Preserving the Tax Exemption

On November 3, 2005, the House Ways and Means Oversight Subcommittee held a hearing entitled “Review of the Credit Union Tax Exemption.” The purpose of the hearing was for that Committee to fulfill its obligation as to whether the public is “receiving something in exchange for the benefit of tax exemption.” It is clear to me that the general public has little to gain and a lot to lose by taxing credit unions. But after observing the events that took place at the hearing, it may be that credit unions need to do some work in order the preserve the tax exemption in the foreseeable future.

History and Evolution of the Credit Union Tax Exemption Structure and Mission

In the 1934 Federal Credit Union Act, it was stated that credit unions received their tax exemption because “credit unions are mutual or cooperative organizations operated entirely by and for their members” Credit unions were eligible for tax exempt status if they met the following criteria, and based on CU structure:

1)      Operating on a not for profit basis

2)      Organized without capital stock

3)      Operating for mutual purposes

Without exception, all of these criteria still apply to credit unions today.

When the Federal Credit Union Act was most recently updated in 1998 (although not in tax legislation), Congress found that “Credit unions, unlike many other participants in the financial services market, are exempt from federal and most state taxes because they are member owned, democratically operated, not for profit organizations, generally managed by volunteer boards of directors, and because they have the specified mission of meeting the credit and savings needs of consumers, especially persons of modest means.” This added the mission as a reason for the tax exempt status of credit unions.

During the hearing on November 3 House Ways and Means Committee Chair Bill Thomas posed the question as to which was the real reason that credit unions are tax exempt (structure or mission?) suggesting that structure is nice, but mission is the reason. Thomas was half right. Structure is a very important difference between credit unions and banks. Credit unions are not about profits and a much smaller percentage of credit union operating income is from fees than is the case with banks. The motivation of a volunteer credit union board of directors, which is made up of members of the credit union, is not the same as the motivation of a leadership that can gain personally from the profitability of a bank. So structure is critical to the credit union tax exemption.

It is also clear that credit unions need to better define how they serve people of modest means. My theory is that credit unions like The Summit Federal Credit Union have done a wonderful job for such consumers—although quite unintentionally—since our inception and that now, with an increased awareness of the problems of the underserved and increased capacity, we are advancing this cause quite intentionally!

It is my suggestion that for the credit union community to continue to enjoy our tax exempt status, that we assure that all of those within our current memberships and our allowed and approved fields of membership, have access to our service offerings, and that if necessary we modify our service offerings and activities to further reach out to those consumers who may need us most.

Expanded services to consumers and people of modest means

Since 1998, new rules have been implemented to allow CUs to do more outreach to people of modest means, and credit unions have taken advantage of these rules to expand their service offerings, and further satisfy our mission. Whereas some argue the larger credit unions are no longer true to our collective mission, this is a flawed argument. In fact, size has actually been an enabler for CUs to do more, as they will have increased capacity and can afford to absorb more of the financial burden of programs for those with lesser means. These programs in some cases lose money, or are less profitable, and so even a not for profit credit union, needs to serve all consumers, including those of modest means, in order to remain safe and sound financial institutions.

Two things have happened that have led credit unions to do more for underserved consumers. One is that credit unions have started to grow into communities. A second is that credit unions are more aware of the needs of consumers within those communities. Both of these trends are relatively recent, and the jury is still out as far as how successful credit unions will be in these efforts. But the early trends are very positive.

The fact is that as credit unions grow, they are financially able to help more people, and therefore they are likely to do more, not less, to help those who need it most. And as credit unions grow their charters into larger and underserved communities, they are made aware of a wide array of needs that members of those communities are confronted with.

Over time, credit unions will address these needs. Opponents of credit union expansion fail to see or admit that increased financial wherewithal due to expansion of credit union fields of membership, expanded service offerings and program growth may very well strengthen the argument for the tax exemption, as opposed to weakening it, simply because more consumers stand to benefit from credit union philosophy and business practices.

Broader memberships, additional services, and growth will allow credit unions to do good for more people, in more ways, and with increased capacity. Most importantly, increased size will help to fund programs that may not be financially beneficial to the credit unions, without damaging safety and soundness. Since credit unions can only build capital from operations, and since taxation would diminish a credit union’s ability to build capital, taxation would, in fact, diminish a credit union’s ability to fund programs for underserved Americans, as these programs tend to be less profitable.

Taxation then, would likely force programs for the underserved to be discontinued or scaled back, for reasons of safety and soundness. In the current environment, these programs are rapidly expanding. But as taxed institutions, credit unions would be forced into doing the absolute minimum for consumers, and put focus on how to avoid taxes, as opposed to how to serve members.

These arguments are not currently supported by data, and are strictly based on my observations and conversations within the industry. Having worked at The Summit Federal Credit Union for 21 years, I can say that I have never heard the amount of talk, nor seen the amount of intentional effort to serve the underserved as I have in the past 5 years. Credit unions are focused on this issue and will come through as never before.

The only data available at this time, to see how credit unions and banks compare, is HMDA data, and while the results have improved in recent years, it does not show a marked difference between the efforts of credit unions and banks in the amount of lending to lower income people, and minorities.

But what the HMDA data does show is that credit unions are far more likely to loan to these groups at market rates, as opposed to prices that are at least 3% higher than market rates. Our detractors have made a huge case for taxing credit unions based on this data, but fail to talk about the rate aspect of real estate lending. They also fail to talk about things like credit union size and the capacity to take risk on long-term, low-rate loans, and the need for credit unions to conform to secondary market standards on nearly any mortgage loan so that it is saleable in the event that the credit union reaches the brink of acceptable interest rate or credit risk levels.

