The Internal Revenue Service's chief counsel has concluded that many credit-counseling agencies do not meet the requirements to be tax-exempt organizations, setting the stage for revocation of their special tax status.
In an internal advice memo issued last week, the chief counsel's office said "it can and should be argued that the new generation of credit-counseling organizations does not meet the criteria for exemption." Laying out its legal analysis of credit-counseling agencies, the memo said: "They are not providing any meaningful education or relief of the poor," as would be required for the tax exemptions many are currently receiving.
The memo, available on the IRS Web site, said that many of the nonprofit organizations may also be violating tax-exempt laws because they are being operated for the private benefit of their executives.
The memo comes as the IRS is auditing 50 credit-counseling agencies accounting for about half of the revenue of the $1 billion nonprofit industry. The audits were prompted by consumer complaints about deceptive and fraudulent marketing practices.
Congress has also held hearings into allegations that many of the newer credit-counseling firms have turned what was once a social-service-oriented industry into a profit-driven business that charges consumers high fees to the benefit of founders who siphon off the cash through for-profit affiliates that they also control.
In light of these allegations, the IRS in April 2003 began to step up scrutiny of applications by new credit-counseling firms for tax-exempt status.
The IRS chief counsel's memo "is a pretty startling and dramatic statement of how the IRS is going to view tax exemption in this industry from here on out and makes it very clear that the IRS is going to be taking a very, very hard line," said Washington attorney Jeffrey S. Tenenbaum, who represents some credit-counseling firms. "The end result will very likely be a large-scale revocation of tax-exempt status of credit-counseling organizations and/or dramatic reorganizations" of these agencies, he said.
Travis B. Plunkett, legislative director for Consumer Federation of America, said the IRS "is laying the groundwork for a large-scale attack on the business practices of many credit-counseling agencies. It isn't going to be tinkering at the margins."
The IRS memo said deceptive business practices, such as contracts that promise free services but then require clients to make a deductible charitable contribution "are incompatible with the purpose" of an organization claiming an educational tax-exempt status.
The chief counsel's office said it was also finding cases of excessive compensation. "The most egregious example was the sale of a for-profit business to an exempt organization for an apparently inflated price. In the same case there were also large loans to the principals of the organization." No firms were named in the memo.
The memo suggested imposing substantial financial penalties on agencies or individuals who benefited from the nonprofit status through excessive salaries or contracts with affiliated for-profit firms, as well as requiring those firms or individuals to return any gains deemed improper.