divisions but did not include the United Kingdom Church. Prior to
trial, petitioner's representatives once acknowledged a formal connection
between the United Kingdom Church and the California Church while denying any
more than a formal connection. In March 1975, during the audit of the Hawaii
Church, petitioner's representative stated that the United Kingdom Church was
incorporated as the Church of Scientology of California as a legal convenience
but operated separately and independently.
The United Kingdom Church had more than a nominal connection to petitioner. It
lacked a bona fide board of *440 directors. Its franchise operations were
controlled by Flag. Policy directives were issued jointly by the United Kingdom
Church and the California Church for the board of directors of the California
Church. United Kingdom Church officials and California Church officials could
and did write checks on each others accounts. Petitioner's 'trust fund' was
administered by the United Kingdom Church.
Church officials knew the United Kingdom Church was only operating in the
United Kingdom as a branch of petitioner. At practically the same time that the
California Church's representatives in the United States were portraying the
United Kingdom Church as a separate and independent entity, petitioner's
representatives in the United Kingdom were filing documents with the Registrar
of Companies in Great Britain, referring to the United Kingdom Church as the
'Church of Scientology of California--U.K. Branch' and stating that the United
Kingdom Church 'was not resident in the United Kingdom during the above
year(s) (1967, 1968, 1970)' and was 'not a 'Close' Company within the meaning
of Schedule 18 Finance Act of 1965.' Petitioner's United Kingdom accountant,
Derek Field, who prepared and reviewed these documents, testified that the
statement was intended to reflect the fact that the United Kingdom Church was
not present in the United Kingdom as an entity. It was only present as a branch
of the California Church.
On July 8, 1977 (and past midnight into July 9, 1977) FBI agents executed a
search warrant at petitioner's premises known as the Cedars-Sinai Complex in
Los Angeles. The search warrant was based on a 33-page sworn affidavit signed
by FBI Special Agent Robert Tittle describing the Government's investigation of
charges that Scientology officials from 1974 through 1976 conspired to steal
documents belonging to the Federal Government and conspired to obstruct justice
by covering up these crimes during a grand jury investigation of a burglary of
the office of an Assistant United States Attorney in the United States
Courthouse in Washington, D.C. The search warrant specified 162 categories of
items to be seized. Category 162 called for seizure of:
*441 Any and all fruits, instrumentalities, and evidence (at this time
unknown) of the crimes of conspiracy, obstruction of justice and theft of
government property in violation of 18 U.S. code secs. 371, 1503 and 641
which facts recited in the accompanying affidavit make out.
During the search FBI agents seized a document identified as Exhibit FX in
this case from a file cabinet in petitioner's Guardian Office. The FBI agent
who seized the document did not testify.
Exhibit FU in the instant case is a folder containing Guardian Order 1361
dated October 21, 1974 and a number of reports discussing compliance with the
Guardian Order. [FN42] Guardian Order 1361 is a 9-page plan to derail
governmental challenges to the tax-exempt status of Scientology churches
including petitioner. Petitioner stipulated that Guardian Order 1361 in Exhibit
FU was prepared by petitioner's United States Guardian Office in 1974.
Petitioner did not stipulate to the authenticity of the remaining documents in
Exhibit FU. However, when the exhibit was moved into evidence some 6 months
after it was first the subject of testimony, petitioner's only continuing
objection was that the documents were the product of an illegal search and
Guardian Order 1361 calls for infiltrating the IRS and the Department of
Justice, stealing documents from IRS offices in London, Los Angeles and
Washington, D.C. and the Tax Division of the Department of Justice and passing
information culled from these documents on to the Deputy Guardians for
Information, Legal, and Public Relations at petitioner's Guardian Offices in
the United States and Great Britain. The contents of most the remaining
documents in Exhibit FU bear on compliance with Guardian Order 1361. Some are
progress reports. Some convey strategic information about *442 Government
offices targeted for burglary. Some refer to Guardian Order 1361 on their face.
Some show on their face that they were sent to a person in petitioner's United
States Guardian Office. One document is a job-posting for a position as clerk-
typist at the IRS.
Stephen C. McKellar, a criminal investigator in the Internal Security Division
of the IRS, testified about the circumstances by which the IRS came into
possession of the documents comprising Exhibit FU. His investigative report of
these circumstances was also placed in evidence.
Agent McKellar first saw the typewriter-case documents on February 8, 1978. On
that date Alvin Jones, an attorney, came to his office in Los Angeles carrying
a black, metal typewriter case full of documents in file folders. The
typewriter case had no markings on it except the letters 'SMC' for SMith-Corona
Corporation. Agent McKellar testified that Jones explained that sometime in
July 1977 one of his clients found the typewriter case by itself in a Sears
store parking lot located on Santa Monica Boulevard and Wilton Place in Los
Angeles. Agent McKeller's report amplifies this testimony somewhat and states
that Jones explained to McKellar that his client saw an unidentified man leave
the typewriter case in the parking lot unattended and that his client picked it
up when the man failed to return after a short while. Agent McKellar testified
that Jones told him he believed the documents would be of some value to the IRS
since they described information about a burglary of IRS offices in Washington,
D.C. The report further amplifies this point explaining that Jones told
McKellar the documents related to break-ins of IRS offices for the purpose of
reviewing records concerning the Church of Scientology.
Agent McKellar did not get a search warrant before opening the typewriter case
and examining its contents. When he opened it he had some belief it contained
evidence of a crime.
The audit of petitioner's 1971-1974 taxable years began in June 1975 and
lasted through July 1976. Respondent's examining agents had no authority to
conduct settlement negotiations during the audit.
The documents in exhibits DU and HG constitute some of petitioner's
correspondence with the IRS. The documents fall into one of three categories.
The majority of the documents are petitioner's responses to formal requests for
information from *443 the IRS during the audit. [FN43] These documents are
identified by the fact they have at least two of the following features: (1)
they are addressed to an examiner and bear a date corresponding to the audit
period; (2) they are captioned by or contain an internal reference to a
specific IRS request for information; (3) their content clearly relates to a
specific request for information. Exhibit DU also contains some of petitioner's
correspondence with the IRS unrelated to information sought by the examiners.
[FN44] These documents bear a date subsequent to July 31, 1976 and are
addressed to Mr. William Connett, Mr. Alvin Lurie or Mr. Joseph Tedesco of the
IRS. There are also a few miscellaneous documents in Exhibit DU which cannot
with certainty be categorized as petitioner's responses to requests for
information from the IRS. [FN45]
This is a complicated case both legally and factually--witness the long list
of issues presented for resolution and the lengthy findings of fact we have had
to make. We, therefore, think it is wise to announce our holdings at the outset
hoping this will help the reader's understanding. We hold that petitioner does
not qualify for exemption from taxation under sections 501(a) and 501(c)(3)
because it is operated for a substantial commercial purpose and because its net
earnings benefit L. Ron Hubbard, his family, and OTC, a private noncharitable
corporation controlled by key Scientology officials. Additionally, we hold that
petitioner is not entitled to tax-exempt status because it has violated well-
defined standards of public policy by conspiring to prevent the IRS from
assessing and collecting taxes due from petitioner and affiliated Scientology
churches. We further uphold the determinations respondent has made in his
notice of deficiency except his determination that petitioner received income
from the United Kingdom Church. Finally, we find that petitioner's failure to
file tax returns was without reasonable cause and *444 that respondent
therefore properly determined an addition to tax.
We have divided this opinion into eight sections, each of them announced by a
Roman numeral. The fist section deals with petitioner's challenges to the
notice of deficiency (questions 1 and 2). The second section treats
petitioner's objections to the constitutionality of the express conditions of
section 501(c)(3). However, it does not treat petitioner's attack on the
constitutionality of public policy requirements which have been read into
section 501(c)(3). See Bob Jones University v. United States, 461 U.S. 574,
103 S.Ct. 2017 (1983). In view of our holding that petitioner fails to qualify
for exemption under the express conditions of section 501(c)(3), i.e., the
provisions prohibiting commercialism and inurement, our holding that petitioner
is not entitled to exemption because it has violated public policy is simply an
additional ground of decision. We, therefore, reserve treatment of the public
policy aspects of this case to a separate section. There is one minor
exception. The second section does include treatment of petitioner's contention
that the public policy requirement is unduly vague. In sum, the second section
covers questions 3 through 10 on the list of issues presented. Midway through
the trial, respondent raised a new issue. Respondent presented evidence that
the United Kingdom Church is a branch of petitioner. The third section of this
opinion considers the legal issues generated by respondent's claim that the
United Kingdom Church is a branch church (question 13). The fourth and fifth
sections deal with the Church's financial operations (questions 14 and 15).
Section four elucidates our holding that the Church's activities evidence a
substantial commercial purpose and section five, our holding that the Church's
earnings inure to the benefit of private individuals. Section six treats the
public policy issues raised in this case (questions 11, 12, and 16). There are
three of them: (1) whether petitioner has, in fact, violated public policy; (2)
whether requiring petitioner to comport with public policy intrudes on the
Church's associational and free exercise rights protected by the First
Amendment; and (3) whether petitioner is deprived of due process by the
retroactive imposition of a public policy requirement. The seventh section
treats a number of evidentiary issues raised in this case and the
*445 eighth and last section deals with petitioner's tax liability as
reflected in the notice of deficiency (questions 17 and 18).
Petitioner mounts two attacks on the notice of deficiency. First, petitioner
alleges that it is invalid for a number of administrative reasons and second,
petitioner alleges that it is invalid because of constitutional consideration.
The main thrust of petitioner's first argument is that respondent never issued
a final letter of revocation or, if he did, he later nullified it and therefore
the notice of deficiency is null and void since an exempt organization cannot
owe taxes. Petitioner relies on A. Duda & Sons Cooperative Ass'n v. United
States, 504 F.2d 970, 973 (5th Cir. 1974), stating that respondent could not
assess taxes against a tax-exempt cooperative where it stipulated the
revocation was void.
We think petitioner misinterprets the administrative record and misreads the
Duda case. On July 18, 1967, respondent formally revoked petitioner's tax-
exempt status and subsequently published an announcement of the revocation in
the Internal Revenue Bulletin and removed petitioner's name from its cumulative
list of charitable organizations. None of respondent's actions subsequent to
the revocation show, as petitioner claims, that the revocation was either
tentative or later nullified. Admittedly respondent made no unflinching effort
to collect taxes from petitioner prior to the taxable years at issue in this
case and continued in subsequent audits to review petitioner's tax status, but
we decline to agree with petitioner that these actions either nullify the
revocation or detract from its finality.
Petitioner argues that respondent's disposition of its 1965-1967 taxable years
voided the letter of revocation issued on July 18, 1967. In 1974 respondent
issued a notice of deficiency to petitioner for the taxable years 1965-1967.
The deficiencies were comparatively small ranging from slightly over $2,500 to
slightly under $14,000. Petitioner contested the 1965 but not the other
deficiencies in the Tax Court. In late 1976, respondent settled the 1965 case
by conceding petitioner's tax-exempt status for that year only and without
prejudice to any other year and closed the other two years on the basis of 'no
*446 Petitioner's contention that respondent's disposition of its 1965-1967
taxable years amounts to a nullification of the letter of revocation stretches
the facts far beyond their reasonable interpretation. By late 1976 respondent
had concluded the 1971-1974 audit. This audit revealed potential income tax
liability in the hundreds of thousands of dollars. Respondent may well have
decided not to pursue the comparatively small deficiencies of the earlier years
in order to marshall his resources to collect the potentially greater
deficiencies of the later years. The settlement entered in the Tax Court on its
fact only applied to 1965, and the closing of the 1966 and 1967 taxable years
on the basis of 'no change' in context marks a concession of tax liability only
and is without bearing on petitioner's tax status. [FN46] That respondent in
post-revocation audits to determine petitioner's tax liability also reviewed
petitioner's tax status is also not significant. More or less the same records
have to be examined in either type of audit. Since the double issue review
required virtually no extra work, respondent's reconsideration of petitioner's
tax status shows nothing more than a desire to check for prior error. It is
noteworthy that after performing these post-revocation audits respondent never
changed his ruling. [FN47]
This case is also readily distinguished from the Duda case. In that case the
Government, in a pretrial conference, stipulated that it had revoked the
taxpayer-cooperative's tax exemption for the wrong reasons and also stipulated
that the revocation was not based on the taxpayer's failure to act as a
cooperative. 504 F.2d at 973. The Government wanted to be relieved of these
stipulations so it could collect taxes on the basis of the taxpayer's failure
to act as a cooperative. 504 F.2d at 975. The court held that the government
could not be relieved of its disastrous concessions and allowed to show that
the revocation was not a nullity. 504 F.2d at 975-976. In comparison
respondent in the case at bar has consistently maintained that petitioner was
not operating for exempt purposes. This was communicated in the letter revoking
*447 petitioner's exempt status and in the notice of deficiency. As a
general rule the notice of deficiency is presumed to be correct, Rule 142;
[FN48] Welch v. Helvering, 290 U.S. 111, 115 (1933), and the Court will not
look behind it. Riland v. Commissioner, 79 T.C. 185 (1982); Greenberg's
Express Inc. v. Commissioner, 79 T.C. 185 (1982); Greenberg's Express Inc.
v. Commissioner, 62 T.C. 324 (1974); Suarez v. Commissioner, 58 T.C. 792
(1972), overruled on other grounds, United States v. Janis, 428 U.S. 433
(1976). This is true even where the record discloses procedural irregularities.
Cataldo v. Commissioner, 499 F.2d 550 (2d Cir. 1974), affg. per curiam 60
T.C 522 (1973); Rosenberg v. Commissioner, 450 F.2d 529 (10th cir. 1971).
Petitioner has not shown any serious procedural irregularity in the way
respondent handled its case much less action rising to the level of a
nullification of the 1967 determination that it did not qualify for exemption
Petitioner also challenges the notice of deficiency and the letter of
revocation on constitutional grounds. The gravamen of petitioner's complaint is
that respondent selectively enforced the tax laws against petitioner, revoking
the Church's exemption form taxation and determining a deficiency because of
hostility to Scientology in violation of the equal protection component of the
Fifth Amendment and the First Amendment. [FN49] In support of its argument,
petitioner makes a number of factual allegations. Most of them boil down to one
of three points. First, respondent's files are suffused with correspondence and
memoranda denouncing Scientology. Second, special intelligence groups within
the IRS charged with investigating politically active organizations targeted
petitioner and affiliated churches for surveillance. Third, respondent
arbitrarily and capriciously handled numerous Scientology tax matters pending
in the IRS.
Ordinarily, this Court will not look behind the notice of deficiency to
examine respondent's motives, policies or procedures in making his
determinations. Suarez v. Commissioner, supra at 813; Greenberg's Express
Inc. v. Commissioner, supra at 327. However, this Court has recognized a
limited exception to this rule which appertains here. When there is substantial
*448 evidence of unconstitutional conduct on respondent's part and the
integrity of our judicial process would be impeded were we to let respondent
benefit from it, this Court will examine respondent's conduct in reaching a
determination. Greenberg's Express Inc. v. Commissioner, supra at 328;
Suarez v. Commissioner, supra. We believe that the evidence supporting
petitioner's accusations raises sufficient doubts about the constitutionality
of respondent's conduct that judicial scrutiny of his actions is required to
prevent our system from becoming an instrument of selective enforcement of the
There are two components to petitioner's religious hostility argument, one
involving equal protection and the other, free exercise considerations.
Petitioner makes the equal protection claim that it has been singled out for
enforcement because of its unpopular religious views and practices. Petitioner
also claims respondent violated its First Amendment rights because respondent's
adverse determinations were motivated by its dislike for the Church's
We first consider petitioner's selective enforcement argument. It is by now
well established that equal protection requires that laws fair on their face be
impartially executed, Yick Wo. v. Hopkins, 118 U.S. 356, 373-374 (1886), and
that discriminations based on hostility to a group's religion are
constitutionally intolerable. Niemotko v. Maryland, 340 U.S. 268 (1951).
However, 'the conscious exercise of some selectivity in enforcement is not in
itself a federal constitutional violation,' Oyler v. Boles, 368 U.S. 448,
456 (1962), and is even necessary, particularly, '(i)n the tax field, with
million of returns, and many thousand that reveal some basis for further
investigation.' United States v. Wilson, 639 F.2d 500, 505 (9th Cir. 1981).
In the criminal field, a case of selective prosecution is made out when the
defendant shows: (1) the decision to prosecute was based on impermissible
grounds such as race, religion or the exercise of constitutional rights; and
(2) that other similarly situated are generally not prosecuted. Karme v.
Commissioner, 673 F.2d 1062, 1064 (9th Cir. 1982), affg. 73 T.C. 1163
(1980); United States v. Ness, 652 F.2d 890, 892 (9th Cir.), cert. denied
454 U.S. 1126 (1981); United States v. Moon, 718 F.2d 1210 (2d Cir.
1983), cert. denied 466 U.S.__, 104 S.Ct. 2344 (1984). Like the Ninth
Circuit, which has appellate jurisdiction of this case, we express our concern
that examining the IRS's actions *449 here under the standard applied in
criminal cases may be too stringent a test. Karme v. Commissioner, supra at
1064. However, we need not decide this issue since petitioner's argument fails
under both prongs of the criminal test.
Petitioner makes a number of factual allegations--some well founded, some
exaggerated and some completely unsupported. Petitioner did demonstrate that
respondent's files contain memoranda and correspondence denigrating
Scientology. During the period in which petitioner's tax-exemption was under
active consideration, a few of respondent's agents called Scientology a
'medical quackery'; a 'threat to the community, medically, morally and
socially'; a 'prey on the public pocketbook'; and similar epithets. These
comments mostly sprang from persons in respondent's Refund Litigation Division,
then assisting the Department of Justice in defending the Founding Church
refund tax case. However, agents in respondent's Exempt Organizations Division
charged with reviewing petitioner's tax status were privy to them. These
comments were the remarks of individuals. There is not evidence respondent
adopted them. However, some derogatory statements about Scientology are clearly
attributable to respondent. In his Trial Memorandum respondent stated that he
intended to prove petitioner violated charitable law standards of public policy
by the infliction of psychic harm including the loss or moral judgment through
brainwashing accomplished by auditing and other practices and procedures. In
correspondence sent to this Court, respondent called the Church a 'cult,' once
again referred to the Church's 'brainwashing' methods, and characterized the
Church's policies and practices as a danger to the moral and physical health of
citizens and responsible for trouble in families. None of these charges were
proved although this Court's rulings did not preclude respondent from showing
Church policies and practices violated civil or criminal law.
Between 1969 and 1975, respondent formed and maintained three special
intelligence units. These units collected information about taxpayers selected
by essentially political criteria ostensibly to monitor their compliance with
the tax laws. All three units collected information about petitioner. In
October 1969 one of these intelligence units, the SSS, added the Founding
Church to a list of 99 organizations selected for *450 investigation. Other
groups selected at the same time included the Black United Front, the New Left
Movement and the Welfare Rights Organization. After the Founding Church was
selected, the SSS received some information from respondent's district offices
about Scientology churches. Virtually all of it concerned matters pertinent to
the tax status of these churches. The Case Development Unit, a local
intelligence unit operating out of respondent's Los Angeles district office,
also collected information about the California Church and Scientology. Most of
the information pertained to financial, religious, or charitable matters. A few
reports linked petitioner or Scientology to criminal activity. A third
intelligence group, the IGRU, established in 1973 had chapters in respondent's
district offices. Intelligence reports in respondent's Los Angeles district
files connected petitioner with tax protest activity. Perhaps based on these
reports, the Los Angeles IGRU chapter classified petitioner as a tax resister.
Files from the St. Louis IGRU unit were destroyed in 1975. One such file
labeled 'subversives' contained material only about Scientology.
Counterbalancing these facts evidencing respondent's political and religious
hostility to petitioner is the record of petitioner's actual treatment by the
IRS. The decision to revoke petitioner's exemption was based upon legitimate
agency concerns. The decision was made after respondent examined petitioner's
1964 and 1965 information returns and following local and national protest
conferences. [FN50] It was based on findings that the Church's activities were
akin to a business, that it was serving the private interests of its members
and not the public, and that its income inured to the benefit of Scientology
practitioners. Thus both the procedures for the grounds of revocation were
based upon the valid exercise of agency authority.
Petitioner's contention that its revocation was rushed through agency channels
as part of a wholesale effort to take away the tax-exempt status of Scientology
churches is not borne out. First, the revocation was not rushed. While we do
not know exactly when the audit of petitioner's 1964 and 1965 informational
returns took place, we surmise that the examination *451 must have taken
place in the first half of 1966 since by July 29, 1966 respondent had sent
petitioner a letter stating proposed grounds for the revocation. The formal
letter of revocation was issued on July 18, 1967. Thus, the deliberations
leading to the revocation, far from being rushed, stretched out, at least, over
the course of a year. Second, petitioner's loss of exemption was not part of a
wholesale scheme. Admittedly, respondent examined several other Scientology
churches during this period. These reviews were prompted by a request from the
Department of Justice which was then defending a tax refund case against the
Founding Church. The Founding church was denied exempt status on the grounds
that it was organized and operated as a profit-making venture benefiting
private interests and not serving religious or educational purposes. The
Department of Justice in October of 1966 asked respondent to investigate
affiliated churches holding tax-exempt status and report on ways they could be
distinguished or rescind their exemptions if they could not. Respondent acted
on this request and investigated several Scientology churches. In some cases
denial or revocation of exemption was recommended. However, no other church
besides petitioner appears to have lost its exemption during this period.
Between 1967 and 1974 respondent delayed action or changed positions on
several matters involving Scientology churches. Respondent also issued Manual
Supplement 42G-228. The manual established guidelines and procedures for
identifying and examining Scientology churches and processing applications for
exemption. The record disclosed no nefarious motive for respondent's
indecisiveness and we think respondent's hesitancy in rushing toward litigation
was justified by the sensitivity and, in some cases, novelty of the issues
involved. As for the Manual Supplement, a panel of the Ninth Circuit has
already commented on this document saying that, in view of the Court of Claims
decision upholding respondent's deficiency determination in the Founding Church
case, the IRS might be remiss were it not to give special scrutiny to
Scientology organizations. Compare United States v. Church of Scientology of
California, 520 F.2d 818, 823 (9th cir. 1975), with Church of Scientology of
Hawaii v. United States, 485 F.2d 818, 823 (9th Cir. 1975), with Church of
Scientology of Hawaii v. United States, 485 F.2d 313, 317 (9th Cir. 1973).
*452 The deficiency determination was based on facts learned during an
extensive audit of petitioner's records. Good-faith negotiations preceded the
issuance of the notice of deficiency. Petitioner's contention that respondent's
conditions of settlement were arbitrary or unconstitutional is not well taken.
Certainly respondent was well within his authority to insist that petitioner's
income could not inure to the benefit of OTC, a private for-profit corporation.
Sec. 501(c)(3); sec. 1.501(c)(3)-1(d)(1)(ii), Income Tax Regs. Respondent could
also require petitioner to file returns and keep records. Sec. 6001. Only
exempt churches are relieved of these obligations, sec. 6033(a)(2)(A)(i), and
respondent was never willing to recognize unconditionally petitioner's exempt
status. Rather, respondent's only offer of recognition was limited to
petitioner's 1970-1972 taxable years. Respondent was also well within his
authority to demand that petitioner disavow participation in the crimes
described in the Tittle affidavit. The First Amendment does not shield a church
from the constraints of the criminal law, Late Corporation of the Church of
Jesus Christ of Latter-Day Saints v. United States, 136 U.S. 1 (1890), and
the Government through respondent could insist its largesse not subsidize
criminal activity. Regan v. Taxation with Representation of Washington, 461
U.S. 461 U.S. 540, 103 S.Ct. 1997, 2002-2003 (1983); Bob Jones University v.
United States, 461 U.S. 574, 103 S.Ct. 2017, 2028-2029, 2032 (1983);
Oklahoma v. Civil Service Commission, 330 U.S. 127 (1947).
Weighing all these facts, we find that petitioner's contention that respondent
selectively enforced the tax laws against the California Church out of
religious or political animosity falls short of the mark. On the one hand,
petitioner was investigated by special intelligence groups formed to collect
information about organizations selected for ideological reasons rather than
tax considerations. Also respondent, perhaps sometimes using a trial lawyer's
hyperbole, denigrated the practice of auditing and made other mostly unproven
charges about petitioner's harmful policies and practices. Weighed against
these facts is the almost flawless record of respondent's actual treatment of
petitioner's tax status and liability. The decision to revoke petitioner's
exemption, the detailed and extensive audits of its records, the lengthy post-
audit settlement negotiations carried on in good faith and the final issuance
of the *453 notice of deficiency were all valid exercises of administrative
authority. We are also mindful that some of respondent's expressed hostility to
petitioner's practices is attributable to petitioner's proven efforts to thwart
respondent's duty to administer the tax laws.
