By Brandy Colbert
Traditionally a beacon of hope for debtors, the credit counseling industry is under federal scrutiny thanks to increasing reports of abuse and ongoing consumer complaints.
The Internal Revenue Service, which grants the coveted tax-exempt status to all nonprofit agencies, has examined more than 250 counseling agencies since 2003 to determine if they are complying with tax-exempt guidelines. This fiscal year, ending September 30, another 80 counseling firms are under review.
The key for the IRS is to answer whether the counseling firms are providing educational and financial literacy services that can help individuals work their way out of debt.
If an agency simply arranges payment plans for clients, for example, without also teaching them how to manage their finances, it would not qualify for tax exemptions.
"Education is the key," says Steve Grodnitzky, manager of the IRS exempt organizations office in Washington, D.C. "These organizations have come to us and said they're educating the public on consumer finance and money management and we want to ensure that's what they're actually doing."
Fueled by complaints that some agencies are not complying with the tax-exempt guidelines, the IRS examined 63 agencies in 2003, representing 50% of total counseling industry revenues, then returned to audit another 111 agencies in fiscal year 2007.
"Credit counseling has always been sort of a community service. But then some agencies brought in people who probably didn't always have the consumers' interest at heart," says Cate Williams, vice president of financial literacy for Money Management International, a Houston-based nonprofit debt management company.
At press time, the IRS had revoked or proposed to revoke the tax-exempt status of 50 agencies. For debtors who count on the free or low-cost help offered by credit counselors, losing access to these services can bring financial ruin.
"As with any time a consumer's pocketbook is touched – either on the investment or the counseling side – both the consumer and the person delivering the services needs to be really aboveboard and practice full disclosure," says Williams. "When consumers start feeling like they're not being treated right, more regulations are quick to follow."
The IRS in the early 1990s accepted nearly 200 applications from counseling agencies seeking approval under section 501(c)(3) of the Internal Revenue Code granting an exemption from federal income tax to nonprofit organizations. The number of approved applicants increased greatly in the late 1990s and early 2000s. At the same time, "we started to receive more complaints and reports of abuse in the industry from state attorneys general, the press and other federal agencies," Grodnitzky says.
The IRS developed what the agency calls a Core Analysis Tool (CAT) to help agents and tax law specialists determine whether counseling agencies are meeting the tax-exempt guidelines. The CAT includes factors considered acceptable and unacceptable for tax exemption approval related to counseling sessions, counselor education and advertising.
The IRS identified 357 credit counseling agencies claiming tax-exempt status during its compliance check in 2006. The IRS created a compliance questionnaire that year to send to counseling agencies not selected for the initial examinations.
Compliant agencies receive a letter from the IRS that indicates their counseling activities are satisfactory for tax-exempt status.
The other agencies receive either: a closing agreement offer, if the IRS has decided an agency can implement the proper action to remain compliant; a written advisory, notifying the agency of the possibility of an examination and identifies where they are at risk of noncompliance; a referral for examination by the IRS.
Once the IRS examines the records of a counseling agency deemed to be non-compliant, it issues the business a proposed revocation letter – an interim step that enables the agency to appeal within 30 days. The agency becomes a taxable entity if the appeal is not met.
To date, none of the audited agencies have successfully appealed revocation but they can reapply for 501(c)(3) status in the future. "We'd take a good look at it because obviously it was revoked for a reason," says Grodnitzky. "We make sure that going forward they're doing what they're supposed to be doing."
A 2003 case involving AmeriDebt Inc. did not help the reputation of credit counseling agencies. In the highly publicized case, the Federal Trade Commission charged the debt management company with scamming customers into paying more than $170 million in hidden fees and posing as a nonprofit company.
The IRS audited AmeriDebt to verify whether it was meeting 501(c)(3) requirements and in 2004 filed a $15 million claim against the company for falsely presenting itself as a nonprofit company. AmeriDebt closed in 2005 as part of a settlement with the FTC.
Mark Guimond, executive director of the American Association of Debt Management Organizations (AADMO), a Kingwood, Texas-based for-profit trade association for credit counseling agencies and debt management firms, believes the advancement of technology lessened the educational focus of these companies.
"Back when credit counseling agencies started [in the early 1950s], it was more of a walk-in type of environment, where you went to a community agency seeking help," he says. "Technology got rid of that educational function and they became more of a method for people to get out of debt. Getting people out of debt is not a charitable, educational purpose, according to the IRS."
The Bankruptcy Abuse Protection and Consumer Protection Act, which went into effect in October 2005, also prompted closer monitoring of credit counseling agencies. The law requires individuals filing for bankruptcy to provide a certificate of credit counseling and a repayment plan from approved agencies at least six months before the filing date.
Under the act, nonprofit credit counseling agencies must become certified through the U.S. Trustee Program before providing bankruptcy counseling. Some states, including Maryland and Idaho, require credit counseling agencies to be tax-exempt to offer their services.
Guimond does not believe this is effective. "My hope is that this will change. It's a silly requirement," he says. "The myth of agencies being good or bad because of 501(c)(3) status is bogus."
He is concerned because once a credit counseling agency's tax-exempt status is revoked in states such as Maryland or Idaho, the agency is unable to service the public. Because agencies in these states must be tax-exempt to operate, they must legally turn over their clients to another agency if the tax-exempt status is revoked.
"That public revocation is limiting the number of agencies that can serve consumers," says Guimond. "Any time someone steps in to limit the competition, you start getting monopolies. Then there's no innovation and no change."
Bill Binzel, chief counsel and senior vice president of legislative affairs for the National Foundation for Credit Counseling (NFCC), based in Silver Spring, Md., disagrees. "501(c)(3) status indicates you are operating according to a strict set of guidelines within the Internal Revenue Code," he says. "We view it as a very good step to ensuring that consumers are provided with the highest level of quality counseling."
NFCC members are required to have 501(c)(3) status and be accredited by the Council of Accreditation, an independent, nonprofit organization based in New York that accredits 38 different service areas and more than 60 types of programs.
Adds Guimond, referring to AADMO members, "We don't need subsidies by the government to provide a quality service. You want an agency that talks to people and truly counsels them." But even so, "The IRS is doing its job. It's not interpreting the law, it's enforcing it."
As far as the IRS is concerned, that law puts consumer education first.