The Internal Revenue Service said yesterday it probably will revoke the tax-exempt status of about 20 credit-counseling firms, accounting for half the industry's revenues.
The disclosure came just five days before a new law takes effect that will require financially strapped consumers to go through credit counseling before filing for bankruptcy. It immediately raised concerns over whether there will be enough bankruptcy court-approved counseling firms to provide debtors with the requisite advisory services.
Credit counseling "is the centerpiece of the new bankruptcy law; it's your ticket to get into bankruptcy. Without it, you're not eligible to file," said Samuel J. Gerdano, executive director of the American Bankruptcy Institute, a nonprofit education and research group made up of attorneys, bankers and bankruptcy professionals.
Steven T. Miller, the IRS commissioner of the tax-exempt and government entities division, said in an interview yesterday that his agency is auditing 40 credit-counseling firms to see whether they should keep their tax-exempt status. "We think by the end of this calendar year, we would have taken adverse action" in about half of the audits, Miller said. The agency plans to audit an additional 20 nonprofit agencies after the current audits are completed.
So far, Miller said, no credit-counseling agency has received a clean bill of health from the IRS, which began its audits more than two years ago after hundreds of consumers complained about deceptive business practices, including high fees, high-pressure tactics and inadequate educational services.
Miller said the IRS's main complaint is that the organizations in question provide inadequate educational services and are simply enrolling their customers in debt-management plans. The Justice Department's U.S. Trustee Program, which oversees the nation's bankruptcy courts, is developing a list of firms it has approved to provide the education and counseling required by the new law in consultation with the IRS.
The Trustee Program has so far approved 41 applications out of nearly 200. Tax-exempt status is not required for approval, but so far all of the approved counselors have been tax exempt.
The IRS also has been concerned that many of the nonprofit counselors have been misusing their tax-exempt status, by pressuring consumers to enroll in debt-management plans with fees that are siphoned off to for-profit companies controlled by the firms' executives.
Miller said the IRS has found such cases, as well as instances of excessively high salaries.
Although the IRS has talked to the Trustee Program about its general concerns, Miller said the law bars the agency, which does not identify firms it is auditing, from talking about specific taxpayers to anyone else, including another government agency.
"Wouldn't it be embarrassing if someone on the list ends up having its tax exemption revoked?" Gerdano asked. "The federal government should be speaking with one voice with something as important as entry into the bankruptcy court."
The two agencies have different concerns, noted Wayne Abernathy, an executive director for policy issues at the American Bankers Association. One is concerned about misuse of the tax exemption, the other about the quality of advice being offered. If the IRS is removing the bad actors, its action is "potentially a real plus," Abernathy said. However, he said, it raises the key question of whether there will be enough counselors.
In the short term, however, the financial industry, credit-counseling firms and bankruptcy experts are not concerned about a shortage of counselors because many expect a sharp drop in bankruptcy filings in the months ahead. That's because filings have reached record highs in the past month as consumers rushed to file before Oct. 17 when the new law takes effect. Last week, bankruptcy filings averaged 20,000 a day, more than triple the average last year. For the first three days of this week the total of personal bankruptcy filings has passed the 100,000 mark, according to Lundquist Consulting Inc.
"Is there anybody left in America to file for bankruptcy after October 17?" Gerdano asked.
Credit-counseling firms that have received approval are rapidly hiring new counselors to meet any anticipated increase in demand. With the trustee's office permitting counseling over the phone and Internet, many say they will be able to meet demand. If they are wrong, they add, the Trustee Program can waive counseling requirements. The program already did it for Hurricane Katrina victims, saying disruption in communication services in the South could make it hard for debtors to contact credit counselors.