Petitioner has also failed to meet the second prong of the criminal selective
enforcement test. It has failed to demonstrate that respondent has not enforced
the provisions of section 501(c)(3) against others similarly situated, Karme v.
Commissioner, supra at 1064. Nor could petitioner meet this test. The cases
in this Court alone are ample evidence of respondent's vigorous enforcement
policy against churches which overreach the conditions of their exemption. See
Bethel Conservative Mennonite Church v. Commissioner, 80 T.C. 352 (1983);
Ecclesiastical Order of ISM of AM, Inc. v. Commissioner, 80 T.C. 833 (1983);
Church of the Transfiguring Spirit v. Commissioner, 76 T.C. 1 (1981); People
of God Community v. Commissioner, 75 T.C. 127 (1980); Basis Bible Church v.
Commissioner, 74 T.C. 846 (1980); Unitary Mission Church v. Commissioner,
74 T.C. 507 (1980), affd. in an unpublished opinion 647 F.2d 163 (2d Cir.
1981); Bubbling Well Church of Universal Love, Inc. v. Commissioner, 74 T.C.
531 (1980), affd. 670 F.2d 104 (9th Cir. 1981). For cases in other courts,
see Founding Church of Scientology v. United States, 188 Ct. Cl. 490, 412
F.2d 1197 (1969), cert. denied 397 U.S. 1009 (1970); Universal Life Church
v. United States, 372 F.Supp. 770 (E.D. Calif. 1974).
Petitioner attempts to take itself out of the simple category of churches by
claiming it is the only hierarchical church to have been selected and the only
church denied exemption on public policy grounds. It is always possible to
define the relevant class so narrowly that all others are eliminated. We
believe the operative class to be churches or the even broader category,
religious organizations. These are the classes employed by the Code. See
sections 501(c)(3), 6033(a)(2)(A)(i), 6033(a)(2)(C)(i) and 7605(c). We see no
reason under the circumstances to ignore the legislative classification.
Furthermore, respondent is well within his rights to mount a test case
challenging a church's tax-exempt status on public policy grounds. Such action
does not constitute discriminatory enforcement. *454 Mackay Telegraph &
Cable Co. v. City of Little Rock, 250 U.S. 94, 100 (1919).
Petitioner repeats its same argument, that respondent revoked its tax-exempt
status and issued a notice of deficiency out of hostility to its religion,
under the First Amendment. The First Amendment, however, offers petitioner no
more protection that the Fifth Amendment. Thus, petitioner is not entitled to
redress even though conduct violative of the First Amendment is a substantial
factor behind adverse governmental action where the Government shows by a
preponderance of the evidence that it would have made the same determinations
without resort to unconstitutional considerations. Givhan v. Western Line
Consolidated School District, 439 U.S. 520, 526-417 (1979); Mt. Healthy City
Board of Education v. Doyle, 429 U.S. 274, 287 (1977); Lee v. Russell County
Board of Education, 684 F.2d 769 (11th Cir. 1982). We recognize that the
cited cases are employment cases involving the firing of untenured teachers who
have spoken out on political issues. However, we believe the rationale of these
cases is fully applicable here. A person whose constitutional rights have been
violated should not be placed in a better position than he would have been in
had his rights not been violated. The proper remedy is to remove the taint. Mt.
Healthy City Board of Education v. Doyle, supra at 286-287. Cf. Duren v.
Missouri, 439 U.S. 357, 368 n. 26 (1979); Village of Arlington Heights v.
Metropolitan Housing Development Corp., 429 U.S. 252, 270-271 n. 21 (1977);
Knoetze v. United States, 472 F. Supp. 201, 214-215 (S.D. Fla. 2979), affd.
634 f. 2d 207 (5th Cir.), cert. denied 454 U.S. 823 (1981). Here, a
healthy preponderance of the evidence shows that Service audits of the Church's
records revealed petitioner had a substantial commercial purpose and had net
earnings which inured to the benefit of a private corporation controlled by key
Scientology officials. These are both valid statutory grounds for determining a
deficiency. They overcome any taint that this case was prosecuted out of
hostility to Scientology.
Petitioner raises a number of challenges to the constitutionality of section
501(c)(3). This section of the Code is one of *455 several sections which
describe entities exempt from taxation under section 501(a). In pertinent part,
section 501(c)(3) states:
Corporations * * * 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. * * *
The inurement restriction has received a narrow construction. While allowing
reasonable expenses as deductions against gross earnings, University of
Massachusetts Medical School Group Practice v. Commissioner, 74 T.C. 1299,
1306 (1980); Saint Germain Foundation v. Commissioner, 26 T.C. 648, 659
(1956), courts have held that any money or benefits flowing to private persons
which are not ordinary and necessary business expences, no matter what the
amount, constitute inurement, Unitary Mission Church v. Commissioner, 74
T.C. 507, 513 (1980), affd. without published opinion 647 F. 2d 163 (2d Cir.
1981); Founding Church of Scientology v. United States, 188 Ct. Cl. 490,
500, 412 F. 2d 1197, 1202 (1969), cert. denied 397 U.S. 1009 (1970). The
'exclusively religious purpose' restriction, on the other hand, has not been
literally construed. A religious organization can have incidental nonreligious
purposes and still maintain its exempt status. However, if from its activities
it can be inferred that the organization has a substantial commercial purpose,
it is ineligible for exemption. Sec. 1.501 (c)(3) - 1 (c), Income Tax Regs.
Christian Manner International v. Commissioner, 71 T.C. 661, 668 (1979);
Pulpit Resource v. Commissioner, 70 T.C. 594, 602 (1978). In addition to
meeting these express statutory conditions, this Court has ruled that section
501(c)(3) impliedly requires petitioner to comply with fundamental standards of
public policy derived from charitable trust law. Petitioner has mounted a
broadside attack on the constitutionality of these express and implied
conditions. This section treats petitioner's constitutional objections to the
express conditions of section 501(c)(3) reserving to another section
petitioner's constitutional objections to the public policy requirement which
has been read into the statute.
We first consider petitioner's challenges to the express statutory conditions
of section 501(c)(3) based on the free exercise clause of the First Amendment.
Petitioner raises three claims of unconstitutionality. Reaching the question
left open in Walz v. Tax Commission, 397 U.S. 664 (1970), petitioner *456
first claims that the requirement of governmental neutrality toward religion
mandated by the joint provisions of the free exercise and establishment clauses
constitutionally compels an exemption from taxation for 'religious income.'
[FN51] Petitioner next argues that, even if an exemption for 'religious income'
is not constitutionally compelled, nevertheless the lack of an exemption
interferes with the free exercise of religion and is not justified by a
compelling governmental interest. Thirdly, petitioner argues that section
501(c)(3) is overbroad because it penalizes commercial activity in aid of
religion that is affirmatively protected by the free exercise clause.
At the outset, we note there is some tension in the case law concerning the
standard of review applicable to questions involving tax exemptions for
preferred activities. The tension springs from the fact that tax exemptions are
generally classified as acts of legislative grace not subject to judicial
review unless arbitrary. Commissioner v. Sullivan, 356 U.S. 27 (1958);
Christian Echoes National Ministry, Inc. v. United States, 470 F. 2d 849,
857 (10th Cir. 1972), cert. denied 414 U.S. 864 (1973); Parker v.
Commissioner, 365 F. 2d 792, 795 (8th Cir. 1966), cert. denied 385 U.S.
1026 (1967), affg. this point Foundation for Divine Meditation, Inc. v.
commissioner, T.C. Memo. 1965-77. Augmenting this line of cases is another
line holding that the Government has no obligation to subsidize preferred
activities, Regan v. Taxation With representation of Washington, 461 U.S.
540, 103 S.Ct. 1997, 2001 (1983); Harris v. McRae, 448 U.S. 297, 316-318
(1980); Maher v. Roe, 432 U.S. 464 (1977); Buckley v. Valeo, 424 U.S. 1,
93-108 (1976); Cammarano v. United States, 358 U.S. 498, 513 (1959), and
declining to scrutinize strictly claims of unequal distribution of government
largesse. Regan v. Taxation With Representation of Washington, 103 S.Ct. at
2003; Buckley v. Valeo, supra at 93-108. On the other hand, another line of
cases holds that the Government cannot put conditions on benefits which dampen
the exercise of First Amendment rights, McDaniel v. Paty, 435 U.S. 618
(1978); Elrod v. Burns, 427 U.S. 347, 358 n. 11 (1976); Pickering v. Board
of Education, 391 U.S. 563 (1968), and the claim of chill *457 has
triggered strict judicial scrutiny, Bob Jones University v. United States,
461 U.S. 574, 103 S. Ct. 2017, 2035 (1983); Sherbert v. Verner, 374 U.S.
398 (1963). [FN52]
Under the lesser standard of review, one which measures the statute by its
reasonableness, section 501(c)(3) clearly does not interfere with the free
exercise of religion guaranteed by the First Amendment. Under the express terms
of the statute as construed, a religious organization does not have to pay
taxes provided it is not operated for private benefit or profit. The
justification for the grant of tax exemption to charitable organizations, as a
group, is that such entities confer a public benefit. Bob Jones University v.
United States, 103 S.Ct. at 2028. They foster the mental, moral, and
physical improvement of society. Walz v. Tax Commission, 397 U.S. 664, 672
(1970). There is an additional justification for granting religious
organizations tax exemption. The grant of exemption guards against potential
acts of hostility to religion in the form of oppressive taxing measures. Walz
v. Tax Commission, supra at 673. However, when a religious organization
loses track of its charitable mission and conducts its operations for profit or
private gain the reasons for the exemption are dispelled. The organization no
longer serves the public benefit. Also, in such circumstances, it is reasonable
for the legislature to conclude that the exemption helps line the pockets of a
chosen few rather than guards against harm to religious freedom.
We believe that some, but not all, of petitioner's free exercise challenges to
the constitutionality of the express conditions of section 501(c)(3) merit
strict scrutiny. Strict scrutiny is not automatically triggered just because
petitioner is a church. Petitioner must show that one of its fundamental rights
protected by the free exercise clause is endangered by the statute. Regan v.
Taxation With Representation of Washington, supra. Petitioner posits
statutory interference with three rights: (1) the right to tax-free religious
income, (2) the *458 right to carry on church-sponsored commercial activity,
and (3) the right to practice its belief in the doctrine of exchange. Only the
last claim involves a fundamental right. Petitioner has no constitutional right
under the religion clauses to tax-free religious income. The activities
shielded by the First Amendment from Government interference--free speech, free
press, free exercise--share a common preferred position in our constitutional
scheme. Just as the press is not free from general economic regulation,
Minneapolis Star and Tribune Company v. Minnesota Commissioner of Revenue,
460 U.S. 575, 103 S. Ct. 1365, 1369-1370 (1983), and is apparently subject
to an ordinary tax, Grosjean v. American Press Co., 297 U.S. 233, 250
(1936), so, too, the free exercise clause does not immunize the income derived
from religious activity from taxation. The free exercise clause takes the first
step and protects religious beliefs and practices from governmental
interference. It does not go a second step and require the Government to
subsidize religion. Follett v. McCornick, 321 U.S. 573, 577-578 (1944);
People v. Life Science Church, 450 N.Y.S. 2d 664, 669 (Sup. Ct. 1982);
Watchtower Bible and Tract Society, Inc. v. County of Los Angeles, 30 Cal.
2d 426, 182 P. 2d 178, cert. denied, 332 U.S. 811 (1947). See also Regan v.
Taxation With Representation of Washington, 103 S.Ct. at 2001. The
establishment clause likewise does not compel a religious exemption from
taxation or, at the very least, allows Congress to interpret the course of :
benevolent neutrality' demanded by the religion clauses. Walz v. Tax
Commission, supra at 669; cf. Meuller v. Allen, 463 U.S. ___, 103 S.Ct.
3062, 3067 (1983); United States v. Lee, 455 U.S. 252, 260-261 (1982). A
compulsory subsidy of religious activity appears to have the primary effect of
advancing religion, a result prohibited by the establishment clause. Sloan v.
Lemon, 413 U.S. 825 (1973); Committee for Public Education v. Nyquist,
413 U.S. 756 (1973). An exemption for 'religious income' is also potentially
entangling since, borrowing petitioner's definition of the term, it requires
church and Government to determine item-by-item what is and is not income
derived from and dedicated to religious activity. New York v. Cathedral
Academy, 434 U.S. 125, 133 (1977); Lemon v. Kurtzman, 403 U.S. 602
(1971). [FN53] Given these dangers of entanglement and establishment, *459
at the very least, Congress ought to be the body to decide whether religious
income is deserving of an exemption.
Petitioner claims that section 501(c)(3) as construed violates its right to
carry on certain commercial activity which is affirmatively protected by the
First Amendment. Specifically petitioner claims that it cannot make a profit,
accumulate earnings sell religious literature, advertise, or remunerate its
founder without losing its exemption by running afoul of the commercial purpose
limitation that has been read into section 501(c)(3). Petitioner exaggerates
the scope of First Amendment protection for church-sponsored commercial
activity. We assume ARGUENDO that the First Amendment protects some, if not
all, of the listed commercial practices. See, e.g., Heffron v. International
Society for Krishna Consciousness, 452 U.S. 640, 647 (1981); Jamison v.
Texas, 318 U.S. 413, 416-417 (1943). However, they are protected only when
they are carried on as part of a religious mission. The First Amendment draws a
vital distinction between purely commercial activity and commercial activity in
furtherance of a religious purpose. Murdock v. Pennsylvania, 319 U.S. 105,
110 (1943). Section 501(c)(3) incorporates the requirements of First Amendment
tolerance for commercial activity in aid of religion. A religious organization
can maintain its exemption and engage in commercial activity provided it is
incidental to its religious purpose. The exemption is only lost when church-
sponsored commercial activity takes on a life of its own and assumes an
independent importance and purpose. Sec. 1.501(c)(3)-1(c), Income Tax Rgs.;
Ecclesiastical Order of Ism of Am v. Commissioner, 80 T.C. 833, 839 (1983),
on appeal (6th Cir. July 6, 1983); Parker v. Commissioner, 365 F. 2d 792,
798-799 (8th Cir. 1966), cert. denied 385 U.S. 1026 (1967). Petitioner,
therefore, does not suffer any constitutional injury on account of section
501(c)(3)'s limitation on commercial activity.
Section 501(c)(3) does interfere with the California Church's practice of its
belief in the doctrine of exchange. [FN54] This belief led the Church to exact
a fee for its religious literature, *460 artifacts and services. Thus, by
its own admission, five of its branch churches earned between 73 and 100
percent of their income from the sale of these items. While this fact alone
does not explain our decision that petitioner is ineligible for exemption
because it has a substantial commercial purpose, it does measurable contribute
to our decision. See infra at 144-145. Since there is direct conflict between
petitioner's religious practices and petitioner's eligibility for exemption,
this claim warrants strict judicial scrutiny. Bob Jones University v. United
States, 461 U.S. 574, 103 S.Ct. 2017, 2035 (1983). Under this standard,
government 'may justify a limitation on religious liberty by showing that it is
essential to accomplish an overriding governmental interest.' Bob Jones
University v. United States, 103 S.Ct. at 2035, quoting United States v.
Lee, 455 U.S. 252, 257-258 (1982). We believe petitioner's claim is directly
controlled by the Lee case. There it was held that the soundness of the social
security system, like the soundness of the revenue system, was an overriding
governmental interest that could not be made to accommodate exemptions based on
religious tenets without destroying the integrity of the revenue base. 455
U.s. at 260.
Having disposed of petitioner's claims that the express conditions of section
501(c)(3) violate the free exercise clause of the First Amendment, we turn to
petitioner's claims that section 501(c)(3) violates the establishment clause. A
statute must pass three separate tests in order to satisfy the requirements of
the establishment clause.
First, the statute must have a secular legislative purpose; second, its
principal or primary effect must be one that neither advances nor inhibits
religion; finally, the statute must not foster 'an excessive government
entanglement with religion.'
Lemon v. Kurtzman, 403 U.S. 602, 612-612 (1971), quoting Walz v. Tax
Commission, 397 U.S. 664, 674 (1970) (citations omitted). Petitioner claims
that section 501(c0(3) violates the second and third tests. The gist of
petitioner's first argument is that the commercial purpose restriction hurts
newer religions since they must rely on commercial techniques to attract
members, propagate their faith, and raise income whereas older religions
already have public recognition, established coffers, and a body of followers.
Although we believe there is *461 play in section 501(c)(3) which allows
newer religions to proselytize aggressively, arguably its overall impact on
newer religions is harsher. However, this fact alone, even if true, does not
invalidate section 501(c)(3). In addition, petitioner 'must * * * show the
absence of a neutral, secular basis for the lines government has drawn.'
Gillette v. United States, 401 U.S. 437, 452 (1971). Petitioner has not done
this. Moreover, we are convinced that the commercial purpose test does not rest
on sectarian favoritism for established religions but instead has its basis in
charitable trust law which requires charitable organizations to eschew
commercialism in favor of serving goals designed to benefit the community at
large. See sec. 1.501(c)(3)-1(d)(1)(ii), Income Tax Regs.; see also
Restatement (Second) of Trusts, secs. 368, Comment a, and 376 (1959).
Petitioner also maintains that section 501(c)(3) on its face and as applied
results in excessive government entanglement at the administrative level in
violation of the third establishment clause test set forth in Lemon v.
Kurtzman, supra. According to petitioner the sheer magnitude of respondent's
enforcement efforts is one tell-tale sign of entanglement. In slightly more
than 10 years, respondent audited petitioner four times. One of these audits
lasted a full year, employed three (perhaps four) agents, and covered millions
of documents. Respondent also collected thousands of documents relating to
petitioner. By the end of 1974, respondent's files contained approximately two
thousand Church policy letters and some books and brochures describing
Scientology beliefs and practices. According to petitioner, respondent also
unconstitutionally entangled himself in petitioner's affairs by questioning the
religiosity of certain Church practices and by using petitioner's policy
letters to inquire into Church discipline, structure, and policy.
Usually the entanglement test is invoked by a claimant seeking to invalidate a
Government program authorizing benefits to religion. See, e.g., Mueller v.
Allen, 463 U.S., 103 S.Ct. 3062 (1983); New York. v. Cathedral Academy,
434 U.S. 125 (1977); Roemer v. Board of Public Works of Maryland, 426
U.S. 736 (1976). Here, petitioner does not want to end the Government benefit
but merely to avoid respondent's interference with its enjoyment. Petitioner's
complaint, therefore, sounds more like a free exercise than an establishment
clause complaint. See *462 United States v. Holmes, 614 F.2d 985, 989 and
n. 7 (5th Cir. 1980). However, the entanglement test has been used on occasion
to limit the reach of governmental power to regulate religious activity. See
NLRB v. Catholic Bishop of Chicago, 440 U.S. 490 (1979). [FN55]
The establishment clause does not prevent the Government from making a
threshold inquiry into whether or not a given practice is religious in nature
and therefore entitled to First Amendment protection. See Wisconsin v. Yoder,
406 U.S. 205, 209-213 (1972); International Society for Krishna
Consciousness, Inc. v. Barber, 650 F.2d 430, 433 (2d Cir. 1981); Jones v.
Bradley, 590 F.2d 294, 295 (9th Cir. 1979). Petitioner's objections to
respondent's inquiry into the religiosity of Dianetics and the E-meter
therefore lack legal merit. The inquiry never crossed the threshold. Once
petitioner's witnesses asserted that the E-meter and Dianetics had a religious
purpose, respondent dropped the inquiry.
Petitioner also contends that respondent aided by Church policy letters made
an impermissibly entangling inquiry into the Church's management, corporate
structure, and its dissemination practices. We disagree. The establishment
clause does not cloak a church in utter secrecy, nor does it immunize a church
from all governmental authority. The thrust of the entanglement component of
the establishment clause is to keep Government out of the business of umpiring
matters involving religious belief and practice. Serbian Orthodox Diocese v.
Milivojevich, 426 U.S. 696, 709-710 (1976); Presbyterian Church in the
United States v. Mary Elizabeth Blue Hull Memorial Presbyterian Church, 393
U.S. 440, 449 (1969). However, civil authorities are not barred from settling
disputes implicating the secular side of church affairs as long as they rely on
neutral principles of law. Jones v. Wolf, 443 U.S. 595, 602-603 (1979);
Maryland and Virginia Eldership of the Churches of God v. Church of God at
Sharpsburg, Inc., 396 U.S. 367 (1970).
*463 Respondent did not rely on Church policy letters to establish basic
facts about the Church. A nine-volume encyclopedia of Scientology policy called
the OEC series was placed in evidence. Some of the policy letters in these
volumes contain instructions on religious practices. The majority contain
information about Church administration. An expert witness for the church
compared the OEC series to the constitution of the Presbyterian Church.
Respondent relied on scattered policy letters in the OEC volumes to question
witnesses about the Church's dissemination practices, its corporate structure
and its management functions. In making his inquiry, respondent skirted matters
of religious doctrine except at the threshold level of inquiry. We have also
used Church policy letters to make findings on these topics and others
including the Church's Franchise Programme and pricing policies. However, we
have not had to resolve doctrinal matters to make our findings. The Church's
documents speak for themselves. We, therefore, find that the use of Church
policy letters in this case is consistent with the rule laid down in Jones v.
Wolf, supra, which allows the state to examine Church documents, including
the constitution of a church, provided the documents are scrutinized in purely
secular terms and the facts determined are not attendant on the resolution of
doctrinal issues. 443 U.S. at 604. See also Maryland and Virginia Eldership
of the Churches of God v. Church of God at Sharpsburg, Inc., supra at 368.
Entanglement per se is not objectionable. What is objectionable is excessive
entanglement. By this is meant a relationship between an arm of government and
a religious institution which threatens religious liberty by coercing,
compromising, or influencing religious belief. Compare Lemon v. Kurtzman,
403 U.S. 602 (1971), with Mueller v. Allen, 463 U.S.__, 103 S.Ct. 3062
(1983). In its more benign form, an entangling statute is one which establishes
some type of government surveillance of a religious institution's affairs. See,
e.g., Lemon v. Kurtzman, supra. In its severe form an entangling statute is one
which imposes a program of government regulation. See, e.g., NLRB v. Catholic
Bishop of Chicago, 440 U.S. 490 (1979). Section 501(c)(3) does not fall into
this second class. It is not a regulatory measure. The determination of a
religious organization's tax liability does not entail *464 free to
structure its finances as it sees fit. United States v. Freedom Church, 613
F.2d 316, 320 (1st Cir. 1979).
Section 501(c)(3) falls into the more benign category of entangling statutes
since it exposes a religious organization to government audits. However, the
audits required under section 501(c)(3) do not share many of the features of
the audits found objectionable in the entanglement cases. First, respondent
does not have to monitor the activities of live human beings. Compare NLRB v.
Catholic Bishop of Chicago, supra at 501; Tilton v. Richardson, 403 U.S.
672, 687-688 (1971). Second, respondent does not have to scrutinize closely the
religious content of the organization's activities. Each receipt, expenditure
and activity of the organization does not have to be reviewed for its
religiosity. Compare New York v. Cathedral Academy, 434 U.S. 125, 132-133
(1977). Of course, records have to be examined and some judgments made about
the purpose of the organization's programs, receipts and expenses. However,
respondent does not have to sit as a religious expert. His task is to judge
whether the records evince a primary commercial purpose. Equally as important,
respondent does not have to make determinations about each and every item of
receipt or expense since section 501(c)(3) permits some commercial activity.
The loss of an exemption comes about only when the church's activities in the
aggregate reflect a primary purpose to engage in private enterprise. Finally,
the audits need not occur on an annual basis. Compare Tilton v. Richardson,
supra at 688. Churches which meet the qualifications for exemption do not
have to file annual returns. Sec. 6033 (a)(2)(A)(i).
Respondent's involvement with petitioner was extensive. However, the blame for
a goodly measure of this involvement must be laid at petitioner's doorstep.
From 1969 onward, petitioner schemed to block the IRS from examining its
records and determining its tax liability. It delayed and stalled revenue
agents. It did not keep normal business records. It falsified records, failed
to respond to requests for information, and misrepresented facts in many of
those it did answer. The First Amendment's injunction against entanglement was
not designed to shield a church against the Government's efforts to lay and
collect taxes in the face of such flagrant and often illegal resistance.
*465 Petitioner's remaining objection, that respondent evaluated the
religiosity of some of its practices, is also without merit. Respondent did
examine certain Church practices, characterized by petitioner as religious, for
their commerciality. The inquiry, however, did not intrude upon Church dogma
and belief except at the threshold level. See Walz v. Tax Commission, 397
U.S. 664, 697-698 n. 1 (1970) (Harlan, J. concurring). As is so often said 'the
line of separation (between church and state), far from being a 'wall,' is a
blurred, indistinct and variable barrier depending on all the circumstances of
a particular relationship.' Lemon v. Kurtzman, supra at 614. We find that the
enforcement measures at issue here have created no more than an incidental
burden on respondent's religious liberty.
