Top Ten Tax Exemption Tips for Credit Counseling Organizations

6 min

Most credit counseling organizations (“CCOs”) operating today are nonprofit corporations exempt from federal corporate income tax under Internal Revenue Code Section 501(c)(3).  (Note that “nonprofit” status comes merely from incorporating as a nonprofit, nonstock corporation under state law; federal tax exemption under Section 501(c)(3) is recognized only after undergoing what can be a rigorous application and approval process through the Internal Revenue Service.)

For a variety of reasons, including exemption from the federal Credit Repair Organization Act and many state consumer protection laws as well as eligibility for creditors’ “fair share” contributions, it is critical for CCOs to maintain their 501(c)(3) tax exemption.  Yet, in the heavily scrutinized environment in which CCOs now operate – under almost daily fire from Congress, the Federal Trade Commission, state attorneys general, and the media, as well as the IRS – it is this tax-exempt status that may be most at risk.

While the most high-profile enforcement actions in the industry to date have focused principally on deceptive business practices, the 501(c)(3) status of CCOs may be the other shoe that has yet to drop.  All indications from the IRS are that change is coming.  The IRS Commissioner recently announced at a congressional hearing that more than 30 CCOs are currently under examination (including nine of the largest 15 agencies), which account for more than 40 percent of the $1 billion in annual revenue collected by the approximately 850 tax-exempt CCOs in existence.  The IRS also has announced that it has ceased using an expedited review process for applications for recognition of tax exemption filed by CCOs; the agency is submitting such applications to a “full review” (which includes posing additional questions and a “close analysis” of the CCO’s marketing materials), and has commenced a program of interactive video training sessions to equip specialists who are reviewing applications and conducting examinations.

While CCOs that counsel and educate consumers about the ordering of their personal finances as a substantial portion of their activities qualify for 501(c)(3) exemption, those that principally provide only services that control and reduce debt are ineligible for such tax-exempt status.  The IRS is concerned that some CCOs may have initially qualified for exemption, but then changed the nature or scope of the services they provide.

None of this is good news for CCO.  But while the uncertainty of exactly what those new standards will be poses planning problems for CCOs, a roadmap fortunately already exists for the prudent CCO.  Existing case law, IRS enforcement actions, an IRS guidebook for auditors, and public and private comments by IRS officials collectively provide a list of steps – a “top ten list,” if you will – for CCOs to follow to help preserve their 501(c)(3) exemption.  Importantly, certain of these steps also will help to minimize the risk of “intermediate sanctions” (penalty taxes) being imposed on related party transactions involving CCOs, such as compensation paid to key executives and fees paid to outside service providers.

As with any list of this nature, beware that adherence to the entire list does not guarantee preservation of exempt status, and the absence of other suggestions from this does necessarily signify their unimportance in certain contexts.  Also recognize that while some CCOs will be able to implement all of the recommendations below, for different reasons, some will not.  One hundred percent compliance may be ideal – from a tax exemption perspective – but less than 100% compliance does not necessarily sound the death knell for a CCO’s exempt status.

  1. Most important, by far, is to conduct a very significant amount of consumer education and counseling, particularly education and counseling that is exclusive of debt management activity.  Education is the basis for the federal tax exemption of most CCOs, so it should comes as no surprise that education and counseling must comprise the principal activity of a tax-exempt CCO.  While the million-dollar-question – How much education is enough (compared to debt management activity)? – has yet to be definitively answered by the IRS, existing guidance and private comments by IRS officials suggest that the prudent CCO will limit its debt management activity (however measured) to no more than one-third of its total activity, with the rest comprised of (generally non-revenue-generating) consumer education and counseling (a financial challenge for sure).  Moreover, the IRS has indicated that pre-packaged literature, CD-ROMs and other frequently utilized educational tools are not enough.  One-on-one consumer counseling, community seminars, and similar interactive educational efforts are critical, including for those who cannot afford to pay for the CCO’s services and particularly for those who do not qualify for or otherwise choose not to participate in debt management plans.
  2. Provide free or greatly-reduced cost services to low-income consumers.
  3. Ensure that the CCO’s Articles of Incorporation, Bylaws, IRS Form 1023 (application for recognition of 501(c)(3) status), and IRS Forms 990 (annual information return) properly reflect the CCO’s consumer education, counseling and debt management activities – and be sure to follow in practice the descriptions and scope of activities laid out in these documents.  In addition, if possible, obtain an annual independent audit of the CCO’s external financial statements.
  4. Have independent, “community” representation on the CCO’s board of directors – ideally, a majority of the board should not be officers or employees (or their relatives) of the CCO – and ensure that all board members have experience and expertise in the credit counseling industry.
  5. The CCO’s board of directors should adopt a conflict of interest policy and annual disclosure form – and follow it in practice.
  6. Ensure that all transactions between the CCO and outside service providers, vendors, landlords, etc. are at arm’s length (parties to the transaction are independent and on an equal footing) and fair market value (prices/fees paid at not more than market rates and transaction terms not less favorable than market terms).  Ideally, before engaging in the transaction, be sure to take advantage of the “rebuttable presumption of reasonableness” laid out in the IRS’ intermediate sanctions regulations:
    1. The transaction must have been approved entirely by independent board members who have no conflicts of interest with respect to the transaction;
    2. The board must have obtained and relied upon appropriate comparability data prior to making its decision (e.g., actual offers/proposals, such as in response to an RFP, a market survey conducted by an independent firm, and/or an independent appraisal of value / fairness opinion); and
    3. The board must have adequately documented the basis for its decision at the time it was made.
  7. If using outside service providers, the CCO should exercise active and hands-on oversight over the service providers, not permit the service providers to control the CCO, and rotate or at least re-bid service providers regularly.
  8. If using outside service providers, the CCO should compensate the service providers on a flat-fee basis – not as a percentage of revenue or expenses – and overall compensation must be at or less than fair market value.
  9. If using outside service providers, ensure enough independence and lack of control to avoid a finding that the CCO is an “alter ego” or “mere instrumentality” of the service provider (or vice-versa), ensure that the service provider has clients other than a single CCO, and avoid excessive compensation of officials of the service provider (which can be a “red flag” to the IRS).
  10. If possible, obtain accreditation that signifies that the CCO has met certain high standards in the credit counseling industry.  Such accreditation has been identified as a favorable factor by the IRS.