Credit unions are conservative in this area because we are relatively small financial institutions, but our industry has been void of the systematic failures that plagued other industries and at one time cost taxpayers over $200 Billion! Many of the areas that credit unions do well at are not measured; things like used car loans, free checking accounts, small loans (under $2,500), check cashing, etc. Many underserved consumers benefit from programs like this, and yet, there are no data sources to compare this to other financial institutions.

All of this said, there is not a lot of support in Washington of any measures to tax credit unions, and no tax law has been introduced. There are also a few barriers to determining how credit unions are at serving the underserved:

1)      There is no definition of modest means. In 1934 people of modest means could have been defined as all working class Americans, and this is still predominantly the case, but to that definition, we might add lower income people, or people of diverse racial or certain ethnic backgrounds within the CU’s field of membership. We believe providing financial services to working class Americans, and/or to anyone who lives in an underserved area will help that area, and fulfills mission.

2)      There are many single sponsor CUs, ethnic or religious credit unions, or some small community chartered CUs that have limited opportunities to reach out to groups or areas that are defined as underserved; still, they are doing a great job for their members. If those credit unions choose to remain as they are, they should be allowed to do so.

3)      Credit unions have only limited data on some of their members. There are software packages that can estimate household income based on a member address, but this is not necessarily accurate. When income is disclosed, some credit unions may have special programs for lower income members, but it is difficult to accurately determine what each member’s income is, and to holistically measure that for a CU or for the industry.

4)      Many times, the services that are provided to underserved credit union members are not those which are included in any federal data collection medium for other financial institutions, so collecting this data might not serve any comparative purposes.

Service to Members – How have expanding fields of membership impacted CUs?

In 1983, the NCUA began to allow credit unions that previously served a single community or group to expand into multiple group fields of membership. Usually this meant that credit unions expanded to add more companies to their fields of membership. It has been argued that this expansion has led credit unions to serve a more affluent member. The truth is quite the contrary.

The Summit Federal Credit Union is a classic example of a credit union that historically (since 1941) served only one group (Rochester Telephone Corporation) and now serves over 500 groups (mostly employees of corporations and small businesses). Quite unintentionally, The Summit added about 30% of its members from underserved areas, even though about 24% the population in our operating areas resides in these areas.

There is really a simple explanation to this. The products and services the credit union provides, and the pricing of these products and services, are very attractive to underserved consumers. By doing business the credit union way, we have rescued people from higher fees and less attractive pricing to our business model, and our statistics show that these are the very people who need them most. Today, we reach out to underserved areas intentionally and we have the capacity to add even more attractive products for the underserved, such as financial counseling, first time home buyer programs, welfare to work used auto loans, financial education and more.

It would be erroneous to say that no affluent people join and belong to credit unions. Some do, because they join through their companies, or because they just appreciate the business model and want to support it. But when a credit union takes a group into its field of membership, it is interesting to see who naturally joins. In a hospital for example, the new members are far more likely to be from the service staff and clerical staff, than nurses, doctors and administrators. That is because the more affluent employees have no reason to leave their current financial institution that has designed pricing models to attract and retain these people as customers. There are other cases where an affluent individual got their first loan at a credit union when they were young, or struggling, and never left.

These are some of credit unions’ best success stories. So where credit unions do serve some affluent members, and whereas this is a good thing in that it contributes to the safety and soundness of our operations, we are far more attractive to people who are left behind by other institutions. Also, the original theory of a credit union was that people who had the means would deposit and achieve a greater return, so that their peers could borrow those funds at a lower rate. We were designed to accommodate savers AND borrowers.

Expanding memberships have also been a source of making each credit union’s membership more diverse, and have served as a significant protection against problems in a particular employer or industry. Credit unions like The Summit that provide service to the employees of manufacturers, utilities, service organizations, municipal groups, students, and underserved areas have significant insulation against isolated economic issues in a particular company or industry. This has been a protection for the American tax payer, as it has further solidified the insurance fund that protects America’s credit unions by protecting credit unions against failures.

Conclusions – Credit Unions earn their tax exemption, and Americans benefit greatly from not for profit credit unions.

All credit unions, large or small, exist for their members, and are still volunteer run cooperatives.

The very way a credit union operates is attractive to people of moderate means, and credit unions naturally attract these individuals into their membership. Credit unions may have to face the fact that although this is logical, there is no data to support this notion.

Credit unions have never cost the American Taxpayer a penny. The regulator and the insurance fund are supported by credit unions themselves, and the industry has been void of the widespread failures that have plagued other types of financial institutions.

Expanding the memberships of credit unions has allowed even more people to get their services from financial cooperatives. It has allowed credit unions to deliver even more services to their members. It has diversified memberships and served as a great insulator of credit union capital against isolated economic events and therefore enhanced safety and soundness.

Credit unions that have expanded their service offerings to include mortgages, credit cards, checking accounts, car loans and more have been great for the American Consumer who now has a low-cost alternative for most financial services.

Taxing credit unions only leaves the American Consumer with less attractive and more expensive options for financial services.

Credit unions have a cooperative mindset, and really are different – and behave differently than other financial institutions every day.

Credit union growth, in the current not for profit structure, will continue to benefit many millions of Americans.

Mike Vadala is president/CEO of $350 million The Summit Federal Credit Union, Rochester, N.Y.

Read about one of The Summit FCU’s outreach efforts in “Tax Time = New Members.”

The Summit FCU has also contributed several documents to CUES’ Financial Literacy Clearinghouse.

Read more in CUES Skybox’s Underserved archive.