Petitioner argues that the express and implied conditions for exempting
religious organizations from taxation under section 501(c)(3) are unduly vague
in violation of the First and Fifth Amendments. Petitioner's argument is
confined to three aspects of the statue: (1) the requirement of an exclusively
religious purpose; (2) the requirement forbidding inurement; and (3) the
requirement of complying with public policy. [FN56] We do not reach the merits
of petitioner's argument since we find petitioner lacks standing to raise it.
A claimant raising a vagueness defense must demonstrate that the statute is
vague with respect to his conduct. He is not entitled to attack the statute
because the language would not give similar fair warning to others. Parker v.
Levy, 417 U.S. 733, 756 (1974). Each of the requirements which petitioner
challenges has received narrowing constructions. The 'exclusively religious'
condition has been construed to mean that a substantial part of the
organizations activities cannot serve a commercial purpose and that the
following factors are to be considered in applying the test: amount of annual
profits, amount of accumulated earnings, methods of operation, competition with
like services in private enterprise, proportion of expenditures devoted to
exempt purposes. See sec. 1.501(c)(3)-1(c), Income Tax Regs.; see also Parker
v. Commissioner, 365 f.2d 792, 798 (8th Cir. 1966), cert. denied 385 U.S.
1026 (1967); Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202,
*466 212 (1978); Fides Publishers Ass'n v. United States, 263 f. Supp.
924 (N.D. Ind. 1967). As construed, the inurement provision allows a religious
organization to make ordinary and necessary business expenditures but disallows
any other payments to private individuals no matter how small the amount.
Founding Church of Scientology v. United States, 188 Ct.Cl. 490, 497, 500,
412 F.2d 1197, 1200, 1202 (1969), cert. denied 397 U.S. 1009 (1970). This
Court construed the public policy requirement to prohibit substantial activity
in violation of well-defined public policy such as may be evidenced by a civil
or criminal statute. Memorandum Sur Order filed April 1, 1980 at 56; Ruling
Memorandum to the Parties, Re: Evidence with Respect to So-Called Public Policy
Issues, dated October 30, 1980 at 5. For reasons only briefly stated here but
amplified elsewhere in this opinion, petitioner's conduct clearly falls within
the ambit of these narrowing constructions. It has made a business out of
selling religion; it has diverted millions of dollars through a bogus trust
fund and a sham corporation to key Scientology officials; and it has conspired
for almost a decade to defraud the United States Government by impeding the IRS
from determining and collecting taxes from it and affiliated churches.
Petitioner, therefore, lacks standing to challenge section 501(c)(30 on
Petitioner's final constitutional argument concerns the burden of proof.
[FN57] Ordinarily the taxpayer bears the burden of proof in the Tax Court to
show that respondent's determination of deficiency is erroneous. Rule 142(a).
Relying on Speiser v. Randall, 357 U.S. 513 (1958), petitioner claims this
rule of procedure offends due process when applied to a church that has been
determined deficient. According to petitioner, due *467 regard for religious
liberty requires respondent to shoulder the burden of proof.
Speiser v. Randall, supra, struck down under the due process clause of the
Fourteenth Amendment a California taxing scheme which denied exemption to
otherwise qualified taxpayers who unlawfully advocated the overthrow of the
Government by force and violence. The California statute placed the burden of
proof on the taxpayer to show he had not engaged in criminal speech. The Court
assumed without deciding that a state had the power to deny tax exemptions to
persons who engaged in criminal speech. 357 U.S. at 520. It then went on to
(W)hen the constitutional right to speak is sought to be deterred by a
State's general taxing program due process demands that the speech be
unencumbered until the State comes forward with sufficient proof to justify its
357 U.S. at 528-529. The similarities between Speiser and the instant case
are only superficial. Both situations involve the interplay between a
fundamental liberty and the Government's authority to lay and collect taxes.
There the similarities end. The taxing provisions found offensive in speiser
were aimed at the suppression of speech. 357 U.S. at 525. Also, the
procedural device employed to ferret out ineligible claimants had the practical
effect of deterring speech. 357 U.S. at 526. Unlike the California
provisions, section 501(c)(3) was not enacted to restrain religious liberty.
The Senate debate on section 38 of the Act of August 5, 1901, 36 Stat. 112-
113, a forerunner of section 501(c)(3), clearly shows that the congressional
purpose behind the measure was to excuse charitable organizations from paying
taxes so long as their profit was exclusively devoted to charitable purposes.
See 44 Cong. Rec. 4150 4151, 4155-4156 (1909) [FN58]. Moreover, as our
earlier discussions of this point concluded, section 501(c)(3) does not operate
as a restraint on religious liberty.
*468 The function of procedural devices like the burden of proof or
standard of proof is to distribute the risk of error in the factfinding
process. Santosky v. Kramer, 455 U.S. 745, 754-755 (1982). Where a claimant
is threatened with serious loss, due process requires that the claimant have
greater protection against error. 455 U.S. at 758. In determining the
seriousness of a claimant's loss, a court will consider both the nature of the
interest at stake and the permanency of the loss. 455 U.S. at 758. Here, no
liberty interest is at stake -- merely the loss of money. Furthermore, the
Church's loss is not permanent. It can regain its exempt status. The burden of
proof has traditionally been placed on the taxpayer out of recognition that
'taxes are the life-blood of government' and therefore the Government's burdens
in collecting the revenue must be few and light. Bull v. United States, 295
U.S. 247, 259-260 (1935). Placing the burden of proof on the taxpayer is also
justified on the basis that the facts and figures on which tax liability rests
are peculiarly within the taxpayer's knowledge. Campbell v. United States,
365 U.S. 85, 96 (1961). Under the circumstances, we see no reason to upset
the normal rule and place the burden of proof on respondent. [FN59]
Neither the notice of deficiency issued on December 28, 1977 nor the pleadings
treated the United Kingdom Church as a branch of petitioner. Respondent first
presented evidence relating to the United Kingdom Church on December 11, 1980
during the third week of trial immediately after petitioner rested its case-in-
chief. Respondent contended that the United Kingdom Church was a branch of
petitioner and that its operations were relevant to petitioner's tax status
under three theories. First, the franchises managed by the United Kingdom
Church were a commercial operation. Second, petitioner's attempt to conceal the
corporate status of the United Kingdom Church was proof that it conspired to
prevent the IRS from *469 performing its duties. Third, L. Ron Hubbard
possibly made personal use of the money deposited in the Worldwide Franchise
accounts. After some shilly-shallying by respondent over the scope of
respondent's intended reliance on evidence relating to the United Kingdom
Church, this Court, over petitioner's objection, ruled on July 20, 1981 that
respondent could present evidence relating to the United Kingdom Church's
activities and corporate status under all three theories of relevance.
Rule 41(b)(2) encourages this Court to accept evidence that is not within the
issues raised by the pleadings 'freely when justice so requires' provided the
objecting party is not prejudiced by its admission. Rule 41(b)(2) closely
parallels Fed. R. Civ. p. 15(b). However, Rule 15(b), Fed. R. Civ. P.,
instructs the bench to grant a continuance to enable the objecting party to
prepare rebuttal evidence.
We think that the interests of justice require us to admit respondent's
evidence concerning the United Kingdom Church. First, petitioner had ample time
through continuances to prepare rebuttal evidence. See Robbins v. Jordan,
181 F. 2d 793, 795 (D.C. Cir. 1950). This case was tried intermittently over
the course of a year. The matter of the United Kingdom Church was first raised
on December 11, 1980. On December 29, 1980 this Court made a preliminary ruling
admitting the evidence. The ruling became final on July 20, 1981, the first day
of the seventh week of trial. This Court then ruled that respondent could
present evidence relating to the United Kingdom Church's activities and
corporate status under three theories of relevance: commercialism, inurement
and conspiracy. Petitioner began its rebuttal case on August 17, 1981. With
continuances, petitioner completed rebuttal on November 12, 1981. During
rebuttal, petitioner presented ample documentary and testimonial evidence
directed toward refuting loss of tax-exempt status as a result of the United
Kingdom Church's operations. Thus, we find that the continuances cured the
prejudice, if any, to petitioner arising form respondent's presentation of the
new material. Second, we are not very sympathetic to petitioner's cry of
prejudice. The facts surrounding the United Kingdom Church's legal status were
known to petitioner long before the trial, see Hodgson v. Colonnades, Inc.,
472 F.2d 42, 48 (5th Cir. 1973); Scruggs v. *470 Chesapeake and Ohio
Railway Co., 320 F.Supp. 1248, 1250 (W.D. Va. 1970), and respondent's
tardiness in raising the issue is clearly more attributable to petitioner's
efforts at obfuscation than to respondent's bad faith or negligence. Finally,
we believe that there would be a miscarriage of justice were the matter
excluded. Petitioner's avowed purpose in bringing the various British churches
under its corporate structure was to blanket them in its tax-exempt mantle
since the British authorities refused to grant them an exemption. Thus, if the
United Kingdom Church is not subjected to our scrutiny, it will probably escape
scrutiny altogether for the tax years at issue.
Petitioner claims that respondent raised the new matter in bad faith.
Petitioner claims that respondent knew all along that the United Kingdom Church
belonged to petitioner but deliberately waited to raise the issue until
petitioner had completed its case-in-chief in order to sandbag petitioner. We
do not interpret the facts as petitioner does. We agree that a few of
respondent's agents had knowledge that the United Kingdom Church was formally
incorporated as a branch of petitioner. Chief among them was Lewis Hubbard, an
attorney in the Chief Counsel's Office, who provided guidance to the 1971-1974
audit team while the audit was in progress. At the time of the audit, Lewis
Hubbard had clearly read documents describing the California Church as a
company registered to do business in the United Kingdom. He had also read the
Foster Report, a document prepared for British Parliament, which explained that
the main activities of Scientology in the United Kingdom were carried on by the
California Church and that
this was done for tax reasons. Nevertheless Lewis Hubbard credibility
testified that at the time of the audit he believed that the United States
Kingdom Church was only nominally connected to petitioner and that it had de
facto independence. Certainly the Church did everything in its power to present
this false picture or, what is worse, to hide the connection altogether. When,
during the Hawaii audit which preceded the 1971-1974 audit, Kreiner, the
Church's attorney, told Lewis Hubbard that petitioner incorporated the United
Kingdom Church but it operated separately and independently, we must imagine
that Kreiner said it in much the same way that another of *471 petitioner's
attorneys when objecting to a subpoena of the bank records of the United
Kingdom Church told this Court:
The accounts referred to there are not accounts of the Church of Scientology
of California and they are not in its custody and control. It is true that the
accounts bear the name Church of Scientology of California Worldwide but they
are actually accounts of the United Kingdom Church of Scientology which until
two years ago, as I understand it, was incorporated as the Church of
Scientology of California but never, ever was a part of the Church of
Scientology of California that's involved in this case.
Those accounts have had nothing to do with the Church of Scientology of
California involved in this case.
Towards the end of the 1971-1974 audit, Agent Endo changed some wording in his
draft report of the audit on Lewis Hubbard's advice. The original version
stated outright that petitioner had seven divisions and listed them. On the
advice of Lewis Hubbard, Endo changed this to state that according to
petitioner's submissions the Church had seven divisions. The listed divisions
did not include the United Kingdom Church. Petitioner sees some form of
sinister entrapment in this. We find nothing but the professional exercise of
Lewis Hubbard ceased advising respondent on Scientology matters in July 1977.
This was several months before agent Endo drafted the notice of deficiency in
November of 1977. There is no evidence that Lewis Hubbard advised Endo when the
latter drafted the notice of deficiency which for all intents and purposes
framed the issues in this case. Other than Lewis Hubbard, none of respondent's
agents with direct responsibility for the prosecution of this case, or the
1971-1974 audit underlying it, even knew that the United Kingdom Church was
connected with petitioner. During the Hawaii audit and the 1971-1974 audit
respondent's agents reviewed letters, checks, receipts and disbursement
vouchers bearing such names as the church of Scientology of California UK or
Church of Scientology WW on the letterhead or as the endorsement or payee. A
few letters and receipts bore petitioner's name in bold print on the letterhead
and the words 'a non-profit corporation in U.S.A. registered in England' in
fine print across the bottom. There were few such documents in comparison to
the more than 2 million documents which the agents reviewed. Under the
circumstances, where Church officials were actively misleading the audit team
about the *472 legal status of the United Kingdom Church, we do not think
that the mere mention of the official name of the United Kingdom Church on a
document, often in fine print, should have appraised respondent of the legal
In conclusion, we find no evidence of bad faith in respondent's initial
failure to incorporate the operations of the United Kingdom Church in its case
petitioner. Admittedly Lewis Hubbard was on the road to discovery. However,
Church officials did everything in their power to throw IRS officials off the
scent of the United Kingdom Church's legal and operating connection to
petitioner. They were almost successful. We cannot, however, countenance their
effort at obfuscation by excluding the issue from our consideration. If any
party is guilty of bad faith, it is petitioner.
Petitioner cites a number of cases in which this Court has disallowed the
introduction of a new issue on grounds of prejudice. See, e.g., Fox Chevrolet,
Inc. v. Commissioner, 76 T.C. 708, 733-736 (1981); Estate of Goldsborough v.
Commissioner, 70 T.C. 1077, 1085-1086 (1978); affd. in an unpublished
opinion 673 F.2d 1310 (4th Cir. 1982); Estate of Mandels v. Commissioner,
64 T.C. 61, 73 (1975); Estate of Horvath v. Commissioner, 59 T.C. 551,
556 (1973). These cases are distinguishable. Unlike the case at bar, no
continuance was granted to allow the objecting party time to meet the evidence.
Also, unlike the case at bar, the objecting party did not induce or contribute
to respondent's failure to grasp and raise the issue sooner.
Respondent bears the burden of proving the United Kingdom Church is an
operating branch of petitioner, since this matter was not pleaded, is
inconsistent with the notice of deficiency, and required petitioner to produce
new evidence to refute it. Rule 142(a); Achiro v. Commissioner, 77 T.C. 881,
890 (1981); Estate of Falese v. Commissioner, 58 T.C. 895, 899 (1972).
Petitioner concedes that the United Kingdom Church was incorporated as the
Church of Scientology of California but argues that the United Kingdom Church
operated independently: *473 De jure it is part of petitioner; de facto it
is separate. Petitioner argues that substance should control over form. We
reject petitioner's argument. Historically, the churches that comprise the
United Kingdom Church were not part of petitioner. They operated independently.
However, the British authorities would not grant them non-profit status. As a
result the assets of these churches were transferred to petitioner so that they
could carry on their operations in the United Kingdom under petitioner's tax-
exempt mantle. As we said in Legg v. Commissioner, 57 T.C. 164 (1971), affd.
per curiam 496 F.2d 1179 (9th Cir. 1974):
The petitioner's first contention has little or no justification in light of
the fact that the form of the transaction was contemplated and carried out by
the petitioners; it was their decision to report the sale on the installment
basis. A taxpayer cannot elect a specific course of action and then when
finding himself in an adverse situation extricate himself by applying the age-
old theory of substance over form.
57 T.C. at 169. Petitioner elected to make the United Kingdom Church a
branch church. It cannot escape the consequences of that decision now. '(W)hile
a taxpayer is free to organize his affairs as he chooses, nevertheless, once
having done so, he must accept the tax consequences of his choice* * *.'
Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134,
149 (1974) (citations omitted).
We also find that the United Kingdom Church was in fact subordinate to
petitioner. Admittedly it appears to have had some operating autonomy, and, by
and large, to have kept separate financial accounts. However, the United
Kingdom Church did not have a bona fide board of directors. Additionally two of
its major activities, its Guardian Office and its Franchise Office, were
ultimately controlled by Flag executives. Also, key officials of both churches
had authority to sign checks on the other church's accounts and sometimes
exercised it. These indicia of the United Kingdom Church's dependence on
petitioner are sufficient to carry respondent's burden of proof.
In his notice of deficiency, respondent determined that petitioner was not
operated exclusively for religious or other *474 tax-exempt purposes as
required by section 501(c)(3) during the years 1970, 1971 and 1972 and,
therefore, was not exempt from tax under section 501(a). Specifically,
respondent contends that petitioner was operated for a substantial commercial
purpose and that the net earnings of petitioner inured to the benefit of
private individuals. At the outset, we note that the burden of proof is on
petitioner to overcome these grounds for denial of exempt status by respondent.
Schoger Foundation v. Commissioner, 76 T.C. 380, 386 (1981); Rule 142(a).
See discussion supra at 129-132.
In order for an organization to be entitled to exemption from Federal income
taxes under section 501(a) and (c)(3), it must establish that it is organized
and operated exclusively for exempt purposes. Thus, qualification for tax-
exempt status under section 501(c)(3) is based on the satisfaction of two tests
commonly known as the organizational and operational tests. In order to satisfy
the organizational test, an organization's articles of incorporation must limit
it to one or more exempt purposes and not authorize substantial activities
which are not in furtherance of such purposes. Respondent concedes that
petitioner satisfied the organizational test during the docketed years.
It is the second test, the operational test, which lies at the heart of the
dispute in this case. Under this test, an organization must not engage, other
than in insubstantial part, in activities which do not further an exempt
purpose. Sec. 1.501(c)(3)-1(b) and (c), Income Tax Regs.; Nat. Assn. of
American Churches v. Commissioner, 82 T.C. 18, 28-29 (1984). With respect to
the operational test, it is 'the purpose towards which an organization's
activities are directed, and not the nature of the activities themselves, that
is ultimately dispositive of the organization's right to be classified as a
section 501(c)(3) organization.' B.S.W. Group, Inc., v. Commissioner, 70
T.C. 352, 356-357 (1978). See est of Hawaii v. Commissioner, 71 T.C. 1067,
1078-1079(1979), affd. in an unpublished opinion 647 F. 2d 170 (9th Cir.
Whether an organization satisfies the operational test is a question of fact
to be resolved on the basis of all the evidence presented by the record. See,
e.g., est of Hawaii v. Commissioner, supra at 1079; B.S.W. Group, Inc. v.
Commissioner, supra at 357. We are, of course, fully cognizant of the fact
that although *475 an organization might be engaged in a single activity,
that activity may further multiple purposes, both exempt and nonexempt.
However, while the term 'exclusively' contained in section 501(c)(3) has not
been construed to mean 'solely' or 'absolutely without exception,' Church in
Boston v. Commissioner, 71 T.C. 102, 107 (1978), it is well established that
the 'word 'exclusively' places a definite limit on the 'purpose' at issue.'
Copyright Clearance Center, Inc. v. Commissioner, 79 T.C. 793, 804 (1982).
Thus, the Supreme Court in Better Business Bureau v. United States, 326 U.S.
279, 283 (1945), explained the limit as follows:
(I)n order to fall within the claimed exemption, an organization must be
devoted to * * * (exempt) purposes exclusively. This plainly means that the
presence of a single * * * (nonexempt) purpose, if substantial in nature, will
destroy the exemption regardless of the number or importance of truly * * *
Accordingly, we must decide toward what end petitioner's activities are
directed and whether such activities are 'animated' by a substantial commercial
purpose. Better Business Bureau v. United States supra at 284. In doing so,
we note that where a nonexempt purpose is not an expressed goal, the courts
have generally focused on the manner in which the activities of the
organization are conducted, implicitly reasoning that an end can be inferred
from the chosen means. Presbyterian & Reformed Publishing Co. v.
Commissioner, __F.2d__(3rd Cir. Aug. 29, 1984), slip op. at 14, quoting from
79 T.C. 1070. 1082-1083 (1982). Among the factors relevant in making such an
inquiry are the particular manner in which an organization conducts its
activities, the commercial hue of those activities and the existence and amount
of annual or accumulated profits. B.S.W. Group, Inc. v. Commissioner, supra
at 357. The existence of any of these factors supports a conclusion that an
organization was not operated exclusively for an exempt purpose.
Practically everywhere we turn, we find evidence of petitioner's commercial
purpose. Certainly, if language reflects reality, petitioner had a substantial
commercial purpose since it described its activities in highly commercial
terms, calling parishioners, 'customers'; missions, 'franchises'; and
churches, *476 'organizations' just to mention a few of the more glaring
examples of petitioner's commercial vocabulary.
Petitioner was eager to make money. This was expressed in HCO PL March 9,
1972, MS OEC 381, 384. It sets out the governing policy of petitioner's
financial offices by exhorting these offices to 'MAKE MONEY. * * * MAKE
MONEY. * * * MAKE MORE MONEY. * * * MAKE OTHER PEOPLE PRODUCE SO AS TO MAKE
MONEY.' (capitalization in the original.) This is not an isolated policy letter
coming back to haunt petitioner. The goal of making money permeated virtually
all of petitioner's activities -- its services, its pricing policies, its
dissemination practices and its management decisions.
Perhaps the most dramatic indicator of petitioner's commercial purpose is the
fact that petitioner sold virtually all of its important religious services and
products. Petitioner did some things for free: weddings, funerals, baptisms,
family counseling, crisis auditing, and charity work. The record does not
disclose how much of petitioner's resources were devoted to these free
activities. [FN61] We do know, however, that the heart of petitioner's
religious program, its auditing and training services, had to be purchased. The
public paid a fee for these services, and while staff, on contract, were
allowed free service, this was secured by a legal note which became due and
payable if the contract was broken. Books and artifacts also had to be
purchased. The dominant role played by petitioner's sales of religious services
and products is brought home by the following table. It shows the percentages
of total income each of petitioner's branch churches providing services to the
public earned from the sale of petitioner's services and products: [FN62]
UK AOLA ASHO LAO SFO
1971 73 92 92 95 97
1972 73 99 99 98 100
*477 Of course, we are fully aware of the fact that these services and
products are religious; however, the overall manner in which they were provided
evidences a commercial purpose. In reaching this conclusion, we are
particularly impressed by three factors: (1) the manner in which petitioner
promoted Scientology services to the public: (2) petitioner's pricing policies
with respect to such services and products; and (3) the contractual
arrangements entered into by petitioner and its parishioners and staff with
respect to Scientology services.
Petitioner made strenuous efforts to promote Scientology to the public. It
gave free lectures and personality testing. It held congresses. It advertised.
Staff members called 'registrars', using a filing system, contacted the public
and parishioners to encourage them to purchase Scientology services. Another
group of people, FSMs, operating on a commission basis also sold services to
the public. These promotional efforts were guided by the results of surveys of
community needs and desires. [FN63] Many of these practices are the stock and
trade of the missionary. However, a few like the payment of commissions to
FSMs, closely replicate business methods. Furthermore, it is clear that the
purpose of these promotional activities was not just to spread religion but to
make money. [FN64]
Pricing policies are another factor we consider in determining whether
petitioner has a commercial purpose. Where prices are fixed to return a profit,
we consider it some evidence of a commercial purpose, although not
determinative. Christian Manner International v. Commissioner, 71 T.C. 661,
670 (1979); Peoples Translation Service v. Commissioner, 72 T.C. 42,
*478 50 (1979). Petitioner's prices for its books and services were set to
earn a profit. The minimum price for books was five times cost. Thus, even with
the various discounts that were offered, petitioner stood to make a profit. The
cost of auditing was also high, ranging from approximately $40 to $50 an hour
and going as high as $76 an hour for specialized auditing. In terms of 1970
dollars these prices seem particularly steep. At Flag, prices were even higher.
Considering that staff who performed these services were paid a weekly salary
of approximately $10 plus room and board, petitioner was clearly realizing a
On brief petitioner called its fees for religious services 'fixed donations.'
However, it is clear they were not donations but payments for services
rendered. Indeed, petitioner itself repeatedly used such terms as 'price,'
'buy,' and 'sell' in describing its activities, and its very own worksheets do
no refer to these amounts as donations but have a separate account entitled
'donations' for charitable contributions. Consequently, we cannot help but
believe that the use of the term 'fixed donation' was employed by petitioner in
an effort to achieve favorable tax treatment.
Petitioner's pricing policies respecting discounts also show a concern for
business. Thus, petitioner had a policy against offering services and products
for free or reducing prices for parishioners who could not afford to pay full
price. However, it did offer discounts where it stood to reap some advantage
for itself, for example, on bulk sales or for advance payments.
Not only did parishioners have to pay for religious services but they also had
to sign a contract to get them. Under the terms of the contract the applicant
waived all rights of action against L. Ron Hubbard and petitioner except the
right to a refund. Likewise staff members had to sign a legal note obligating
them to pay for services rendered in the event they broke their employment
contracts. Petitioner's insistence on these legal formalities as a prerequisite
to the rendition of Scientology services certainly colors its services with a
Petitioner derived substantial income from its franchising operations. By
petitioner's own records the income from its franchising operations during the
tax years in question was as follows:
1970 .. $288,672
1971 ... 307,809
1972 ... 435,960
*479 In examining petitioner's activities with respect to its franchising
operations, we find the manner in which these activities were conducted
virtually indistinguishable from the manner in which most commercial franchises
are operated. Petitioner allowed the franchise holders to market its name and
copyrights in a designated area and sold them books at a discounted price;
while, in turn, the franchise holders remitted 10 percent of their gross income
to petitioner. These aspects of petitioner's franchising operations are closely
analogous to the way in which all commercial franchising operations are
conducted. Furthermore, the fact that petitioner paid its franchise holders
commissions of 10 percent of the amounts their students spent at higher level
organizations certainly punctuates the commercial nature of these operations.
Additionally, the income generated from petitioner's franchising operations
appears to be almost pure profit since petitioner received its percentage off
the top from the franchise holder's gross income.
During trial, Lorna Levett, a former franchise holder, testified that the
Scientology franchise that she operated in Calgary, Alberta, Canada, from 1968
through April 1974 was run as a private business. We find her characterization
appropriate not only for her individual franchise but also for petitioner's
entire franchising operations. They were indeed run as commercial businesses.
A further example of the commercial manner of petitioner's operations was the
income generated by the Flag Bureau through the provision of management
services to Scientology organizations around the world, including branches of
petitioner. Flag collected statistics from local churches, developed programs
to improve church administration, and sent staff On assignment to local
churches to help correct areas of administrative difficulty. Most of the
statistics that were reported to Flag and then charted on graphs concerned
income or production. Flag concentrated its attention on the organizations that
made the greatest contributions to its support. All organizations that did not
tithe to Worldwide paid Flag a management fee usually set at 10 percent of
*480 These management services rendered by Flag closely resemble the types
of management consulting services offered by numbers of commercial enterprises.
They emphasized income production and retention and were clearly commercial in
Petitioner's policy of selling religious services, its franchise program, its
emphasis on income and production statistics, it management services, it
pricing policies, its promotion programs, especially the payment of commissions
on sales of services, show convincingly that petitioner operated in a
commercial manner. From this we draw the inference that petitioner had a
substantial commercial purpose. However, we do not rest our decision on the
commercial hue of petitioner's activities alone. Our conclusion that petitioner
had a substantial commercial purpose is buttressed by two additional factors:
the existence of sizable annual profits and substantial cash reserves.
Although the presence of substantial profits is not necessarily determinative
of a commercial purpose, such profits constitute 'evidence indicative of a
commercial character.' Scripture Press Foundation v. United States, 152
Ct.Cl. 463, 468, 285 F.2d 800, 803 (1961), cert. denied 368 U.S. 985
(1962). See also Incorporated Trustees of the Gospel Worker Society v. United
States, 510 F.Supp. 374, 378 (D.D.C. 1981), affd. without opinion 672
F.2d 894 (D.C. Cir. 1981), cert. denied 456 U.S. 944 (1982); Parker v.
Commissioner, 365 F.2d 792, 798 (8th Cir. 1966), cert. denied 385 U.S.
1026 (1967). In his notice of deficiency, respondent determined that
petitioner's seven stipulated divisions (SFO, LAO, FOLO, ASHO, AOLA, USGO, and
Flag) had the following consolidated net incomes during the docketed years:
Income 1970 1971 1972
Gross receipts $2,249,013.08 $3,301,143.73 $3,134,391.00
Advance payments 373,222.37 788,704.96 1,198,763.86
Flag income --- 263,557.47 240,932.55
Payment Danish Kingdom Church --- 77.92 53,609.76
Payment United Kingdom Church --- 76,497.24 161,018.38
-------------- -------------- --------------
Total income 2,622,235.45 4,429,981.32 4,788,715.55
Expenses 1970 1971 1972
Per Form 990 $2,438,646.65 $4,242,124.02 $4,178,876.05
Trust (28,930.34) (67,892.40) (77,986.62)
Charter Mission (disallowed) (982,415.39) (1,143,928.02) (1,400,015.99)
Flag expenses --- 1,238,466.30 1,036,108.56
-------------- -------------- --------------
expenses 1,427,300.92 4,268,769.90 3,736,982.00
Net income 1,194,934.53 161,211.42 1,051,733.55
*481 Petitioner does not actually contest the accuracy of these figures;
however, it does disagree with the tax treatment accorded them by respondent.
The most significant disagreement between the parties, at least in terms of
amount, centers around the tax treatment of the amounts characterized as
advance payments. In his notice of deficiency, respondent included such advance
payments in income, stating:
As a cash basis taxpayer, you received payments for services to be rendered
in the future. These amounts were not included in the gross receipts reflected
on Forms 990 but are includible in your taxable income. Accordingly, your
taxable income is increased in the amounts indicated.
Initially in its petition, the Church argued that not only were the advance
payments not income in the years of receipt, but in addition all amounts paid
for religious services should be excluded from income since such amounts were
received as charitable contributions from its parishioners. However, on brief,
petitioner apparently abandons this contention and asserts instead that the
advance payments of $373,222.37 in 1970, $788,704.96 in 1971, and $1,198,763.86
in 1972 were incorrectly included in its income. Petitioner claims that the
advance payments should not be treated as income since it had not earned them
by rendering services and since it had a duty to refund them on demand at any
time before the services were taken. [FN65]
As a general rule, under the cash receipts and disbursement method, money
which is received must be reported as gross income in the year in which it is
received. Sec. 451(a); sec. 1.446-1(c)(1)(i), Income Tax Regs. Petitioner
contends, however, *482 that the fact that it was under an obligation to
refund the advance payments in full at any time prior to the rendering of
services upon the request of the 'donor' somehow changes this tax treatment.
Petitioner is clearly wrong on the law. At least since the seminal case of
North American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932), the
receipt of money under a claim of right is treated as taxable income even
though the recipient may be under a contingent obligation to return it later.
We find the claim of right doctrine is applicable here. In order to avoid the
application of the claim of right doctrine, 'the recipient must at least
recognize in the year of receipt 'an existing and fixed obligation to repay the
amount received' and 'make provisions for repayment.' ' Nordberg v.
Commissioner, 79 T.C. 655, 665 (1982), affd. in an unpublished opinion
720 F.2d 658 (1st Cir. 1983); Hope v. Commissioner, 55 T.C. 1020, 1030
(1971), affd. 471 F.2d 738 (3d. Cir.), cert. denied 414 U.S. 824 (1973).
The first condition is clearly not present in the instant case since petitioner
was never under an existing and fixed obligation to repay the advance payments
in question. Repayment was instead contingent on a refund request initiated by
one of petitioner's 'donors.' Furthermore, there is no evidence in the record
that petitioner's contingency liability to refund the advance payments imposed
any restriction upon the use of the money in its hands. If petitioner
eventually was required to refund any of the advance payments in a later year,
it would then be entitled to a deduction for such amounts. However, such
amounts are clearly income in the year of receipt.
In reaching this conclusion, we find petitioner's reliance on our holding in
Miele v. Commissioner, 72 T.C. 284 (1979), misplaced. In Miele, we found
that a law firm that used a cash method of accounting did not have taxable
income in the year in which its clients transferred advances to a special bank
account. We distinguished North American Oil Consolidated v. Burnet, supra,
on two grounds. The clients' funds were kept in separate bank accounts and the
firm could only draw on the funds when an amount was undisputed. 72 T.C. at
289-290. Our holding in Miele is clearly distinguishable from the instant case
since there is absolutely no suggestion in the record that petitioner
segregated the advance payments in any *483 of its numerous bank accounts.
On the contrary, it appears that these payments were comingled with
petitioner's other receipts and were thus received under claim of right. [FN66]
Consequently, we find that respondent correctly included the amount of the
advance payments in petitioner's taxable income for the taxable years in
Another major area of disagreement between the parties is the appropriate tax
treatment of the Charter Mission expenses. These payments represented amounts
transferred by petitioner to OTC during the tax years at issue. On its Forms
990 petitioner claimed them as business expenses. In his notice of deficiency,
respondent disallowed petitioner's claimed Charter Mission expenses of
$982,415.39 in 1970, $1,143,928.02 in 1971, and $1,400,015.99 in 1972, stating:
It is determined that the amounts reported as Charter Mission Expense are not
deductible because said amounts do not constitute ordinary and necessary
expenses paid or incurred during the taxable years 1970, 1971, and 1972, but
rather represent an internal transfer of funds to the Flag Division, which is a
division of the Church of Scientology of California.
However, concurrent with these adjustments, respondent did allow petitioner
deductions for Flag Division expenses in the amounts of $1,238,466.30 in 1971
and $1,036,108.56 in 1972, which were not previously reflected on the Forms 990
filed by petitioner.
It is here that the fluidity of petitioner's position is particularly
impressive. Surprisingly, petitioner does not actually object to the
adjustments made by respondent for either 1971 or 1972, although it does assert
that respondent erred in not allowing a similar deduction for Flag expenses of
$419,856.76 in 1970, which it now asserts was the actual amount Flag paid out
for expenses that year. Basically, despite the fact that petitioner initially
claimed deductions for all payments made to OTC, albeit without explanation,
and despite the fact that it has steadfastly maintained that OTC is a separate
corporation *484 from petitioner, it now argues that all payments to OTC
from any branch of petitioner are essentially internal transfers to Flag for
purposes of running religious activities aboard the Apollo. In order to explain
its position, the petitioner now argues that OTC merely acted as a 'bank' or
'agent' for petitioner.
This relationship between petitioner and OTC was described by petitioner's
accountant, Martin J. Greenberg, in his correspondence with respondent's agent.
In a letter dated December 18, 1975, Greenberg stated,
1) The basic relationship of the Church with OTC during the years 1971-74 was
as follows: The Church chartered the ship Apollo from OTC for $2,000 per month.
In addition, OTC acted as the Church's agent in the financial matters relating
to Flag's operations. OTC received funds on behalf of the Church, and at the
Church's instructions would pay all of the Church's expenses. OTC would issue a
monthly statement of each individual disbursement made and an annual statement
showing the receipts and disbursements for the year and the balance that the
Church still had to its credit.
In a follow-up letter dated February 9, 1976, Greenberg further stated,
2c) The first point that should be made is that ALL payments to OTS/OTC from
any branch of the Church of Scientology of California are essentially internal
transfers to Flag to run their religious activities aboard the ship. That is
the exempt purpose and the ONLY purpose of every single penny sent to OTS -- NO
EXCEPTIONSs OTS MERELY ACTED AS A 'bank' OR 'agent' FOR THE CHURCH and the only
funds actually paid to OTS for them to keep were the Charter fees and the
finance charges. [FN67] * * *
(2d and 2e) * * * The Churches have no 'liability' to OTS for management
fees, training or any other service (except as noted in 2b). OTS, WHEN ACTING
AS THE CHURCH'S AGENT IS IN EFFECT ACTING AS A BANK. THERE IS NO 'LIABILITY' TO
DEPOSIT FUNDS IN THE BANK. As long as you maintain a credit balance the 'bank'
will make whatever disbursements you authorize out of the 'account.' They have
no say at all in telling you what you have to deposit. THAT IS BASICALLY THE
RELATIONSHIP OF THE CHURCH TO OTS. * * * (Capitalization added.)
What appears to be happening is this. It appears that initially the Charter
Mission expenses were deducted on the *485 Forms 990 probably on the basis
of the story concocted in 1969 that OTC was providing supportive services to
Flag. Petitioner has now changed its story. It now argues that OTC is merely a
private 'bank' for petitioner. It therefore concedes that the Charter Mission
payments are not deductible since deposits in banks are not expenses, but
claims it should be allowed a deduction for the actual expenses incurred by
Flag in 1970 in the amount of $419,856.76.
Before addressing this issue we digress briefly to point out the flaws in
petitioner's new story about OTC. First, it is nonsensical. According to
petitioner's story, OTC was in constant debt to petitioner since it continually
transferred to OTC sums far in excess of what was currently needed by it to
meet its alleged expenses. By petitioner's own admission, the balance OTC owed
to petitioner increased during each of the docketed years. It is here that the
logic of petitioner's story breaks down. After all, why would petitioner leave
increasingly large sums in control of a commercial Panamanian corporation
without any provision for interest and also pay it finance charges if it were
truly independent? Second, OTC did not act as a banker for petitioner. The
evidence is overwhelming that petitioner's employees handled the Church's
finances. This is so because as far as the record discloses OTC had no offices,
officers or employees with which to perform financial services for petitioner.
We turn now to petitioner's claim that respondent erred in not allowing
petitioner to deduct Flag's operating expenses of $419,856.76 for 1970.
Petitioner bears the burden of proving the amount of allowable Flag expenses
for that year. We cannot accept petitioner's records as trustworthy. In 1969
petitioner engaged in a plan to cover up OTC's relationship to petitioner. In
pursuit of this plan records were manufactured and falsified to show
petitioner's branch churches in debt to OTC for support services. In April and
May of 1975, shortly before the 1971-1974 audit began, petitioner again engaged
in a project to falsify Flag records to present to the IRS. During the 1971-
1974 audit IRS auditors made repeated requests for substantiation that OTC
expenditures were made on petitioner's behalf. Church officials did not comply.
Instead they offered a variety of excuses including a claim that Church
activities aboard the Apollo were funded essentially through *486 cash
expenditures. This evidence casts severe doubts on whether any of the Flag
expenditures were actually incurred. Petitioner has, therefore, failed to
satisfy its burden of proof. We are not at liberty to redetermine the amount of
deductible Flag expenditures incurred during the tax years 1971 and 1972 since
respondent has not seen fit to disturb his allowance of the amounts set forth.
However, we do find that respondent correctly disallowed such expenditures for
1970 and that, in reality, the actual allowable expenditures for 1971 and 1972
should probably be substantially less than those allowed by respondent.
A third major area of disagreement between the parties is the proper tax
treatment of the payments made by petitioner to the United States Churches of
Scientology Trust. These payments were deducted by petitioner and were
designated as payments to the Central Defense and Dissemination Fund and
amounted to $28,930.34 in 1970, $67,892.40 in 1971, and $77,986.62 in 1972. In
his notice of deficiency, respondent disallowed these deductions in full,
It is determined that the payments to the Central Defense and Dissemination
Fund (United States Churches of Scientology Trust) are not allowable as
deductions under IRS section 162.
In its petition, petitioner contests this disallowance on the ground that such
payments to the Trust were reasonable and necessary expenses. However, on
brief, petitioner apparently concedes that such payments are not deductible if
it is judged not be tax exempt, although petitioner does assert that the
payments were in furtherance of its exempt purpose. We do not agree.
The facts surrounding the United States Churches of Scientology Trust, which
are set out in detail in our findings of fact, can only be described as
bizarre. Some of the more incredible are recited again here. To begin with,
although the Trust purportedly originated in 1962, there was no trust document
until June 25, 1973. Also financial statements were not prepared for the Trust
during the docketed years. Furthermore, although the Trust was purportedly a
United States trust, it was administered in England and the financial
statements which were belatedly prepared in 1973 were prepared in South Africa.
The purported purpose of the Trust *487 was the defense of the United States
Churches of Scientology. However, there was only one disbursement for such
purpose in the amount of $9,290.47 although the Trust had accumulated funds of
$812,134.51, $930,400.08 and $1,307,237.26 in 1970, 1971 and 1972,
respectively, and although USGO spent substantially greater amounts for legal
fees during the docketed years. The trust funds were not invested. They were
kept in numbered Swiss bank accounts. L. Ron Hubbard was the sole trustee and
generally kept the trust checkbooks. According to petitioner's worksheets, in
1972 over $1 million in trust funds was removed from some of these accounts and
placed in a locked file cabinet on the Apollo where they were allegedly kept
until 1975. Mary Sue Hubbard supposedly had the only key. The circumstances of
this trust are just too bizarre to credit its validity. Petitioner has not
carried its burden. We therefore find that respondent correctly disallowed
petitioner's claimed expenses for the Central Defense and Dissemination Fund
for the tax years in question.
The final area of disagreement between the parties centers on the proper tax
treatment to be accorded the payments received by petitioner from the Danish
Kingdom Church and United Kingdom Church. In his notice of deficiency,
respondent included in petitioner's income payments from these churches as
Year DK payment received UK payment received
1971 $77.92 $76,497.24
1972 53,609.76 161,018.38
However, petitioner contested the inclusion of these amounts in its income,
stating that these funds were actually received by OTC and represented debt
For his part, respondent now contends on brief that since the United Kingdom
Church, both in form and in substance, was a branch of petitioner, such
payments were merely internal transfers, which, by definition, cannot be either
debt repayment or income. Furthermore, respondent states that the same is also
undoubtedly true of the Danish Kingdom Church.
With respect to the Danish Kingdom Church, we cannot find from the record in
this case that it was in actuality a branch of petitioner. On the other hand,
petitioner has not satisfied us *488 that a bona fide debt from the Danish
Kingdom Church to OTC actually existed. Consequently, we find that respondent
correctly included such amounts in petitioner's income in its notice of
The same is not true for the payments from the United Kingdom Church. In light
of our finding that the United Kingdom Church was in actuality merely a branch
of petitioner, respondent is correct in his assertion on brief that the
payments from the United Kingdom Church to OTC merely represent internal
transfers and are, thus, not properly included in petitioner's income.
Having resolved the contested items in the notice of deficiency, we are now in
a position to calculate petitioner's net income during the docketed years. By
petitioner's own admission, the United Kingdom Church, during the docketed
years, had net income of $299,681 in 1970, $796,417 in 1971 and $816,572 in
1972. Subtracting the United Kingdom Church payments and adding the United
Kingdom Church's net taxable income to petitioner's other income, we find that
petitioner's net income for the tax years in question was not less than
$1,494,615.53 in 1970, $881,131.18 in 1971, and $1,707,287.17 in 1972.
Additionally, there is considerable evidence in the record that the true income
of petitioner was substantially in excess of those amounts. For example, during
trial John McLean testified that in 1972 the average WEEKLY income of U.S.
Scientology organizations controlled by Flag was about $1 million and ranged as
high as $1,400,000 during that year. Annualizing such weekly amounts would
result in a figure in the $50-70 million range, an amount which obviously
dwarfs the income reported by petitioner on its informational return for 1972.
Furthermore, our finding that OTC is merely a front for petitioner, along with
our recognition that the massive cash reserves held by OTC actually belong to
petitioner, certainly raises the project that petitioner had millions of
dollars of unreported income. However, even disregarding these indications of
vast undisclosed profits, we find the amount of petitioner's determinable
profits in the docketed years to be substantial. The existence of these
substantial profits, when viewed in light of the commercial nature of
petitioner's operations, lends additional support *489 to our finding that
petitioner was operated in furtherance of a substantial commercial purpose.
The remaining factor supporting our finding is the existence of substantial
reserves. Several cases have recognized this factor as indicative of a
commercial purpose. See B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352,
357 (1978); Incorporated Trustees of the Gospel Worker Society v. United
States, 510 F.Supp. 374, 378-379 (D.D.C. 1981), affd. without opinion 672
F.2d 894 (D.C. Cir. 1981), cert. denied 456 U.S. 944 (1982); Parker v.
Commissioner, 365 F.2d 792, 798 (8th Cir. 1966), cert. denied 385 U.S.
In the instant case, the record is replete with evidence that petitioner was
obsessed not only with making money but also with building up massive cash
reserves. In HCO PL March 9, 1972, MS OEC 381, L. Ron Hubbard wrote the
If a management unit such as a Bureaux, a Continental Liaison Office, an OT-
Liaison Office or any agent thereof such as a Guardian or FBO or Flag Rep is
any good, THE NEAREST SERVICE ORG WILL MAKE AMPLE MONEY TO PAY the managing
unit and HAVE LOTS LEFT OVER TO SWELL SO Reserves. (Emphasis in original.)
In this same policy letter, L. Ron Hubbard defined 'SO Reserves' as follows'
SO RESERVES: Often miscalled 'Flag Reserves' or 'Management Reserves' which
they are NOT. SO Reserves are: The amount of money collected for the
corporation over and above expenses that is sent by various units (via FBOs and
the Finance Network) to the corporation's Banks. It is used for purposes
assigned by the BOARD OF DIRECTORS and for NO OTHER PURPOSE. These are normally
employed for periods of stress or to handle situations. They are NOT profit. It
is NOT support money for 'Flag' or 'Management.' It is NOT operating money
(Examples: Huge sums were required to cover WW when under attack and to catch
the PUBS 1970 crash.) (Emphasis in original.)
This policy letter illustrates petitioner's fervor for building cash reserves.
More importantly for this case, petitioner's accumulations matched its fervor.
In just two months in 1971 Sea Org Reserves swelled by $270,175. The bulk of
petitioner's reserves were held in 16 active bank accounts maintained in the
name of OTC. The year-end balances on these accounts were $1,772,981.72 in
1970, $2,042,832.04 in 1971, and $2,561,688.98 in 1972. Petitioner also
accumulated reserves in *490 the sham United States Churches of Scientology
Trust. By year's end in 1972 the Trust had accumulated funds totalling
$1,307,237.26. Approximately 6 months later this balance had grown to
$1,998,343.08. Petitioner also kept cash reserves aboard the Apollo. In 1968
and 1969 the ship's cash reserves fluctuated between $50,000 and $200,000. In
1972 slightly over $3 million in cash from the OTC and trust accounts was
stored on board the ship. The total amount of petitioner's reserves for the
docketed years is shrouded in mystery. Whatever the exact amount, it is clear
that the accumulated reserves were substantial. [FN68]
In conclusion, petitioner's highly commercial method of operations, its high
annual profits and its substantial, undedicated cash reserves convince us that
it had a substantial commercial purpose. B.S.W. Group, Inc. v. Commissioner,
supra; Parker v. Commissioner, supra.
Petitioner offered several justifications for its large reserves. Petitioner
claimed that they were needed to purchase a land base for petitioner's
operations; to protect the Church from its many foes; and to pay the Church's
tax liability in the event it lost its battle for tax-exempt status. It is true
that many years later the Church did secure land headquarters in Clearwater,
Florida. Also, no doubt, the Church needed money to protect itself from its
detractors. Finally, since the IRS revoked the Church's tax-exempt status in
1967, there was a strong likelihood it would have to pay taxes.
However, the bulk of the evidence in the record undermines the legitimacy of
these justifications, so that we have no difficulty in concluding that the
reserves were accumulated to make money for the Church and its leaders. Thus,
although the Church eventually secured land headquarters, this was done several
years after the reserves were built up. Furthermore, the Church failed to
introduce any evidence of the cost of the new headquarters in Clearwater,
Florida or that reserves were used to pay for the premises. We also note that,
although the purported purpose of the Trust was the defense of Scientology,
only one small disbursement was made for this purpose during the docketed
years. The Church presented no evidence that the amount of its reserves bore
any relationship to its anticipated needs. These facts alone cast doubt on the
Church's stated reasons for accumulating reserves. However, what compels us
further to conclude that the Church's justifications are mere pretense is the
manner in which the reserves were maintained. They belonged to a bogus trust
and a sham corporation and were mostly held in cash and numbered Swiss bank
accounts. Under these facts the Church has not carried its burden in
demonstrating that the reserves were accumulated to further its tax-exempt
In light of our conclusion, we need not decide whether we concur in the Third
Circuit's reversal in Presbyterian & Reformed Publishing Co. v. Commissioner,
Respondent asserts, and we agree, that petitioner fails to qualify for tax-
exempt status because a portion of its net earnings inured to the benefit of
private individuals. In order to qualify for tax-exempt status under section
501(c)(3), not only must an organization establish that it is organized and
operated exclusively for exempt purposes, but it must also prove that no part
of its net earnings inures to the benefit of any private shareholder or
individual. The term 'private shareholder or individual' is defined in section
1.501(a)-1(c), Income Tax Regs., as a person having a personal and private
interest in the activities of an organization. It does not refer to unrelated
third parties. People of God Community v. Commissioner, 75 T.C. 127, 133
(1980). In other words, the inurement prohibition under section 501(c)(3)
denies exempt status to an organization whose founders or controlling members
have a personal stake in that organization's receipts.
Basically the thrust of the concept of private inurement is to ensure that an
exempt charitable organization is serving a public and not a private interest.
See Baltimore Health and Welfare Fund v. Commissioner, 69 T.C. 554 (1978);
Callaway Family Association, Inc. v. Commissioner, 71 T.C. 340 (1978). Thus,
if part of the net earnings of an organization, no matter what its purpose,
inures to the benefit of any private shareholder or individual, tax exemption
under section 501(c)(3) will not be allowed. An organization bears the burden
of proving that it is not operated for the benefit of private interests such as
that of the founder or his family. Basic Bible Church v. Commissioner, 74
T.C. 846 (1980).
The term 'net earnings' includes more than net profits and they may inure to
an individual in more ways than in the distribution of dividends. Unitary
Mission Church v. Commissioner, 74 T.C. 507 (1980), affd. in an unpublished
opinion, 647 F.2d 163 (2d Cir. 1981). For example, we have found that the
paying over of a portion of gross earnings to those vested with control of a
charitable organization constitutes private inurement. People of God Community
v. Commissioner, supra. Additionally, the amount or extent of such benefit
is not determinative of a finding of private inurement. Church of the
Transfiguring Spirit, Inc. v. Commissioner, 76 T.C. 1, 5 (1981).
*492 Thus, the fact that the benefit conveyed may be relatively small does
not change the basic fact of inurement. Founding Church of Scientology v.
United States, 188 Ct.Cl. 490, 497, 412 F.2d 1197, 1200 (1969), cert.
denied 397 U.S. 1009 (1970).
In the instant case, there can be no question that L. Ron Hubbard and his
family are clearly private shareholders or individuals within the meaning of
section 501(c)(3). [FN69] During the tax years at issue, the obvious indicia of
benefit to L. Ron Hubbard and his family include salaries, directors fees,
management fees, complete support of the family, and royalties; while convert
indicia of benefit include repayment of alleged debts in unspecified amounts
and unfettered control over millions of dollars in funds purportedly belonging
to OTC and the United States Churches of Scientology Trust.
During the tax years at issue, L. Ron Hubbard and Mary Sue Hubbard received
salaries from petitioner totaling $20,249.27 in 1970, $49,647.61 in 1971, and
$115,679.76 in 1972. We recognize that the payment of reasonable salaries by an
allegedly tax-exempt organization does not result in the inurement of net
earnings to the benefit of private individuals. However, excessive salaries do
result in inurement of benefit. Founding Church of Scientology v. United
States, supra. The burden falls upon petitioner to establish the
reasonableness of the compensation paid to L. Ron and Mary Sue Hubbard.
Bubbling Well Church of Universal Love, Inc. v. Commissioner, 74 T.C. 531,
538 (1980), affd. 670 F.2d 104 (9th Cir. 1981). In the instant case, the
salaries paid by petitioner to L. Ron and Mary Sue Hubbard are far from
shocking. We are puzzled, however, by the increase in salaries in 1972 over
1971 since the record does not disclose what additional job responsibilities L.
Ron and Mary Sue Hubbard undertook in 1972 to precipitate the increase.
Furthermore, the salary payments are but the tip of the iceberg of the total
benefits actually received by them. For example, L. Ron Hubbard, Mary Sue
Hubbard, and their four children resided for the most part aboard the Apollo.
While aboard ship, petitioner paid the family's living and medical expenses.
L. Ron Hubbard also received royalty payments in connection with petitioner's
sales of books and E-meters. We, of *493 course, do not dispute an author's
right to receive compensation in the form of royalties for his literary works.
However, this does not mean that an individual can use a tax-exempt
organization that he clearly controls, as is the case with L. Ron Hubbard and
petitioner, to market his own works. Undoubtedly, it was this type of self-
dealing that the prohibition against inurement under section 501(c)(3) was
enacted to ban. For although it may indeed be common, as petitioner asserts,
for an author to receive royalties of 10 percent on the sales of his
copyrighted works, in a normal commercial setting, it is the publisher and not
the author who establishes the price for which the books are ultimately sold.
However, in the instant case, it was L. Ron Hubbard who personally controlled
what amount he received on each book and E-meter sale through his setting of
the price that petitioner charged for each item, and as we have previously
found, such prices were well above cost. Additionally, it is uncontroverted
that the majority of ASHO PUB's sales of E-meters and books upon which
royalties were paid to the account of L. Ron Hubbard were to other Scientology
churches, including branches of petitioner. The combination of L. Ron Hubbard's
first contracting with petitioner, to sell his books and E-meters in exchange
for royalty payments, then his pushing the sales of such books and E-meters
through his own policy letters, and finally his establishment of the prices of
such items and the fact that the majority of sales were to petitioner's
branches and other Scientology churches certainly constitutes a flagrant case
of self-dealing, which clearly benefited L. Ron Hubbard personally and thus
Not only did L. Ron Hubbard receive royalty payments on his own works, but he
also received royalties attributable to the literary efforts of some of
petitioner's other employees. It was a long-standing policy of petitioner that
all works involving Scientology had to be copyrighted to L. Ron Hubbard. This
policy was articulated by L. Ron Hubbard in HCO PL of November 15, 1958, 1 OEC
13-14, as follows:
SIMILARLY, ANY BOOK ON DIANETICS AND SCIENTOLOGY MUST BE COPYRIGHTED IN THE
NAME OF L. RON HUBBARD and the copyright becomes the property of HCO. No
copyright of anything must ever be permitted to escape. In the case of its
having been done (a book on the subject copyrighted in the name of someone or
something else) HCO Secretary in the area must request an *494 assignment of
copyright to L. Ron Hubbard from its present owner and must be tireless and
remorseless in getting the copyright, using any available means at whatever
Similarly and trademark, registered mark, or patent for any sign, symbol,
shield, device or design for Dianetics or Scientology or their organizations
must be secured for HCO. All these are registered to L. Ron Hubbard and by
blanket transfer are the property of HCO only. The name in which it is done is
L. Ron Hubbard; the owner is then HCO.
Don't let one seal, one copyright, one design, one device, or even the names
Dianetics and Scientology escape you on this. All the money you need to hire
experts, lawyers, artists and pay fees is yours for the asking from the main
office of HCO. Just ask. (Emphasis added.)
Pursuant to 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';
however, both books were copyrighted by L. Ron Hubbard. Additionally, numerous
policy letters contained in the OEC were actually written by paid employees of
petitioner with L. Ron Hubbard's approval. Nevertheless, despite the fact that
L. Ron Hubbard did not personally author the entire nine-volume set, he did
receive royalty payments on the sale of this publication.
Without addressing the legality of copyrighting materials and receiving
royalty payments on the works of others, we find the policy of using paid
employees of an organization to write materials that are then copyrighted to
the organization's founder and upon which he receives royalties to be a clear
use of an organization for a private, as opposed to a public, purpose--the crux
of a finding of inurement.
The record reveals glimpses of other self-dealing transactions in addition to
L. Ron Hubbard's receipt of royalties from literature published, sold, and
sometimes, even written, by petitioner. For example, a portion of the debt
allegedly owned by petitioner. For example, a portion of the debt allegedly
owned by petitioner to L. Ron Hubbard during the tax years in question arose
from his sale in 1966 of the St. Hill Manor to petitioner. Although we know
from petitioner that the sale price in that transaction was 79,410.5.6 pounds,
petitioner has failed to introduce any evidence as to the fair market value of
*495 St. Hill at the tie of the sale or the reason why petitioner needed L.
Ron Hubbard's specific property. However, there is unrebutted evidence in the
record that L. Ron Hubbard represented to the British Government on a statement
of his assets to the Inland Revenue as of April 1966 that the value of this
property was only 17,707.7.6 pounds--an amount less than one-fourth the
eventual sales price. Admittedly, we do not really know what the actual fair
market value of St. Hill was at the time of the sale. However, in light of the
degree of control which L. Ron Hubbard maintained over petitioner and the fact
that the debt arising from this transaction was apparently being serviced
during the docketed years, absolute full disclosure of all facts relevant to
such sale is in order.
In sum, the total value of the overt benefits received by the Hubbards during
the tax years at issue in living expenses, and from salaries and royalties was
several hundred thousand dollars. These payments are substantial. When viewed
in light of the self-dealing that transpired, they prove conclusively that
petitioner was operated for the private benefit of L. Ron Hubbard and his
family. However, we need not rest our conclusion on this evidence alone since
the record also abounds with indicia of convert inurement.
Probably he most covert form of compensation paid to L. Ron Hubbard was
tithes (or a percentage of gross income) which petitioner and other Scientology
organizations routed to him in the guise of 'Founding Debt Payments.' Although
petitioner failed to produce a single witness who credibly testified about
these payments, and we are thus left somewhat in the dark regarding the actual
amounts and duration of such payments during the docketed years, there is
considerable evidence in the record that these payments did indeed take place.
A trail of documentary evidence shows that Scientology organizations began
making these alleged debt repayments in the 1960s. In HCO PL December 21, 1965,
3 OEC 51, L. Ron Hubbard remonstrated all Scientology organizations for their
failure to keep proper records of their debts to him for his past services in
establishing Scientology. He directed the organizations to correct their
records and to set up a system in the Office of LRH for keeping track of these
debts and collecting payments. L. Ron Hubbard went on to state that the reason
for these policies stemmed from the IRS's actions against the *496 Founding
Church of Scientology. That controversy was eventually litigated in the Court
of Claims. In finding that the net earnings of the Founding Church inured to
the benefit of L. Ron Hubbard, the Court of Claims found that from 1957 on, L.
Ron Hubbard was paid, in lieu of salary, 10 percent of the gross income of the
Founding Church and of other Scientology congregations, franchises and
organizations, and that '(s)uch an arrangement suggests a franchise network for
private profit.' Founding Church of Scientology v. United States, 188 Ct.Cl.
490, 494, 498, 412 F.2d 1197, 1199, 1201 (1969), cert. denied 397 U.S.
1009 (1970). Thus, HCO PL of December 21, 1965, 3 OEC 51, was apparently issued
in realization of the fact that the current scheme of compensating L. Ron
Hubbard placed Scientology churches in a dangerous tax position. However,
although the payments made to L. Ron Hubbard from that time on certainly
differed in form, it appears that they differed little in substance.
HCO PL December 21, 1965, 3 OEC 51, marks the beginning of a documentary trail
that leads through the tax years in issue. HCO PL June 25, 1967, 3 OEC 63,
repeated L. Ron Hubbard's instructions to record debts owed to him. Flag Order
773 issued on May 25, 1968 ordered the removal of staff who incorrectly handled
debt repayment to L. Ron Hubbard and as a result exposed him to greater income
tax liability. FBO correspondence between Flag and AOLA in 1968 and 1969
discussed L. Ron Hubbard debt repayment (sometimes called 'LRH RR' or LRH 10).
A 1968 LETTER DISCUSSED THE NEED TO BUILD UP CASH RESERVES ABOARD THE APOLLO,
IN PART, TO REPAY L. RON HUBBARD QUICKLY. FBO CORRESPONDENCE IN MARCH 1969
CONCERNED WAYS TO SEND LOAN REPAYMENT TITHES FROM AOLA TO L. RON HUBBARD, THEN
ON BOARD THE APOLLO, IN A NEGOTIABLE FORM OTHER THAN DOLLARS TO AVOID POSSIBLE
LOSSES FROM A FEARED DEVALUATION OF THE DOLLAR. THESE REFERENCES TO THE ALLEGED
DEBT REPAYMENT WHICH PEPPER THE RECORD CONVINCE US THAT L. RON HUBBARD WAS
PERSONALLY RECEIVING A CERTAIN PERCENTAGE--IN MOST CASES 10 PERCENT--OF
PETITIONER'S AND OTHER SCIENTOLOGY ORGANIZATIONS' GROSS INCOME IN THE LATE
These loan repayments continued in the docketed years. The official story with
respect to these payments is detailed in HCO PL September 7, 1972, which
*497 'REPAYMENT OR DUE MONEY COLLECTED FOR LRH PERSONALLY.'
WHAT IS OWED
For years, public have thought or been told that the income of orgs goes to
Ron, but this has never been true.
Quite the reverse, Ron's personal income and capital - even Veterans checks
and Author's royalties have been invoiced and used by orgs.
The entire Technology of Dianetics and Scientology have been used by orgs
without reimbursement to Ron for research or development, nor even repayment
for out of pocket expenses.
Where such payments have been made records will show that they were usually
not received by LRH but that they too were invoiced and used by orgs and remain
a debt of the Church in most cases.
The Saint Hill Organization, piloted and built and made prosperous by LRH
personally, now belongs to the Church of Scientology of California, but has
never been paid for.
The name 'L. Ron Hubbard', an asset worth millions in goodwill and high
credit rating, is used by all Scientology organizations but has not been paid
In the early years, the personal funds of LRH guaranteed org overdrafts and
even loaned orgs money. Income from ACC's (Advanced Clinical Courses, taught by
LRH) rightfully due to LRH were instead received and used by orgs.
Very little of the sums due have been repaid.
ORG BALANCE SHEETS
Many orgs have invoiced LRH personal income as 'their own income'. This gives
them a raised INCOME. But it was not their money and is actually a DEBT owed to
LRH. Balance sheets of the orgs, particularly in the tax matters, therefore
show inflated income when a debt exists.
It is to the interest of all orgs that their balance sheets be correct. It is
therefore incumbent upon them to furnish proper service in LRH collections.
The post of LRH ACCOUNTS OFFICER is being established in the personal Office
of LRH at Flag, directly under LRH Pers Comm Flag.
LRH Accounts will provide LRH Comms with monthly statements showing monies
owed and payments made, and will set weekly payments targets for LRH Comms to
The routing of all payments and correspondence is direct to LRH accts, via
the Cont'l FOLO as a mail relay point.
LRH GOODWILL REPAYMENT ACCOUNT
Orgs having an LRH GOODWILL REPAYMENT ACCOUNT may use it to begin payments or
to supplement current income in meeting their weekly payment target.
*498 OIC CABLE
As OIC cable format is subsequently updated the second stat of the LRH Comm
will eventually be included. Meanwhile the OIC cable remains as currently but
the collection stat of each LRH Comm will be graphed at Flag based on amounts
actually received and date of receipt, and graphed locally by amount and date
LRH COMM DUTIES
Any friction or opposition encountered by LRH Comms in obtaining repayment or
collection of monies due must be reported with full factual details of WHO and
WHAT to LRH Accts Flag.
Hat material on duties and functions relating to this collection statistic
will be issued from time to time, as the post of LRH Accts is further
established and developed.
However it will be found that a demand to meet the target, backed up by
standard LRH Comm functions to get LRH Technology and Policy known and used
correctly, will keep GI up trended and make it easy for the LRH Comm to keep
his collection stat rising as well.
The exchange factor in this is very simple and direct. To the degree that the
LRH Comm gets LRH Technology and Policy known and used he will be able to make
increasing repayment for it from the org to Ron, as the org will prosper and do
So STARTs And good luck to you with your new stats
LRH Accounts Officer and
LRH Pers Comm
by order of
L. Ron Hubbard
This policy letter clearly establishes that payments, other than salary and
royalties, were being made by petitioner to L. Ron Hubbard under the guise of
debt repayments. Additionally, it is obvious from this policy letter that the
so-called debt repayments were not just for money advanced by L. Ron Hubbard to
petitioner but were also compensation for L. Ron Hubbard's past work in
developing Scientology and for the use of his name. Petitioner has not produced
any evidence of bona fide indebtedness, and it is clear from the record that
there was no recognized debt which had been negotiated between petitioner and
L. Ron Hubbard but rather a continuing obligation to make payments based on
petitioner's total receipts. [FN70]
*499 Petitioner denies such payments existed and asserts that HCO PL
September 7, 1972 was cancelled two days later by another policy letter.
However, not only is the document allegedly cancelling the quoted policy letter
self-serving, but it is totally impeached by the testimony of John McLean and
Eugene Endo who both testified that such debt repayments continued to be made
long after the purported cancellation. Indeed, petitioner's own financial
records for the period October 9, 1972 to December 28, 1972 indicate that
payments designated either 'LRH Repayments,' 'Founding Debt Payment,' or 'Per
HCO Policy Letter 7 Sept. 72,' totalling $19,324.41 were made during this
period. [FN71] We thus find that the weight of the evidence clearly indicates
that HCO PL September 7, 1972 was adhered to long after its alleged
cancellation. It is, therefore, apparent that, although Scientology
organizations rearranged their forms of payment to L. Ron Hubbard during the
tax years in question, L. Ron Hubbard was still continuing to receive a
percentage of their gross income.
Finally, although the apparent existence of an arrangement whereby all
Scientology organizations funneled a percentage of their gross income to L. Ron
Hubbard under the guise of debt repayment certainly constitutes evidence of
inurement on a grand scale, probably the most blatant source of covert
inurement to L. Ron Hubbard in the present case is the complete control that he
exercised over the millions of dollars transferred to OTC and the United States
Churches of Scientology Trust.
During the docketed years, L. Ron Hubbard had complete control of the United
States Churches of Scientology Trust which in 1972 had accumulated earnings of
$1,307,237.26. Our finding that the Trust was not legitimate creates a
presumption, left unrebutted, that L. Ron Hubbard privately benefited from the
With respect to OTC we observe that, even were we to believe petitioner's
story that OTC was a truly independent *500 corporation, we would
nevertheless have to conclude that OTC's use of petitioner's funds constitutes
inurement. OTC was a non-tax-exempt corporation. According to petitioner it was
constantly in debt to petitioner for huge sums of money. As petitioner's
banker, this arrangement is best characterized as an interest-free loan.
In Hancock Academy of Savannah, Inc. v. Commissioner, 69 T.C. 488 (1977),
we found the existence of private inurement where a non-profit corporation,
formed to take over the educational functions of a non-tax-exempt corporation,
required parents of its students to make interest-free loans to the non-tax-
exempt corporation. In that case we held that the interest-free feature of the
loans was an unwarranted benefit to private individuals. We find the rationale
of Hancock Academy equally applicable to the case at bar. If OTC had truly been
independent, then certainly the huge sums transferred to it by petitioner
constituted inurement to private individuals. See also Founding Church of
Scientology v. United States, supra. ('Indeed, the very existence of a
private source of loan credit from an organization's earnings may itself amount
to inurement of benefit.' 188 Ct.Cl. at 499, 412 F.2d at 1202.)
We do not, however, credit petitioner's story that OTC was independent. It was
a sham corporation controlled by L. Ron Hubbard.
Petitioner's burden of proof with respect to inurement in this case is of
necessity a heavy one. Where one individual is dominant in an organization,
'there exists the opportunity for abuse which, in turn, evinces a need for open
and candid disclosure of all the facts.' Basic Bible Church v. Commissioner,
74 T.C. 846, 858 (1980). In the instant case, however, petitioner has been
less than open and candid and has failed totally in carrying its burden of
proof with respect to both OTC and the Trust.
Several key Scientology officials were noticeably absent from the trial. L.
Ron Hubbard did not testify, although he was the Church's leader, was a
signatory on all Church and OTC accounts, and allegedly held sums of money in
trust for petitioner. [FN72] Mary Sue Hubbard did not testify although she
*501 was the senior person on the Aides Council, commanded the International
Guardian Network, and held the only set of keys to the Apollo strongroom where
millions of dollars belonging to OTC and the Trust were stored. Greenberg, the
California Church's accountant, did not testify although he coordinated the
1971-1974 audit on behalf of the Church, allegedly counted on February 23, 1975
the OTC money kept aboard the Apollo, and prepared petitioner's tax returns for
the docketed years. [FN73] Mary Rezzonico did not testify although she served
as Greenberg's assistant during the 1971-74 audit and was invested with the
power of attorney to represent the California Church before the IRS on all
matters and all years. H.A. Ross did not appear although he was the auditor of
the trust accounts for the docketed years. Neither Fred Hare nor Vicki Polimeni
testified although they were the Church officials who allegedly transported the
trust funds from Switzerland to the Apollo. We stop here although there were
others who were privy to facts and transactions of critical importance to the
issues in this case, particularly concerning the Trust and OTC, who did not
Petitioner also failed to introduce important documentary evidence. The trust
records were not produced although a file containing trust banking records and
correspondence was allegedly maintained at the United Kingdom Church. The
Church never produced records of OTC's expenditures, claiming OTC was a
separate corporation over which it had no control and also claiming that the
Swiss banks, where the OTC accounts were maintained, did not return cancelled
checks. These claims were false. OTC was a separate corporation in name only.
Furthermore, petitioner regularly received debit advices from the OTC accounts
which provided the same information as would have been shown on a cancelled
check. The ready availability of these debit advices is underscored by the fact
that at least one Church witness reviewed them in Los Angeles before giving
testimony. Finally, petitioner did not produce instructions called 'Flag
Mission Orders' and reports *502 pertaining to the two trips to Switzerland
to close out the OTC and trust accounts, although these records were preserved
in a mission file maintained at Clearwater, Florida.
The failure of a party to produce relevant evidence within its possession or
control gives rise to the presumption that, if produced, it would be
unfavorable. United States for the Use and Benefit of C.H. Benton, Inc. v.
Roelof Construction Co., 418 F.2d 1328, 1332 (9th Cir. 1969); Malat v.
Commissioner, 302 F.2d 700, 706 (9th Cir.), cert. denied 371 U.S. 934
(1962), affg. 34 T.C. 365 (1960). This is especially true where the party
failing to produce the evidence has the burden of proof. Witchita Terminal
Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 F.2d
513 (10th Cir. 1947). The need for full and candid disclosure is also
particularly great where a church is dominated by its founder since there is
obvious opportunity for abuse of its tax-exempt status. Basic Bible Church v.
Commissioner, 74 T.C. 846, 858 (1980); Bubbling Well Church of Universal
Love, Inc. v. Commissioner, 74 T.C. 531 (1980), affd. 670 F.2d 104 (9th
Cir. 1981). In view of L. Ron Hubbard's unfettered control of the OTC and trust
funds ranging in the millions of dollars, petitioner's failure to come forward
with relevant evidence bearing on these holdings constitutes an overwhelming
failure of proof. Consequently, we find petitioner was operated for the private
benefit of L. Ron Hubbard and his family and that its net earnings inured to
In a pretrial ruling we held that in order to qualify for exemption under
section 501(c)(3) petitioner must meet the express conditions of that section
and in addition must comply with fundamental notions of public policy. Our
ruling anticipated the holding in Bob Jones University v. United States, 461
U.S. 574, 103 S.Ct. 2017 (1983), which found that section 501(c)(3) was
informed by charitable trust law and which read into the section a requirement
that charitable organizations seeking to qualify for exemption from federally
imposed taxes must serve a valid public purpose and confer a public benefit.
103 S.Ct. at 2026-2027 n. 12.
*503 (T)o warrant exemption under section 501(c)(3), an institution must
fall within a category specified in that section and must demonstrably serve
and be in harmony with the public interest. The institution's purpose must not
be so at odds with the common community conscience as to undermine any public
benefit that might otherwise be conferred.
103 S.Ct. at 2029 (footnote omitted). Pursuant to our ruling respondent
offered proof that petitioner did not satisfy this public policy requirement
because it conspired to impede the IRS in performing its duty to determine and
collect taxes from petitioner and other Scientology churches, a felony offense
under 18 U.S.C. sec. 371. Petitioner contends that our construction of
501(c)(3) impermissibly intrudes upon its associational rights and free
exercise rights because there are less restrictive ways to purge petitioner's
conduct than to withhold its exemption. [FN74] Petitioner suggests that the
Government's interests could just as well be vindicated by prosecuting Church
officials who broke the law as by penalizing the entire California Church and
denying its tax exemption. Petitioner reminds us that the First Amendment
principle of requiring the least restrictive means has a sympathetic chord in
charitable trust law. 'If the purposes for which a charitable trust is created
are legal, the *504 mere fact it would be possible to accomplish the
purposes by illegal means does not make the charitable trust invalid.'
Restatement (Second) of Trusts, sec. 377, Comment d (1959). This issue was also
raised in a slightly different form in the Bob Jones University case. There the
Court pondered what remedy should apply where an exempt organization confers
some benefit but also violates a law.
(W)e need not decide whether an organization providing a public benefit and
otherwise meeting the requirements of section 501(c)(3) could nevertheless be
denied tax-exempt status if certain of its activities violated a law or public
Bob Jones University v. United States, 103 S.Ct. at 2031 n. 21.
It is axiomatic that a charitable trust is invalid if it is created for an
illegal purpose. Restatement (Second of Trusts, sec. 377 (1959). Thus, a trust
can be voided at the request of an interested party if trust property is used
to perpetrate a crime defined by statute, or if the object of the trust is to
defraud the Government or if its purpose is to evade taxes. 4 Scot, Trusts 377
(3d ed. 1967); Bogert, The Law of Trusts and Trustees, sec. 211, pp. 63-64,
114 (2d ed. 1979). See also Carriage Square, Inc. v. Commissioner, 69 T.C.
119 (1977); Temple Square Mfg. Co. v. Commissioner, 36 T.C. 88 (1961).
Respondent has conceded that petitioner's stated purposes, i.e., the purposes
described in petitioner's organizing documents, are religious. However, to
qualify for a charitable exemption, not just the stated purposes, but the
actual purposes manifested through the organization's activities must further a
charitable purpose. Sec. 1.501(c)(3) - 1(a), Income Tax Regs. This is a
question of fact to be determined from all the circumstances. B.S.W. Group,
Inc. v. Commissioner, 70 T.C. 352, 357 (1978); Pulpit Resource v.
Commissioner, 70 T.C. 594, 602, 604 (1978); Parker v. Commissioner, 365
F.2d 792, 795 (8th Cir. 1966), cert. denied 385 U.S. 1026 (1967).
When we consider all the facts spread across the voluminous record in this
case, we are left with the inescapable conclusion that one of petitioner's
overriding purposes was to make money. We also conclude that criminal
manipulation of the IRS to maintain its tax exemption (and the exemption of
affiliated churches) was a crucial and purposeful element of
*505 petitioner's financial planning. [FN75] We need not repeat in detail
our findings regarding petitioner's efforts to block the IRS from
investigating, determining and collecting taxes from petitioner and affiliated
churches. The highlights of the conspiracy show its nature and scope.
The conspiracy spanned 8 years beginning in 1969 and continuing at least until
July 7, 1977 when the FBI, pursuant to a warrant, searched petitioner's
premises for evidence of the conspiracy and related crimes. The scheme involved
manufacturing and falsifying records to present to the IRS, burglarizing IRS
offices and stealing Government documents, and subverting Government processes
for unlawful purposes. For example, Freedom of Information Act requests were
planned for the purpose of having the IRS amass records in one central place
where they would be easier to steal. At first, petitioner's FBO network
masterminded the conspiracy, developing plans to conceal that OTC was s sham by
falsifying and manufacturing records. Later petitioner's Guardian Office, whose
top officials served on petitioner's board of directors during the docketed
years, directed the conspiracy. The Guardian Office developed plans to
infiltrate the IRS and steal documents. Later it monitored the implementation
of these plans.
In pursuit of the conspiracy, petitioner filed false tax returns, burglarized
IRS offices, stole IRS documents, and harassed, delayed, and obstructed IRS
agents who tried to audit the Church's records. Petitioner gave false
information to and concealed relevant information from the IRS about its
corporate structure and relationship to OTC. In the end, Jane Kember, the
Guardian Worldwide, acting just under L. Ron and Mary Sue Hubbard in
petitioner's hierarchy, was convicted of burglarizing the offices of
respondent's Exempt Organizations Division on three occasions in 1976. The
burglaries occurred while an extensive audit of petitioner's records was in
progress. Furthermore, Mary Sue Hubbard, Duke Snider, and Henning Heldt were
convicted of conspiring to obstruct justice. Their convictions in part rested
on their efforts to conceal petitioner's connection to burglaries of IRS
offices and *506 the theft of IRS documents relating to this case. Mary Sue
Hubbard was petitioner's second highest ranking official. Duke Snider was
petitioner's president for part of 1975 and 1976. Henning Heldt was
petitioner's vice-president during the docketed years.
Petitioner's course of conduct between 1969 and 1977 constitutes a violation
of 18 U.S.C. sec. 371 and convincingly shows that petitioner had a
substantial illegal purpose during the docketed years. We are, therefore, faced
with the question of what remedy to apply. Are we required by either the First
Amendment or charitable trust principles to find that the Government's only
remedy is a criminal prosecution? For a number of reasons, we think not.
First, 18 U.S.C. sec. 371, which provides that it is a felony offense for
two or more persons to conspire to defraud the United States or its agencies,
is a venerable and major Federal criminal statute. It was first enacted as
section 30 of 'An Act to amend existing laws relating to Internal Revenue and
for other purposes' on March 2, 1867, 14 Stat. 471, 484, and has continued
in effect almost in its present form ever since then. See United States v.
Gradwell, 243 U.S. 476, 481 (1917). One has only to look at the numerous
annotations which follow 18 U.S.C. sec. 371 in the United States Code
Annotated to realize its importance in safeguarding our governmental functions.
Second, petitioner's conspiratorial efforts were systemic and long lived.
People in petitioner's FBO network, Guardian Office and affiliated churches
were involved. Church officials at the highest level of the hierarchy, not just
ordinary Church members, participated in the conspiracy. Indeed, some high
Church officials were finally convicted for their illegal activities. Three
held top-ranking positions in petitioner's hierarchy during the docketed years
and four others held important positions in petitioner's Guardian Offices in
later years. At least four of petitioner's branch churches were affected by the
conspiracy. There were plans to manufacture and falsify records at Flag and
AOLA. Also officials at Flag and the Guardian Offices in the United Kingdom and
United States spearheaded the conspiracy. The conspiratorial plan knew no
geographic boundaries. Guardian Order 1361 called for infiltrating and stealing
documents from IRS offices in London, Los Angeles, and Washington, D.C. Third,
the Government's interest in ferreting *507 out crime is not the only
interest at stake here. The Government also has an interest in not subsidizing
criminal activity. Were we to sustain petitioner's exemption, we would in
effect be sanctioning petitioner's right to conspire to thwart the IRS at
taxpayer's expense. We think such paradoxes are best left to Gilbert and
Sullivan. Finally, under the statutory scheme, the denial of an exemption is
not a permanent loss to petitioner. Only petitioner's 1970-1972 tax years are
before us. Petitioner is free to show that it qualifies for exemption in
subsequent years since each tax year is a separate cause of action.
Commissioner v. Sunnen, 333 U.S. 591, 598 (1948).
Petitioner states that in 1970, 1971, and 1972 it had no warning that public
policy violations could lead to a denial of its tax-exempt status. Petitioner,
therefore, claims respondent cannot, consistent with due process, invoke this
requirement to deny its exemption. The public policy requirement is not
strictly speaking a new provision. It is an implied condition of section
501(c)(3). However, it has only recently been read into that section and it was
not until the trial of this case was over that the requirement received Supreme
Court sanction in Bob Jones University v. United States, 461 U.S. 574, 103
S.Ct. 2017, decided May 24, 1983. The application of a public policy
requirement to petitioner's operations during the taxable years at issue,
therefore, has retroactive effect.
Holding petitioner subject to public policy standards embodied in charitable
trust law does not violate petitioner's right to due process. The application
of this requirement to petitioner's operations calls into play a form of
limited retroaction first discussed in United States v. Schooner Peggy, 5
U.S. (1 Cranch) 103 (1801). There it was held that if a law changes while a
case involving public rights is pending the new law must govern the case. 5
U.S. (1 Cranch) at 110. This approach has been followed not only in
instances where a statutory change has intervened, Carpenter v. Wabash Railway
Co., 309 U.S. 23 (1940), but also where judicial decision has clarified or
overruled earlier case law. Vandenbark v. Owens-Illinois Glass Co., 311 U.S.
538 (1941); Oklahoma Packing Co. v. Oklahoma Gas & Electric Co., 309 U.S. 4,
7-8 (1939). See also Linkletter v. Walker, 381 U.S. 618, 625-627 (1965).
Petitioner's claim fails even when measured by general due process
considerations in the area of retroactive law. The due *508 process clause
does not make every retroactive law unconstitutional. Usery v. Turner Elkhorn
Mining Co., 428 U.S. 1, 16 (1976); Welch v. Henry, 305 U.S. 134, 146
(1938). A retroactive tax law offends the due process clause only when the
nature of the tax and the circumstances in which it is laid leave little doubt
that it is harsh and oppressive. Welch v. Henry, supra at 147; Hospital Data
Center of S.C., Inc v. United States, 225 Ct.Cl. 158, 163, 634 F.2d 541,
544 (1980). See also, Hazelwood Chronic & Convalescent Hospital, Inc. v.
Weinberger, 543 F.2d 703, 708 (9th Cir. 1976), vacated on other grounds
430 U.S. 952 (1977).
Under the circumstances, we find that the retroactive application of the
public policy requirement is neither harsh nor oppressive. First, petitioner
had ample notice that it was against the law to conspire to obstruct the IRS.
18 U.S.C. sec. 371 has been in effect for over 100 years. If the threat of
criminal penalties was not sufficient to keep petitioner within the bounds of
the law, it can hardly be supposed that petitioner would have acted differently
had it known it would incur a tax liability for planning a campaign to thwart
the IRS. Second, section 7605 places petitioner on notice that the Commissioner
has broad authority to make tax rulings retroactive. Cf. Central Illinois
Public Service Co. v. United States, 435 U.S. 21, 33 (1978) (Breenan, J.,
concurring). Third, the public record belies petitioner's assertion that it did
not have warning that it must comply with public policy standards to maintain
its eligibility for exemption. In Rev. Rul. 67-325, 1967-2 C.B. 113,
respondent stated his view that an organization which is not 'charitable in the
generally accepted legal sense' does not qualify for section 501(c)(3) status.
Rev. Rev. 67-325, supra at 117. Regulations in effect during the docketed years
defining the term 'charitable' state the term is 'used * * * in its generally
accepted legal sense.' See 26 C.F.R. sec. 1.501(c)(3)-1(d)(2)(1970), (1971)
and (1972). The Commissioner of the IRS was on record in 1970 as saying that an
organization seeking exemption within the meaning of section 501(c)(3) must
meet the test of being 'charitable' in the legal sense. Statement of Randolph
W. Thrower, Commissioner of Internal Revenue, before the Senate Select
Committee on Equal Educational Opportunity, 91st Cong., 2d Sess., August 12,
1970 at 1995. Rev. Rul. 71-447, 1971-2 C.B. 230 states:
*509 All charitable trusts * * * are subject to the requirement that the
purpose of the trust may not be illegal or contrary to public policy.
This same rule was also stated in Green v. Connally, 330 F.Supp. 1150,
1159 (D.D.C.) decided on June 30, 1971 and affirmed per curiam sub nom. Coit v.
Green, 404 U.S. 997 (1971). [FN76] Some, but not all, of these rulings were
made in the context of determining whether racially discriminatory schools
qualified for tax-exempt status since they violated Federal public policy
against racial discrimination. We find this of little significance since the
rule was stated broadly enough to throw into question petitioner's eligibility
for exemption for violating 18 U.S.C. sec. 371. For all of the above
reasons, we find that petitioner is not unduly injured by the retroactive
application of public policy standards.
Several of respondent's witnesses were former Scientologists. Petitioner
challenges their credibility, claiming their disenchantment with the Church
caused their testimony to be biased. This Court had ample opportunity to
observe these witnesses. Most of them were questioned at length under cross-
examination. With one exception this Court found all of them to be credible.
The exception is Lauren Gene Allard. There were significant inconsistencies in
his testimony and this Court has therefore only credited his testimony where it
is corroborated by documentary evidence. The remaining ex-Scientologists were
credible and markedly free of any tendency to be vindictive. Lorna Levett, a
former Scientologist who had been in charge of a Scientology mission in Canada,
admitted that she was disillusioned with Scientology. However, her
disillusionment did not prevent her from giving candid and straightforward
answers. Petitioner on brief did not point to any inconsistencies in her
testimony, although she was cross-examined at length. Kathryn Kirsch was
reluctant to testify and had to be subpoenaed. She worked in finance
*510 positions at the Celebrity Center Church of Scientology during the
docketed years and testified about instructions from her superiors regarding
techniques to resist passively IRS inquiries. Her testimony was unimpeached.
Scott Mayer, another former Scientologist, served as an unpaid consultant to
respondent's counsel. During the course of the trial, at the request of
respondent's counsel, he became a paid consultant. Mayer was in the courtroom
throughout the trial and this Court, therefore, had ample opportunity to
observe him both on and off the witness stand. Some of the details of his
testimony regarding a 1975 project to falsify Church financial records were
impeached, but the essentials of his story stood up under attack. On balance
this Court found Mayer to be both truthful and well-informed.
The most sterling witness among the many former Scientologists who testified
was John McLean. Petitioner tried very hard to impeach his testimony since he
had damaging things to say. He told about orders to falsify records, direct
payments to L. Ron Hubbard, the removal of money from secret Swiss bank
accounts and the Church's heavy emphasis on making money. Petitioner tried hard
to impeach three collateral aspects of McLean's testimony: (1) that McLean
travelled to join Flag in 1971 with a man named Foster Tompkins; (2) that Flag
kept statistics on 'paid completions' in May 1971; and (3) that McLean's salary
was suspended for a time as punishment.
The impeachment failed. McLean testified that on his journey from Los Angeles
to join the Flag ship in Tangier, Morocco he was met in New York by Foster
Tompkins, who then accompanied him on his journey. Foster Tompkins testified as
an impeachment witness. He said that he travelled from New York to Madrid and
then on to Tangier but not with McLean. However, a passport and travel vouchers
show that both men were at the Barajas Airport in Madrid on February 19, 1971.
Furthermore, both men testified that on arrival in Madrid they went to a Flag
outpost or relay point to meet with a man named David Rapp for a briefing. The
similarities in the men's stories about their course of travel combined with
the documentary evidence placing both men at the Madrid airport on the same day
convince us of the truth of the gist of McLean's testimony. We find that the
two men must have travelled from New York to the Flag outposts in Madrid
*511 together, although it appears from other evidence that the men
travelled separately on the very last leg of the journey from Madrid to the
Apollo in Tangiers. The Church also tried to impeach McLean's story that his
pay was temporarily suspended as punishment because Church money in his custody
was stolen from him while he was on a Church mission. However, this testimony
was corroborated by a Flag order dated June 22, 1971 and disbursement vouchers
signed by him. [FN77] The Church also failed to impeach McLean's testimony
about 'paid completions.' (A 'paid completion' is a course or level that is
completed and paid for.) McLean testified that in May 1971 the file room aboard
the Apollo had files for the different churches including AOLA and that the
AOLA files had subdivisions for statistics on gross income and 'paid
completions.' Petitioner tried to establish that statistics on paid completions
were not kept until August 1971 when L. Ron Hubbard wrote a policy letter
declaring that it was harmful for Scientology organizations to concentrate on
increasing gross income at the expense of delivering quality services. The
policy letter explains that L. Ron Hubbard therefore developed a new
statistical goal called 'paid completions accompanied by an acceptable success
story.' This new goal was meant to counteract the misguided tendencies of
certain organizations to emphasize gross income statistics over quality
services. However, it is clear from other policy letters that as early as March
of 1969 Scientology organizations were instructed to report statistics on the
number of grade levels that were paid for and completed. We, therefore, credit
McLean's testimony and surmise that the new statistic introduced in 1971 had to
do with QUALITY paid completions and not just paid completions which were
already being tabulated.
Lewis Hubbard and the examining agents for the 1971-1974 audit testified at
length in this trial and underwent extensive cross-examination by petitioner's
counsel. They each displayed a high degree of professional dedication and an
absence of any prejudice towards petitioner or Scientology.
*512 This Court does not credit the testimony of two Church witnesses, Fran
Harris and Joel Kreiner. Harris was very evasive on cross-examination about
topics that were clearly within her area of competence. She did not know what
discount prices were given to staff members; whether ASHO paid money to the so-
called trust; how much money ASHO sent to Flag, what percentage of the ASHO
budget was devoted to operating expenses; which organizations sent staff to
train at Flag; whether staff training payments were routed through Los Angeles
to Flag or went directly to Flag; how the Swiss banks notified her of their
intention to charge negative interest on foreign deposits; whether one or two
Swiss trust accounts were closed out in 1972; how she could be certain no one
had access to the OTC and trust monies; why the OTC cash aboard the Apollo was
not deposited in the Banque du Benelux account in Luxembourg until 1975 even
though the account was opened in 1973 and held other cash deposits from the
Apollo; what the terms of her contract with the Sea Organization were; or why
her close friend Robin Roos lost her position as CS-3 on the Aide's Counsel.
Taking into account that Harris served as the chief financial officer at USLO,
ASHO, AOLA and then Flag, and considering that she and L. Ron Hubbard
masterminded the transfer of the OTC and trust monies from banks in Switzerland
to the Apollo, we can only conclude that her evasiveness was intentional.
Joel Kreiner was the Church's chief legal officer (Deputy Guardian Legal,
U.S.) from the fall of 1969 to June 1974. In June he stepped down from his
position as chief legal adviser but continued to hold a legal post in
petitioner's Guardian Office. Kreiner was the Church's primary tax attorney and
had custody and control of the Church's tax files. Kreiner's manner of giving
testimony raised doubts about his credibility. He repeatedly revised his
statements. Under respondent's examination his memory was short and often had
to be refreshed by documentary evidence. This Court was ultimately persuaded to
disbelieve Kreiner by three factors. First, Kreiner prepared applications for
exemption for several Scientology missions. Statements on the application form
about the mission's relationship to the United Kingdom Church were misleading.
The form failed to mention the mission's obligation to remit 10 percent of its
corrected gross income to the *513 United Kingdom Church and described its
practice of sending financial reports to the United Kingdom Church as purely
voluntary although in fact it was obligatory. Second, Kreiner wrote a letter
transmitting the Church audit report to the IRS which characterized the report
as 'a fair and accurate version' of the Church's tax position. The report is
filled with falsehoods about OTC, the Trust, and the United Kingdom Church.
Kreiner, as the Church's chief tax counsel during the docketed years, must have
known this. Third, when Church operatives pursuant to Guardian Order 1361 were
having difficulty stealing documents from IRS intelligence files, a Freedom of
Information request prepared by Kreiner was made to the IRS for the purpose of
amassing these documents in a central location where they would be easier to
Petitioner raises four evidentiary objections to the introduction of the OEC
series, a nine-volume compilation of Scientology policy letters. [FN78]
Petitioner claims (1) that the compilation is hearsay; (2) that the policy
letters predating the docketed years are irrelevant; (3) that the policy
letters are not comprised of statements within the meaning of Fed. R. Evid.
801(a); and (4) that volumes cannot be admitted wholesale without examination
of each policy letter for nonadmissible material. None of these objections is
Under the Federal Rules of Evidence, a party-admission is not hearsay. Fed. R.
Evid. 801(d)(2)(B) provides:
A statement is not hearsay if--* * * (t)he statement is offered against a
party and is * * * a statement of which he has manifested his adoption or
belief in its truth.
Petitioner notes the following disclaimer published in the front of each OEC
volume and contends that the volumes, therefore, do not constitute a party-
This is part of the religious literature and works of the Founder of
Scientology, L. Ron Hubbard. It is presented to the reader as part of the
record of his personal research into Life, and should be construed only as a
written report of such research and not as a statement of claims made by the
Church or the author.
*514 A statement can be adopted by conduct as well as by words. State v.
Hamilton, 236 N.W. 2d 325, 330 (Iowa 1975); 4 Weinstein's Evidence par.
801(d)(2)(B)(01) at 801-144 (1981). Here, despite its written disclaimer,
petitioner has clearly manifested its adoption of the policy letters in the OEC
series by its conduct. Petitioner distributed policy letters to staff
throughout the Church. Staff were expected to know and follow the policy
letters. The policy letters made up some of the material in staff folders
containing job instructions and staff were quizzed from time-to-time on their
content. Petitioner even offered a course, the OEC course, devoted to the study
of policy letters--each volume requiring 2- 1/2 weeks of study. On balance,
petitioner's actions speak louder than its words and the OEC series must be
considered the statements of a party-opponent within the meaning of Fed. R.
Some of the policy letters in the OEC series predate the docketed years and
petitioner claims they are, therefore, irrelevant. Evidence is remote and
irrelevant only when it bears no connection to provable issues in the case.
N.L.R.B. v. Ed Chandler Ford, Inc., 718 F.2d 892, 893 (9th Cir. 1983).
Policy letters were effective until officially cancelled. An editor's note in
the OEC series marks when a policy letter has been cancelled. Thus, all the
policy letters in the OEC volumes predating the docketing years are relevant
except the ones marked by an editor's note showing they were cancelled.
Petitioner claims that some policy letters fell into desuetude without being
officially cancelled. As a general proposition this is probably true. However,
according to petitioner each Church allegedly kept a current index of updated
orders and policy letters. Petitioner never produced this index. [FN79] Under
the circumstances we think the early policy letters in the OEC series must be
deemed to be in effect during the docketed years in the absence of specific
evidence to the contrary.
Petitioner claims that the policy letters should not be admitted because they
are so obscure that they cannot be said to be written assertions within the
meaning of Fed. R. Evid. 801(a). Petitioner relies on Zenith Radio Corp. v.
Matsushita *515 Electric Industrial Co., 505 F. Supp. 1190 (E.D. Pa.
1980), which held that certain diaries kept by Japanese businessmen were not
admissible because they were unintelligible. The diaries were written purely
for the diarist. They were not intended for an audience. They contained mostly
coded notations which would have required the services of a cryptographer to
decipher. 505 F.Supp. at 1211. The Zenith court did note, however, that a
proper foundation for the diaries could have been laid had their meaning been
explained. 505 F.Supp. at 1242. The policy letters at issue here are
markedly different from the diaries. The policy letters were collected for
publication and sold in petitioner's bookstore which was open to the general
public. They were written in sentences rather than coded notations. Words or
abbreviations which had idiosyncratic meaning were explained at the trial by
Petitioner's final objection to the OEC series is the admission of the volumes
as a whole without separate analysis of each policy letter for inadmissible
material. Petitioner again relies on the Zenith case which held that 'Rule
801(d)(2) requires that each statement (in a compilation) be separately
admissible.' 505 F.Supp. at 1240. The Zenith court was dealing with
vicarious admissions under Fed. R. Evid. 801(d)(2)(C) and (D). The policy
letters are, however, adoptive admissions within the meaning of Fed. R. Evid.
801(d)(2)(B) so that different considerations are at stake. The Zenith court
was concerned that the diaries contained entries which did not qualify as
admissions for one of three reasons. They were not assertions. They were not
made in the scope of employment. They contained double hearsay. No such
problems exist here. First, as we have already explained, the policy letters
contain statements within the meaning of Fed. R. Evid. 801(a). Furthermore,
since we are dealing with adoptive admissions and not vicarious admissions, we
need not be concerned whether the statements were made in the course of
employment. Finally, there is no double hearsay problem. California Church
officials were expected to know the content of policy letters and to follow
them lock, stock, and barrel. Under these circumstances all of the policy
letters in the OEC series constitute adoptive admissions, including the ones
containing double hearsay, 505 F. Supp. at 1243 n. 64; cf. United States v.
Article of Drug, 362 F.2d 923 (3d Cir. 1966).
*516 The admissions of a party-opponent have been freed under the Federal
Rules of Evidence from many of the restraints placed on other forms of evidence
to guaranty their trustworthiness and the policy respecting them is one which
calls for 'generous treatment' of their admissibility. Advisory Committee's
Note to Rule 801 reprinted in P. Rothstein, Rules of Evidence for the United
States Courts and Magistrates at 355-356 (2d ed. 1983). In keeping with this
policy, we see no reason to scrutinize individually each policy letter in the
OEC series prior to its admission.
The following Flag Orders were conditionally received in evidence provided
respondent demonstrated they were applicable during the docketed years: Flag
Orders RS391 (Exhibit AG), 565 (Exhibit AH), 773 (Exhibit AI), 2132 (Exhibit
AJ), 3152 RR (Exhibit AK), 3302 (Exhibit AL), 3385-1 (Exhibit AN), 3385-7R
(Exhibit AO), 3474-2 (Exhibit AP). Flag Order 3152 RR is dated March 30, 1972
and, therefore, shows on its face that it was in effect during the docketed
years. Flag Orders RS391, 565, 773, and 2132 were all issued prior to the
docketed years. Respondent demonstrated that Flag Orders did not automatically
expire and thus made a prima facie showing that these orders continued in
effect during 1970-1972. McLean's testimony corroborated the continuing
vitality of one Flag order in this group. Flag Order RS391 states that L. Ron
Hubbard must approve financial planning and McLean testified this practice
continued during the docketed years. Fran Harris was the only witness to rebut
respondent's showing. Since this Court did not find her to be a credible
witness, we find that Flag Orders RS391, 565, 773, and 2132 were in effect
during the docketed years. Flag Orders 3302, 3385-1, 3385-7R and 3474-2 post
date the docketed years and were not in effect during 1970-1972.
Petitioner objects to several bits of evidence which respondent used to prove
petitioner violated public policy. Petitioner objects to any evidence of
conspiratorial events occurring after the docketed years on relevancy grounds;
to Exhibit FG, the stipulation of evidence filed on October 26, 1979 in United
States v. Hubbard, Crim. No. 78 401 (D.D.C. 1979), affd. per curiam sub nom.
United States v. Heldt, 668 F.2d 1238 (D.C. Cir. 1981), cert. denied 456
U.S. 926 (1982), on hearsay grounds; to Exhibit FU, the typewriter case
documents, on *517 Fourth Amendment grounds; and to Exhibit FX, a Guardian
Order, on Fourth Amendment grounds. We consider each of these objections in
Many of the events making up the conspiracy to prevent the IRS from assessing
and collecting taxes from Scientology churches occurred after the taxable years
at issue in this case. To recapitulate, the most significant of these
activities were the execution of petitioner's 1972 return, the burglaries of
the IRS, the coverup of the burglaries, the falsification of petitioner's
records on board the Apollo, and the misrepresentations made to the IRS
auditors during the 1971-1974 audit. Petitioner claims that evidence of these
and similar conspiratorial events occurring after 1972 is irrelevant.
We recognize that each tax year is a separate cause of action. However, this
rule does not force us to blind ourselves to events occurring outside the
docketed years which have a direct bearing on the taxable years at hand. Fed.
R. Evid. 404(b) authorizes the use of evidence of other crimes, wrongs, or acts
to prove 'motive, opportunity, intent, preparation, plan, knowledge, identity,
or absence or mistake or accident.' Pursuant to this rule a trial court has
broad discretion to admit evidence of SUBSEQUENT similar acts and crimes
provided it is probative of one of these purposes and is not used merely to
show criminal disposition. United States v. Arroyo-Angulo, 580 F.2d 1137,
1149 (2d Cir.), cert. denied 439 U.S. 913 (1978); United States v.
Cavallaro, 553 F.2d 300, 305 (2d Cir. 1977). See also United States v.
King, 587 F.2d 956, 962 (9th Cir. 1978); United States v. McDonald, 576
F.2d 1350 (9th Cir. 1978). The burglaries, the thefts, the coverup, the
falsification of records, all represent actions taken on petitioner's part to
alter the facts and influence the issues presented in this very case. They are
probative of petitioner's intent and plan to prevent the IRS from inquiring
into the tax status of Scientology churches. Petitioner has insisted that it is
innocent of any wrongdoing prior to and during the docketed years. For example,
on brief, petitioner attempts to characterize a 1969 FBO network plan to
disguise payments to OTC as an honest effort to record Flag expenses in a more
organized fashion. Also, on brief, petitioner claims that Exhibit FX, a 1972
Guardian plan to counter IRS investigations of Scientology churches, does not
contemplate illegal activity. The subsequent conspiratorial acts are,
therefore, *518 highly probative of petitioner's criminal intent. They also
show the magnitude of petitioner's plan. In sum, December 31, 1972 is not a
magic cutoff date for evidence that so clearly elucidates petitioner's role in
a conspiracy that was rooted in the docketed years but continued to grow and
flourish for a long time afterwards. Cf. United States v. King, supra at
962; United States v. Testa, 548 F.2d 847, 852 (9th Cir. 1977). This is
especially so where a primary purpose of the subsequent acts was to influence
the very matters before us.
Exhibit FG is a stipulation of evidence entered on October 26, 1979 in United
States v. Hubbard, Crim. No. 78-401 (D.D.C. 1979). On the basis of this
stipulation, several of petitioner's officials were convicted of conspiracy to
obstruct justice in violation of 18 U.S.C. sec. 371. Petitioner claims that
this Court cannot rely on Exhibit FG because it is hearsay. We agree that the
stipulation is hearsay and that it cannot be used by itself for substantive
purposes. However, petitioner misconceives what is being done here. The
stipulation is not being used as substantive evidence. It has merged into the
convictions of Mary Sue Hubbard, Henning Heldt, and others. Their judgments of
conviction were received in evidence and we are here relying on the stipulation
to determine the facts underlying the convictions.
Fed. R. Evid. 803 (22) allows evidence of a judgment of a felony conviction
'to prove any fact essential to sustain the judgment.' It is the duty of the
trial judge in the subsequent case to determine just which facts were essential
to the previous conviction. The Supreme Court in Emich Motors Corp. v. General
Motors Corp., 340 U.S. 558 (1951), discussed the difficulties of the problem
and the trial judge's task:
The difficult problem, of course, is to determine what matters were
adjudicated in the antecedent suit. A general verdict of the jury or judgment
of the court without special findings does not indicate which of the means
charged in the indictment were found to have been used in effectuating the
conspiracy. And since all of the acts charged need not be proved for
conviction *** such a verdict does not establish that defendants used all of
the means charged or any particular one. Under these circumstances what was
decided by the criminal judgment must be determined by the trail judge *** upon
an examination of the record, including the pleadings, the *519 evidence
submitted, the instructions under which the jury arrived at its verdict, and
any opinions of the courts. (Citations omitted.)
340 U.S. at 569. [FN80] See also United States v. Podell, 572 F.2d 31,
36 (2d Cir. 1978).
Ordinarily the evidentiary utility of a finding of guilt on a general count of
conspiracy is limited to the essentials of the conspiracy due to the difficulty
in determining what substantive violations occurred. See Emich Motors Corp. v.
General Motors Corp, supra at 569-571; see also United States v. Guzzone,
273 F.2d 121, 122-123 (2d Cir. 1959); United States v. Kates, 419 F.Supp.
846, 852-853 (E.D. Pa. 1976). In the instant case, however, we do not have to
operate in a vacuum. Petitioner's officials were convicted on the basis of a
detailed uncontested stipulation of evidence. We can, therefore, determine with
precision what the unlawful objects of the conspiracy were and what means were
taken to effect its purposes.
Under the circumstances, we can safely conclude that the criminal court which
handed down the convictions must have found facts in complete accordance with
the stipulation of evidence. This follows from its duty to consider rationally
the evidence. Jackson v. Virginia, 443 U.S. 307 (1979). The only evidence
presented was an uncontested, written stipulation supported by documents. There
were no witnesses. Thus, since credibility was not an issue, and since the
stipulation was devoid of internal inconsistency and not contrary to the laws
of nature, the criminal court had no principled basis for accepting only part
of the stipulation and rejecting other parts. As a rational trier-of-fact, it
had to adopt the stipulation in its entirety. We, therefore, are entitled to
rely on the stipulation not as a discrete piece of substantive evidence but as
a comprehensive statement of the facts clothing the convictions.
Exhibit FU consists of Guardian Order 1361 and a number of reports discussing
compliance with the order. The documents were brought to the IRS in Los Angeles
in an unmarked typewriter case by an attorney in private practice named Jones.
They were received by Agent McKellar. Petitioner claims that respondent should
have obtained a warrant before *520 opening the typewriter case, since
attorney Jones told McKellar that he had read the documents and they appeared
to relate to burglaries of IRS offices for the purpose of reviewing IRS records
concerning the Church of Scientology. Petitioner lacks standing to pursue this
Fourth Amendment claim. The typewriter case was found abandoned in a Sears
parking lot sometime in July, 1977 by a client of attorney Jones. The client
saw an unidentified man leave the case containing the documents in the parking
lot and, after a short while, when the person did not return to retrieve the
case, the client took it and later gave it to attorney Jones. The typewriter
case had no markings on it identifying it as belonging to the California Church
and it appears from the record that it was not even locked. Under these facts
petitioner's objections to Exhibit FU lack merit. Abandoned property is not
protected by the Fourth Amendment. Abel v. United States, 362 U.S. 217
(1960). Furthermore, a person who voluntarily abandons property lacks standing
to complain of its search and seizure. United States v. Kendall, 655 F.2d
199 (9th Cir. 1981), cert. denied, 455 U.S. 941 (1982); United States v.
Cella, 568 F.2d 1266 (9th Cir. 1977); United States v. Jackson, 544 F.2d
407 (9th Cir. 1976).
Exhibit FX is a 19-page document dated April 5, 1972, written in the format of
a Guardian Order. FBI agents seized the document from a file cabinet in
petitioner's Guardian Office during a search of petitioner's offices on July 8,
1977. The FBI agents had a warrant for the search. We agree with petitioner
that Exhibit FX falls outside the scope of the warrant. The search warrant
enumerated 162 items to be seized. In most instances each item described a
specific document. However, item 162 was a catchall calling for the seizure of
'(a)ny and all * * * evidence * * * of the crimes of conspiracy * * * which
facts recited in the accompanying affidavit make out.' The reference to the
'accompanying affidavit' is the affidavit of FBI Special Agent Robert Tittle.
His affidavit describes, among other crimes, a conspiracy to steal documents
from the IRS but the conspiracy is limited to the years 1974 through 1976.
Exhibit FX describes a plan to infiltrate the IRS and so is logically related
to the conspiracy described in the Tittle affidavit. However, Exhibit FX is
dated April 5, 1972 and thus predates the conspiracy described in the Tittle
affidavit. We conclude that the FBI agents who *521 seized FX acted in
excess of their authority under the warrant. Marron v. United States, 275
U.S. 192, 196 (1927); United States v. Heldt, 668 F.2d 1238, 1256-1257 (D.C.
Cir.1981) (per curiam), cert. denied sub nom. Hubbard v. United States, 102
S.Ct. 1971 (1982).
This does not end the matter. In a few carefully defined circumstances,
searches without a warrant do not offend the Fourth Amendment. Coolidge v. New
Hampshire, 403 U.S. 443, 455 (1971) (Stewart, J., Plurality Opinion). A
warrantless search is justified in exigent circumstances where evidence will
most likely be destroyed in the time it takes to obtain a warrant. Vale v.
Louisiana, 399 U.S. 30, 35 (1970). Another exception to the warrant
requirement is the 'plain view' exception. Under this exception police, armed
with a warrant to search a given area for specified objects, may seize an
unlisted, incriminating object which inadvertently falls into plain view.
Coolidge v. New Hampshire, supra at 465. These are the two most likely
exceptions justifying the seizure of Exhibit FX. There are others, but we do
not consider any of them for however well-founded one of these grounds may be,
they are of no avail here because of respondent's failure of proof. The rule is
well settled that, when evidence is presented showing that an item was seized
that was not listed in the warrant, the burden is on the proponent of the
evidence to prove that the seizure of the item was justified under one of the
exceptions to the warrant requirement. Vale v. Louisiana, supra at 34;
United States v. Jeffers, 342 U.S. 48, 51 (1951); McDonald v. United
States, 335 U.S. 451, 456 (1948). The seizing officer did not testify so we
have no way of knowing if Exhibit FX was in plain view; nor was there
convincing evidence put before us to support a finding under the requirements
of Vale v. Louisiana, supra, that the document stood in imminent danger of
destruction. We, therefore, conclude that Exhibit FX was seized in violation of
the Fourth Amendment.
In Suarez v. Commissioner, 58 T.C. 792 (1972), we held 'that as a matter of
law, the protective rule of the fourth amendment which excludes evidence
illegally obtained is applicable in a civil tax case.' 58 T.C. at 806. In
that case we applied the rule to exclude records unlawfully seized by the Miami
police in a raid on an abortion clinic. Our holding was partially overruled in
United States v. Janis, 428 U.S. 433 (1976), which *522 held that the
exclusionary rule did not prevent one sovereign from using in a civil
proceeding evidence illegally seized by another sovereign's law enforcement
officers. 428 U.S. at 459-460. What has become clear since our holding in
Suarez is that the exclusionary rule is not a constitutional right but a
judically created remedy designed to deter unreasonable invasions of privacy by
governmental officials. United States v. Leon, 468 U.S. ___, 52 U.S.L.W.
5155, 5157 (July 5, 1984); United States v. Calandra, 414 U.S. 338, 348
(1974). The rule is thus properly invoked only where its deterrent effect is
likely to outweigh the societal cost of proscribing relevant evidence.
Immigration and Naturalization Service v. Lopez-Mendoza, 468 U.S. ___, 52
U.S.L.W. 5190, 5192 (July 5, 1984); United States v. Janis, supra at 453-
454. As a general proposition, the exclusionary rule is most efficacious where
it is used to exclude evidence from a proceeding in the seizing officer's zone
of primary interest. United States v. Janis, supra at 458. However, even in
such a case the application of the rule is not automatic. The societal cost of
invoking the rule may be too great a price to pay, see Immigration and
Naturalization Service v. Lopez-Mendoza, supra, or under the particular facts
of the case the application of the rule might be of little deterrent value. See
United States v. Leon, supra.
The FBI was solely responsible for the seizure of Exhibit FX. The IRS had
nothing to do with it. FBI agents seized the document during an authorized
search of petitioner's premises on July 8, 1977. The search was made pursuant
to a warrant for the purpose of gathering evidence about seven criminal
conspiracies involving Scientology officials. Exhibit FX was one of some 23,000
documents seized. The rather complex history of these documents following their
seizure is set out in United States v. Hubbard, 650 F.2d 293 (D.C. Cir.
1980). For our purposes it suffices to say the documents were initially used in
connection with criminal proceedings against eleven officials of the Church of
Scientology and were kept under seal first by the California district court and
then by the district court for the District of Columbia. Our record does not
disclose when respondent first came into physical possession of Exhibit FX.
However, it is clear that respondent's counsel first examined a copy of the
document in Washington sometime in May 1980 during a period when the seal on
the Church's records was improperly lifted by the district court for the
*523 District of Columbia and the document was thus available to the general
public for inspection. [FN81] Sometime thereafter Exhibit FX was forwarded to
respondent's counsel in Los Angeles.
Under these facts the attenuation between the FBI's initial seizure of Exhibit
FX and its subsequent use by the IRS in this proceeding is so great that we
perceive no meaningful deterrent effect to be achieved by excluding the
document from evidence. On the other hand, Exhibit FX is a highly relevant
document. It shows that during the docketed years petitioner was developing
plans to prevent the IRS from investigating Scientology churches. It is,
therefore, a significant building block in respondent's public policy case
against petitioner. We, therefore, hold that the exclusionary rule does not
preclude the receipt of Exhibit FX into evidence.
For the reasons we have stated, in Part IV of this opinion, we agree with
respondent's determinations in the notice of deficiency, except his inclusion
in petitioner's income of payments of $76,497.24 in 1970 and $161,018.38 in
1972 from the United Kingdom Church. In light of our finding that the United
Kingdom Church is a branch of petitioner, these payments represent an internal
transfer of funds. They, therefore, are not properly included in petitioner's
income. Respondent concedes this point.
On brief, respondent for the first time asks us to offset this downward
adjustment to the deficiency notice with income from the United Kingdom Church.
We decline to do so. In its preliminary ruling and its final ruling, this Court
said it would entertain evidence concerning the United Kingdom Church's
activities under one of three theories of relevance: to prove the Church
operated commercially, to prove it benefited private interests, or to prove it
violated public policy. During the trial, respondent repeatedly disavowed any
intent to increase the notice of deficiency by reason of the United Kingdom
Church's *524 activities. He made this disavowal knowing that, if he proved
his claim that the United Kingdom Church was a branch of petitioner, the notice
of deficiency would be in error and a Rule 155 hearing would be required to
recompute the deficiency. Nevertheless, during the course of the trial,
respondent repeatedly disavowed any intent to increase the notice of deficiency
by reason of the United Kingdom Church's income. Now for the first time on
brief respondent seeks to shore up the faulty notice of deficiency with income
from the United Kingdom Church's accounts.
We need not delve into the thorny question whether increasing and shoring up
the notice of deficiency are legal equivalents. There may well be circumstances
where the distinction is meritorious. However, here we must treat respondent's
disavowal of intent to increase the notice of deficiency as inclusive of his
intent not to shore up the notice of deficiency with income from the United
Kingdom Church's accounts. We interpret respondent's disavowal expansively
since he made it with full realization that his claim that the United Kingdom
Church was a branch of petitioner would cause the notice of deficiency to be in
error and would necessitate a Rule 155 hearing. Respondent now seeks to get out
from under this requirement. Respondent's concession in open court not to seek
an increase in the notice of deficiency was the equivalent of a stipulation.
Massachusetts Ave. Heights Citizens Assoc. v. Embassy Corp., 433 F.2d 513,
515 (D.C. Cir. 1970) (per curiam). Respondent is bound by his stipulations.
Kampel v. Commissioner, 634 F.2d 708, 710, n. 3 (2d Cir. 1980); United
States v. 237,500 Acres of Land, 236 F.Supp. 44, 46 (S.D. Cal. 1964), affd.
sub nom. United States v. American Pumice Co., 404 F.2d 336 (9th Cir. 1968).
Respondent also asks this Court to shore up the notice of deficiency with
OTC's income. This is a new theory advanced for the first time on brief.
Respondent is well aware of the lateness of this theory but nevertheless urges
this Court to adopt it under the authority of Wilkes-Barre Carriage Co. v.
Commissioner, 39 T.C. 839 (1963), affd. per curiam 332 F.2d 421 (2d Cir.
1964), which held that 'a deficiency may be approved on the basis of reasons
other than those relied upon by the Commissioner * * *.' 39 T.C. at 845.
*525 It is too late in the day for respondent to raise this issue.
Respondent knew well before trial that OTC was a sham corporation but did
nothing to adjust the notice of deficiency to include this source of unreported
income. [FN82] While OTC was clearly a sham and had substantial reserves in its
bank accounts, petitioner has had no opportunity to prove that these reserves
were not income. Petitioner cannot be expected to shoulder its burden if it
does not know under which Code provision the Commissioner has proceeded and 'if
it does not know which transactions or group of transactions the Commissioner
has determined to have resulted in distortions of true net income.'
Commissioner v. Chelsea Products, 197 F.2d 620, 624 (3d Cir. 1952).
The case of Wilkes-Barre Carriage Co. v. Commissioner, supra, on which
respondent relies, is inapposite. In that case, unlike the case at bar, the
taxpayer was aware at the outset which particular transactions were disputed by
the Commissioner. The rule laid down simply allowed the Commissioner to put
forward a new legal theory in support of deficiencies arising from well-defined
transactions. In other words the very same source of income was supported under
a different theory. Here, however, respondent attempts to support his
determination not only with a new legal theory but also from an entirely
different source of income. Respondent is too late. See Brook v. Commissioner,
360 F.2d 1011, 1013 (2d Cir. 1966). [FN83]
Respondent determined an addition to tax under section 6651(a) for failure to
file a corporate income tax return (Form 1120). Section 6651(a) provides a
mandatory 5 percent per month addition on the amount of tax owed not to exceed
25 percent for failure to file a required return unless it is shown that the
failure to file 'is due to reasonable cause and not *526 * * * willful
neglect.' The burden of proof is on the taxpayer to show reasonable cause for
failing to file a require return. Funk v. Commissioner, 687 F.2d 264 (8th
Cir. 1982). Generally the taxpayer must file his return on the proper form to
satisfy this filing requirement. Parker v. Commissioner, 365 F.2d 792, 800
(8th Cir. 1966), cert. denied 385 U.S. 1026 (1967); Olean Times Publishing
Co. v. Commissioner, 42 B.T.A. 1277, 1279 (1940).
On July 18, 1967, respondent revoked petitioner's tax exemption and instructed
petitioner it was thereafter required to file a Federal income tax return, in
petitioner's case, Form 1120. Petitioner ignored this instruction and continued
to file its returns on Forms 990 'Return of Organization Exempt From Income
Tax.' Petitioner claims that it was justified in continuing to file its returns
on Forms 990 since the revocation of exemption was null and void. We hold in
Part II of this opinion that the revocation was valid and effective.
Petitioner's unilateral doubts about its effectiveness are not 'reasonable
cause' for its failure to file a proper return.
Decision will be entered under Rule 155.
FN1. Unless otherwise indicated, all section references are to the
Internal Revenue Code of 1954 as amended and in effect during the taxable
years in issue.
FN2. As FOLO evolved and developed, it went through several name changes.
At its inception it was called Operation Transport Liaison Office (OTL). It
then became variously referred to as the Continental Liaison Office (CLO)
and the United States Liaison Office (USLO). Finally, it was designated
Flag Operation Liaison Office, Western United States (FOLO WUS or FOLO).
FN3. The petition in this case was filed March 28, 1978. Final
supplemental briefs on the public policy issue in this case were filed on
August 4, 1983 (petitioner) and August 22, 1983 (respondent) after the
decision in Bob Jones University v. United States,___U.S.___, 103 S.Ct.
2017 was handed down on May 24, 1983.
FN4. The text of the letter listed several branch churches but omitted
mention of the United Kingdom Church. In fine print, the stationery
referred to petitioner as 'a non-profit corporation in U.S.A. registered in
FN5. The stipulation is carefully worded and does not explicitly state
that the list is a list of petitioner's divisions, but the impression
created is that it is a list of the Church's divisions.
FN6. Petitioner claimed that missions were actually chartered by the
United Kingdom Church and to the California Church. For several reasons we
find that the California Church chartered the missions. First the Charter
Agreement form recites that the California Church is the chartering
authority, and Clive Whittaker, the Franchise Communicator for the United
States, testified that this form was faithfully adhered to during the
docketed years. Second, the Calgary Scientology Mission was chartered by
the California Church. Third, the Church's report of the 1971-1974 audit
states that the California Church had the authority to charter missions.
The only evidence to the contrary is the unsupported statements of church
FN7. Throughout this opinion we have cited specific policy letters by the
abbreviation 'HCO PL,' followed by the letter's date and where applicable
the volume and page number in the OEC series so that a typical cite reads
as follows: HCO PL June 15, 1984, 3 OEC 164.
FN8. Whether Scientology served a religious purpose was an issue that was
never reached in the Founding Church case. Founding Church of Scientology
v. United States, Ct. Cl. Com. Rept. (Aug. 7, 1968), 7 CCH Standard Federal
Tax Reporter par. 7927 (1968), modified 188 Ct.Cl. 490, 412 F.2d 1197
(1969), cert. denied 397 U.S. 1009 (1970).
FN9. These included a summons enforcement action against petitioner for
the taxable years 1968 and 1969 on appeal to the Ninth Circuit;
reconsideration of the revocation of exemption of the Florida Church issued
on November 7, 1969; negotiations to settle a refund case involving the
Hawaii Church; consideration of the eligibility of Scientology ministers
for exemption from the self-employment tax; and review of pending
applications of numerous Churches of Scientology for recognition as tax-
exempt organizations. Between 1967 and 1974 respondent had delayed action
or changed positions on some of these issues.
FN10. The procedural understandings that were reached at the conference on
February 14, 1975 were not reduced to writing. Petitioner's lawyer wrote a
letter dated February 26, 1976 purportedly memorializing the agreements
reached at the conference. This letter is a one-sided reflection of the
understandings that were reached.
FN11. The record mentions a fourth agent, Melvin Young, but does not
disclose if he worked full time.
FN12. The technical advice procedure is described in Rev. Proc. 73-8,
1973-1 C.B. 754, modified by Rev. Proc. 78-14, 1978-2 C.B. 486.
'Technical advice' is a term of art meaning 'guidance as to the
interpretation and proper application of internal revenue laws * * *
furnished by the National Office upon request of a district office in
connection with the examination of a taxpayer's return * * * as a means of
assisting Service personnel in closing cases.' Rev. Proc. 73-8, supra. The
district office writes a statement of facts and issues for submission to
the National Office. However, before it is sent to the National Office, it
is given to the taxpayer for his concurrence. If the taxpayer does not
agree with the statement of facts and issues, he drafts his own and both
statements are submitted to the National Office. If after review of the
statements, the National Office proposes advice adverse to the taxpayer,
the taxpayer is entitled to a conference. Following the conference, the
National Office issues a technical advice memorandum addressed to the
district office giving the conclusions of the National Office and
instructing the district office on how to process the case.
FN13. When Agent Endo accepted the factual content of the footnotes at
face value, he had no independent knowledge to judge the Church's
FN14. The transmittal memorandum presented four issues for consideration
by the National Office: (1) whether petitioner was a religious
organization; (2) whether petitioner was organized and operated for
religious purposes; (3) whether petitioner had a substantial commercial
purpose; and (4) whether petitioner's net earnings inured to the benefit of
FN15. These admissions form an attachment to a letter dated October 3,
1980 from respondent to petitioner, a copy of which was sent to the Court.
The letter and the attachments have been marked as Court's Exhibit 6.
FN16. Almost all of the materials that the SSS collected on Scientology,
which have been made a part of this record, are tax-related. Only two
sentences in one report on the Hawaii Church arguably refer to non-tax
matters, making reference to complaints from neighbors about the use of
'pot' and LSD at the Church.
FN17. Some other files on militants were also destroyed but there is no
evidence they contained material about Scientology or petitioner.
FN18. Before the trial of this case began, as we have noted, respondent
pressed several different grounds in support of his contention that
petitioner should be denied tax-exempt status for public policy violations.
One such ground was that petitioner used the E-meter to conduct security
checks on employees in violation of California state law. This Court ruled
that it would not accept evidence on this ground if petitioner established
that the E-meter was a religious artifact. Petitioner's witnesses testified
that the E-meter was a religious aid, and respondent afterwards abandoned
FN19. HCO PL September 27, 1970 (Issue I), 3 OEC 89, describes
petitioner's policy against free services and price cutting. It states:
Price cuts are forbidden under any guise. 1. PROCESSING MAY NEVER BE GIVEN
AWAY BY AN ORG. Processing is too expensive to deliver.
9. ONLY FULLY CONTRACTED STAFF IS AWARDED FREE SERVICE, AND THIS IS DONE BY
INVOICE AND LEGAL NOTE WHICH BECOMES DUE AND PAYABLE IF THE CONTRACT IF
BROKEN. * * *
FN20. Historically the price of a 25-hour intensive was fixed at an amount
equal to 3 months of pay for the average middle class worker in the
district of the Scientology church providing the service.
FN21. Petitioner's policy against reducing established prices is set forth
in HCO PL April 27, 1965, 3 OEC 91, 92, which states:
Therefore we can draw up some policies on prices.
1. The advertised and reported price of anything sold by an org must be the
actual price received by the org for that item.
2. There may be no hidden discounts, trick reductions, whims or favours
given in pricing.
3. Merchandising by advertising that prices are going up soon is forbidden.
4. Anyone covertly reducing prices is guilty of suppressing an org which is
a high crime.
5. Any price passed upon at Saint Hill by myself may not be changed for
anything by anyone else in an org. And finally:
6. Efforts to reduce prices below a set scale will be considered
This policy was reaffirmed in HCO PL September 27, 1970 (Issue I), 3 OEC
FN22. 'Dianetics' and 'Scientology' are the registered trademarks of L.
FN23. Book prices fluctuated during the course of the docketed years so
that these amounts may have varied.
FN24. This objective was expressed by L. Ron Hubbard in HCO PL May 1,
1971, 6 OEC 294, as follows: 'MOTIF: THE ROLE OF A MISSION: RAW PUBLIC, GET
THEM IN AND UP THE LINE TO ORGS.'
FN25. For purposes of this case a conversion ratio of 2.4 dollars per
pound has been used.
FN26. The LRH Comm. Statistic Revised income was money that went to L. Ron
Hubbard personally as debt repayment.
FN27. For purposes of this case, we used a conversion ration of .2652
dollars per Swiss franc which is the rate quoted for December 29, 1972 in
Vol. 46, No. 1, Bank and Quotation Record (January 1973, New York).
FN28. These balances are taken from petitioner's exhibit. We note that the
year-end balance for 1971 is mathematically incorrect and should be
2,042,832.04. OTC's cash reserves may have even been larger than the
amounts shown in these accounts. Petitioner contends that OTC had
$1,986,409.50 in cash on board the Apollo on December 31, 1972. There is
some confusion in the record whether this amount is in addition to the
listed bank accounts. Consequently, we were unable to ascertain the actual
amount of cash reserves held by OTC.
FN29. According to petitioner's own records, L. Ron Hubbard received or
was expected to receive a salary from Worldwide of 10,000 pounds per year,
while Mary Sue Hubbard was to receive from Worldwide an annual salary of
6,340 pounds. However, petitioner now asserts that L. Ron Hubbard and Mary
Sue Hubbard were not actually paid these full amounts during the tax years
in question. Without endorsing the accuracy of these amounts, we shall use
them for purposes of our discussion.
FN30. This scheme draws on L. Ron Hubbard's advice for handling tax
matters set forth in a policy letter dated June 25, 1967. L. Ron Hubbard
Now as to TAX, why this is mainly anybody's game of what is a PROFIT. The
thing to do is to assign a significance to the figures before the
government can. The whole thing is a mess only because arithmetic figures
are symbols open to ANY significance. So I normally think of a better
significance than the government can. I always put enough errors on a
return to satisfy their bloodsucking appetite and STILL come out zero. The
game of accounting is just a game of assigning significances to figures.
The man with the most imagination wins. BUT there must be correct figures
and there must not be gross misassignment of debts as profits or the whole
thing won't hang together.
Income tax is a suppressive effort to crush individuals and businesses and
deprive the state of national gross product (since none can expand). The
thing which baffles any suppressive is truth. It's the only thing that
works. Significances one assigns figures are neither true nor false but
always must be reasonable and DEFENDABLE. And the figures themselves must
always check out.
INCOME does not mean profit. One can and should make all the INCOME one
possible can. Always. The only crime really is to be broke. But when one
makes INCOME be sure it is accounted for as to its source AND that one
covers it with expenses and debts. Handling taxation is as simple as that.
FN31. This cover story underwent modification so that by the time of the
1971-1974 audit petitioner was claiming that OTC, as petitioner's banking
agent, was making expenditures ON BEHALF OF PETITIONER.
FN32. The mock statement was addressed to OTC and had a blank space for
indicating the name of the Advanced Organization which prepared the
billing. The mock statement provided four examples of expenditures paid by
the Advanced Organization on behalf of OTC: (1) a payment for marine fuel
for the Apollo; (2) a payment to an OTC employee for expenses while on
field assignment; (3) an airfare payment, and (4) a payment to the captain
of the Neptune to cover ship's expenses.
FN33. Those present were: Kima Jason, Assistant to the Deputy Commodore;
Jane Kember, Guardian Worldwide; and Scott Mayer, a low-level Scientology
official and later a Government witness.
FN34. Initially the audit covered just the 1968 tax return. In March 1972
petitioner's 1969 tax return was added. Office policy required audits to
cover all back tax years until the taxpayer was brought up to date.
FN35. Petitioner maintained that the purpose of the IRS audit of its 1968
and 1969 tax returns was harassment and justified its refusal to cooperate
on this ground. Our findings on this issue are contained supra at 34-48.
FN36. In 1973 James Mulligan's title was changed to Commodore Staff
Guardian Communicator, U.S.
FN37. The Intelligence Division of the Guardian Office was also referred
to as 'B-4' or 'Bureau 4.'
FN38. The Guardian Office trained personnel to filch documents critical of
Scientology from other organizations.
FN39. Three other Scientology officials were convicted at the same time.
One of these officials was not convicted of a crime related to the
conspiracy of obstructing the IRS. We were unable to tell which churches
employed the remaining two Scientologists.
FN40. In footnote 108 of the Church audit report, petitioner represented
that OTC put its own monies into OTC accounts used by petitioner. IRS Agent
Eugene Endo initialed footnote 108. His initials signified his agreement
with the facts in the footnote but not their interpretation. The factual
portion of footnote 108 states that Church-prepared summaries of OTC
accounts 'show that in 1971 OTC deposited $2,295,164 into these accounts
out of total deposits of $3,957,813 or 58%. In 1972 OTC deposited 38%,
in 1973, 64%, and in 1974, 64%.' The Church audit report contained many
false representations and material omissions. Respondent did not ratify or
adopt Agent Endo's admission.
FN41. Joyce Popham was a signatory on major OTC accounts. She served on
the OTC board of directors but was also a Flag employee and apparently
never wrote a check on the OTC accounts.
FN42. The documents which comprise Exhibit FU are sometimes referred to
as 'the typewriter-case documents' since they were brought to the IRS in a
FN43. All of the documents in Exhibit HG belong in this category. The
following pages of Exhibit DU also contain documents in this category: pp.
1-121, 129-132, 132A-132B, 133-148, 150-201, 225-241.
FN44. The following pages of Exhibit DU contain documents in this
category: pp. 210-216, 221-223, 247-249.
FN45. The following pages of Exhibit DU contain documents in this
category: 122-128, 149, 202-209, 217-220, 224, 242-246.
FN46. The Court takes judicial notice of the fact that all indexed
references to 'no change' cases or reports in the Internal Revenue Manual
refer to the closing of cases on the basis of no tax liability.
FN47. Petitioner placed in evidence the 'Foley memorandum' referring to
the tentative revocation of petitioner's exempt status. The memorandum was
not written by an IRS employee and petitioner itself questioned the
trustworthiness of the information in this memorandum.
FN48. All references to 'Rules' shall refer to the Tax Court Rules of
Practice and Procedure.
FN49. Petitioner first raised this argument in a pretrial Motion to Render
the Notice of Deficiency Nugatory and for Other Relief. The motion was
denied after a hearing. However, the Court allowed petitioner to present
evidence on this issue during trial and to reargue it on brief.
FN50. Petitioner's allegation that it had no opportunity to contest the
revocation is not borne out.
FN51. Petitioner avoids defining 'religious income' but concedes it is not
income gained from nonreligious activities, income gained from religion and
put to nonreligious uses, income taxed to defray Government services, or
income earned by ministers and church employees.
FN52. The tension between these lines of cases was present in Federal
Communications Commission v. League of Women Voters of California, 468
U.S. ___, 52 U.S.L.W. 5008 (July 2, 1984). There the Supreme Court
examined section 399 of the Public Broadcasting Act of 1967 and found that
the provision did more than merely prohibit government funding of editorial
broadcasts by noncommercial television stations; it even barred them from
using private funds to finance editorial activity. 52 U.S.L.W. at 5017-
5018. Applying a slightly more exacting standard of review than it
ordinarily does in broadcasting cases, 52 U.S.L.W. at 5011-5012, the
Supreme Court held that the statute was an unconstitutional interference
with First Amendment activities.
FN53. We note that petitioner has made no attempt to provide a careful
definition of the claim to exemption it asks us to carve out and protect.
As a general rule, the more complicated the basis of classification for
exemption the greater the danger of involving the Government in entangling
inquiries. Gillette v. United States, 401 U.S. 437, 456-457 (1971); Walz
v. Tax Commission, 397 U.S. 664, 698-699 (1970) (Harlan, J. concurring).
FN54. Respondent did not challenge the sincerity or the religiosity of
this belief, and we, therefore, accept it as a sincerely held tenet of
Scientology. United States v. Lee, 455 U.S. 252, 257 (1982).
FN55. In NLRB v. Catholic Bishop of Chicago, 440 U.S. 490 (1979), the
Supreme Court construed the National Labor Relations Act, holding that it
did not give the National Labor Relations Board (NLRB) jurisdiction over
schools operated by a church. Noting the risk of entanglement and other
interferences with religious freedom were the Act to confer jurisdiction
over church schools, 440 U.S. at 501-504, the Court, in order to avoid
serious questions about the Act's constitutionality, declined to construe
the Act to confer such jurisdiction in the absence of an affirmative
showing that Congress intended to bring church schools under the NLRB's
jurisdiction. 440 U.S. at 501.
FN56. We treat this one public policy issue here. As we noted earlier, the
other public policy issues in this case are considered in section six of
FN57. Petitioner tacked on one other constitutional issue in its post-
trial brief without discussion. Petitioner claims that section 501(c)
enumerating exempt organizations is arbitrary and capricious because it
prohibits some exempt organizations but not others from allowing their net
earnings to inure to the benefit of private individuals. Congress has broad
discretion in enacting tax legislation, Madden v. Kentucky, 309 U.S. 83,
87-88 (1940), and the courts will not set aside a legislative
classification in the tax field if it can be justified under any set of
facts. United States v. Maryland Savings-Share Insurance Corp., 400 U.S.
4,6 (1970). The entities which are exempted from the inurement provision
are either mutual self-help organizations or funds dedicated to the welfare
of a specific group. These groups by definition have earnings which inure
to the benefit of private individuals as the inurement provision has been
construed to prohibit organizations from operating for the benefit of
members. See secs. 1.501(a)-1(c); 1.501(c)(3)-1(c)(2); Club v. United
States, 222 F. supp. 151, 153 (E.D. Wash. 1963). See also B. Hopkins,
The Law of Tax Exempt Organizations, 209-227 (4th ed. 1983). It would be
self-defeating for Congress to help these groups by granting a tax break in
one breath and in the very next breath take it away.
FN58. The exemption for religious charitable and educational organizations
originated in section 32 of the Act of August 27, 1894, 28 Stat. 509,
556, which was the first Federal statute to impose an income tax on
corporations. The congressional debates preceding the enactment do not
reveal the reasons for the exemptions. However, similar exemptions for
mutual savings banks and life insurance companies were created because they
were not operated as businesses for gain. 26 Cong. Rec. 6622-23 (1894).
Furthermore, the income tax provisions of the Act of August 27, 1894, were
modeled, in measure, on the English system. 26 Cong. Rec. 6612-13
FN59. We note the possibility of constitutional infirmity in placing the
burden of proof on the Church to disprove it violated 18 U.S.C. sec.
371. Norwood v. Harrison, 413 U.S. 455 (1973) ('(N)o one can be
required, consistent with due process, to prove the absence of violation of
law.' 413 U.S. at 471.) However, we need not decide this issue.
Respondent raised this issue after filing his answer. The parties therefore
agreed that the burden of proof was upon respondent to show that petitioner
had an illegal purpose which disqualified it for exemption under section
501(c)(3). See Rule 142(a).
FN60. While the Church now claims that its stationary put respondent on
notice of the status of the United Kingdom Church, the Church obviously did
not think so in 1967. Writing on Church stationery to the IRS in 1967, the
Church, in response to a request, listed its subordinate branches failing
to mention the United Kingdom Church. The stationery in fine print referred
to petitioner as 'a non-profit corporation in U.S.A. registered in
England.' In a true display of 'chutzpah' the Church placed the letter in
evidence as an example of the type of document which should have given IRS
officials notice that petitioner incorporated the United Kingdom Church.
FN61. The Church audit report estimates that 38 percent of the Church's
time was spent on those activities but no substantiation of this estimate
was ever produced.
FN62. Two of petitioner's branches, FOLO and USGO, did not provide
religious services to the public. Flag mainly provided religious services
to Scientology staff. The United Kingdom Church received a substantial
portion of its income from franchise tithes. When these payments are added
in the percentages increase to 88 percent for 1971 and 97 percent for 1972.
FN63. An excellent illustration of the businesslike philosophy petitioner
employed in marketing its services is found in HCO PL, November 21, 1969, 6
OEC 133. This letter provides in relevant part:
The purpose of this policy letter is to provide a SET FORMAT that can be
used over and over again by Orgs to find out in their country, area, city,
community WHAT IS NEEDED AND WANTED. Once this is known to an organization
it can angle its promotion on it and produce it. For example, an area wants
more INTELLIGENT PEOPLE AND ACTIONS and LESS STUPIDITY. The Org of the area
finds out and goes into a promotional programme of 'We can RAISE your IQss
' or 'Tired of being STUPID? We can restore your NATURAL INTELLIGENCEs' Of
course through training and processing an organization can produce this
If an organization or group does this OVER and OVER CONTINUALLY to keep up
with the trends and cover new areas its income will ROCKET. A 'Needed and
Wanted Survey' as laid out below should be done by an org or group AT LEAST
twice a year and again if the trend seems to be changing or a new area is
disseminated to. As we expand we REPEAT the action.
FN64. This purpose of making money lies barely beneath the surface in the
promotional activities described in HCO PL May 23, 1969 (Issue III), 6 OEC
91-93, quoted in our findings of fact, supra at 64.
FN65. Petitioner failed to produce any evidence regarding the actual
amounts, if any, of such refunds during the tax years at issue.
FN66. Petitioner also relies on five other cases: Rosenthal v.
Commissioner, 32 T.C. 225 (1959); Draper v. Commissioner, 6 T.C. 209
(1946); Greenwood v. Commissioner, 22 B.T.A. 1187 (1931); Webb Press Co.
v. Commissioner, 9 B.T.A. 238 (1927); Webb Press Co. v. Commissioner,
3 B.T.A. 247 (1925); Cary Van Fleet v. Commissioner, 2 B.T.A. 825
(1925). The Rosentahl case involved the question of the applicability of
the installment method and is clearly inapplicable to the present facts.
The other four cases are irrelevant because they predate the seminal case
of North American Oil Consolidated v. Burnet, supra.
FN67. OTC allegedly received a 1-percent monthly finance handling charge,
which was computed based on its total disbursements for the month.
FN68. We find that petitioner's large reserves are a factor indicating
petitioner had a substantial commercial purpose even under the test
announced in Presbyterian & Reformed Publishing Co. v. Commissioner, __
F.2d__ (3d Cir. Aug. 29, 1984), revg. 79 T.C. 1070 (1982). In the
Presbyterian & Reformed Publishing Co. case the Third Circuit, relying by
analogy on the accumulated earnings tax, section 531 et seq., held that
accumulations of cash may be considered evidence of a commercial purpose
where they are unexplained by the legitimate needs of the organization, but
that cash accumulations which are explained and dedicated to meet
legitimate needs of the organization are not evidence of a non-exempt
purpose. Presbyterian & Reformed Publishing Co. v. Commissioner, (84-2
USTC P 9764), 743 F.2d 148 (3d Cir. Aug. 29, 1984), slip op. at 18-21.
See also, Incorporated Trustees of the Gospel Worker Society v. United
States (81-1 USTC P 9174), 510 F.Supp. 374, 379 and n. 13 (D.D.C.
1981), affd. without opinion 672 F.2d 894 (D.C. Cir. 1981), cert.
denied 456 U.S. 944 (1982).
Petitioner offered several justifications for its large reserves.
Petitioner claimed that they were needed to purchase a land base for
petitioner's operations; to protect the Church from its many foes, and to
pay the Church's tax liability in the event it lost its battle for tax-
exempt status. It is true that many years later the Church did secure land
headquarters in Clearwater, Florida. Also, no doubt, the Church needed
money to protect itself from its detractors. Finally, since the IRS revoked
the Church's tax-exempt status in 1967, there was a strong likelihood it
would have to pay taxes.
However, the bulk of the evidence in the record undermines the legitimacy
of these justifications, so that we have no difficulty in concluding that
the reserves were accumulated to make money for the Church and its leaders.
Thus, although the Church eventually secured land headquarters, this was
done several years after the reserves were built up. Furthermore, the
Church failed to introduce any evidence of the cost of the new headquarters
in Clearwater, Florida or that reserves were used to pay for the premises.
We also note that, although the purported purpose of the Trust was the
defense of Scientology, only one small disbursement was made for this
purpose during the docketed years. The Church presented no evidence that
the amount of its reserves bore any relationship to its anticipated needs.
These facts alone cast doubt on the Church's stated reasons for
accumulating reserves. However, what compels us further to conclude that
the Church's justifications are mere pretense is the manner in which the
reserves were maintained. They belonged to a bogus trust and a sham
corporation and were mostly held in cash and numbered Swiss bank accounts.
Under these facts the Church has not carried its burden in demonstrating
that the reserves were accumulated to further its tax-exempt purposes.
In light of our conclusion, we need not decide whether we concur in the
Third Circuit's reversal in Presbyterian & Reformed Publishing Co. v.
FN69. Indeed, petitioner concedes as much on brief.
FN70. Indeed, in light of L. Ron Hubbard's degree of control over
petitioner, there could be no independent negotiations between L. Ron
Hubbard and petitioner.
FN71. We are not at all convinced that these records represent the total
amount of such alleged debt repayments in light of John McLean's testimony.
McLean credibly testified that, during the fall of 1972, statistics were
posted aboard the Apollo each week showing the amount of weekly payments to
L. Ron Hubbard. According to McLean, the weekly payments to L. Ron Hubbard
which were posted pursuant to the policy letter of September 7, 1972,
ranged between $7,000 and $22,000 per week. We credit McLean's testimony on
FN72. Petitioner's counsel acknowledged his awareness of the negative
inferences that could be drawn from the Church's failure to produce a
witness. Nevertheless he represented that petitioner would not allow L. Ron
Hubbard to appear as a witness thereby tacitly confirming the California
Church's ability to produce him.
FN73. Respondent's agents spent about 20 hours trying to serve Greenberg
with a subpoena. They were not successful. However, several Church
witnesses spoke with Greenberg during the course of the trial and found him
in good health.
FN74. Petitioner raises two other objections to the public policy
requirement we have read into section 501(c)(3). First petitioner claims
that the Bob Jones Court reserved ruling on the applicability of charitable
law public policy standards to churches. We disagree. We believe the Bob
Jones opinion unqualifiedly held that all organizations seeking exemption
under 501(c)(3) must comply with fundamental standards of public policy.
Ruling was limited only on the second issue presented in the case--whether
the particular fundamental interest in eradicating racial discrimination
could be applied to churches. In any event, we believe that the application
of public policy requirements to churches does not in and of itself offend
the constitution. Churches are not above the law. Historically there have
been a number of compelling governmental interests justifying curtailment
of religious liberty. See, e.g., Reynolds v. United States, 98 U.S. 145
(1878) (monogamy); Late Corporation of the Church of Jesus Christ of
Latter-Day Saints v. United States, 136 U.S. 1 (1890) (monogamy);
Jacobson v. Massachusetts, 197 U.S. 11 (1905) (control of smallpox);
Prince v. Massachusetts, 321 U.S. 158 (1944) (protection of children
from exploitative labor); Gillette v. United States, 401 U.S. 437
(1971) (conscription); United States v. Lee, 455 U.S. 252
(1982) (soundness of the social security system). If the Government has the
power to prohibit religious practices outright which interfere with
fundamental public interests, and even to deny corporate existence for
engaging in such practices, Late Corporation of the Church of Jesus Christ
of Latter-Day Saints v. United State s, supra, then a fortiori it has
the power to deny tax benefits to churches which espouse and practice such
Petitioner also claims that this Court's interpretation of the public
policy requirement is an overboard regulation of its free exercise rights.
Prior to trial this Court ruled that petitioner must comply with
fundamental public policy such as may be evidenced in a civil or criminal
statute. Respondent did not rely on this definition. Except for some brief
cross-examination at the very beginning of the trial, respondent confined
his case to showing petitioner conspired to defraud the Government in
violation of 18 U.S.C. sec. 371. Since petitioner does not dispute that
a charitable trust is invalid if it has an illegal purpose, petitioner's
overbreadth claim is moot.
FN75. Organizations qualifying for tax-exempt status under section
501(c)(3) are doubly rewarded. Not only do they not have to pay taxes, but
they also stand in a better position to attract income since taxpayers who
contribute to section 501(c)(3) organizations are permitted by section
170(c)(2) to deduct the amount of their contributions on their Federal tax
FN76. Subsequent to the decision in Coit v. Green, 404 U.S. 997 (1971),
the Supreme Court has twice questioned its precedential value. See Allen v.
Wright, 468 U.S. ___, 52 U.S.L.W. 5110, 5117 (July 3, 1984); Bob Jones
University v. Simon, 416 U.S. 725, 740 n. 11 (1974). We find this of
little significance for notice purposes. What is important is that in 1971
the decision was 'on the books' and informed petitioner that a charitable
organization could not qualify for a tax exemption if it had an illegal
purposes or violated public policy.
FN77. Petitioner introduced several disbursement vouchers for impeachment
all signed by John McLean save one which was signed simply with the name
'Karen.' The Court only credits the disbursement vouchers signed by John
McLean. These show that following the incident which occurred on June 18,
1971 McLean was taken off the payroll until July 13, 1971. However, even if
the voucher signed 'Karen' were taken into account, John McLean at least
went without pay for the week ending June 24, 1971.
FN78. Petitioner also objects to the introduction of the OEC series on
constitutional grounds claiming entanglement. We have treated this
objection supra at 123-125.
FN79. On redirect examination petitioner's witness Fran Harris said this
index was not exhaustive. We do not believe this aspect of her testimony
since the statement contradicts her earlier testimony and was only elicited
after repeated questioning by counsel.
FN80. Although the Supreme Court in Emich Motors Corp. v. General Motors
Corp., 340 U.S. 558 (1951), was construing sec. 5 of the Clayton Act,
15 U.S.C. sec. 16(a), the language of the decision suggests that the
Court felt it was applying general principles regarding the estoppel effect
of a prior criminal conviction. See 4 Weinstein's Evidence par.
803(22) (01), p. 803-274 nn. 19, 20 (1981).
FN81. The seal on Exhibit FX was lifted by the District Court for the
District of Columbia by orders dated October 25, 1979 and October 30, 1980.
It was reimposed by order of the District Court dated November 5, 1980 on
remand from the United States Court of Appeals for the District of
Columbia. United States v. Hubbard, 650 F.2d 293, 295 n. 1 and 332-333
(D.C. Cir. 1980).
FN82. In his Trial Memorandum filed October 3, 1980, respondent stated
that petitioner's net earnings inured to the benefit of L. Ron Hubbard
through 'the diversion of large sums from petitioner to Hubbard utilizing
sham entities know as O.T.C. and O.T.S. which were completely controlled
and dominated by Hubbard.' Respondent also said he would put on witnesses
to show 'petitioner * * * (and) entities known as 'O.T.C.' and 'O.T.S.'
constitute, in substance, a single organization under Hubbard's absolute
and total control.' Respondent's Trial Memorandum filed October 3, 1980 at
pp. 6, 47.
FN83. In some cases, even the Commissioner's attempt to raise a new legal
theory comes so late in the day that it cannot be heard because of its
prejudicial impact on petitioner. United States v. First Security Bank,
334 F.2d 120, 122 (9th Cir. 1964); Riss v. Commissioner, 56 T.C. 388,
400-401 (1971), affd. sub. nom. Commissioner v. Transport Manufacturing and
Equipment Co., 478 F.2d 731 (8th Cir. 1973). See also cases collected
supra at 138-139.