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Unrelated Business Activities of Exempt Credit Unions: An Analysis of 2007 TAMs By Carla Neeley Freitag, Esq. Merritt Island, FL Mutual credit unions described in §501(c)(14) are exempt from income taxation. The exempt purposes of a mutual credit union are to promote thrift and to provide a source of low-cost credit for its members through mutual and nonprofit operation.1 Like most other exempt organizations, exempt mutual credit unions are taxed on their unrelated business taxable income (UBTI). The tax applies to income from a regularly conducted trade or business that is not substantially related to the organization's exempt purposes. Conversely, income from a related trade or business is not subject to taxation. The present justification for exempting mutual credit unions from taxation is a subject of much debate.2 Mutual credit unions have evolved considerably since they were first granted tax exemption in 1937. Some have transformed into large, multi-service institutions that resemble banks in many respects. Members of the banking industry argue that mutual credit unions should not continue to be exempt because they now compete directly with banks. Credit union representatives counter that mutual credit unions provide credit to persons in underserved areas who otherwise may not be able to qualify for credit at all. Mutual credit unions have come under IRS scrutiny as they have expanded their activities beyond making loans to members. A series of technical advice memoranda issued in 2007 (the TAMs) examines whether income exempt credit unions derive from various non-savings and non-loan activities is subject to the unrelated business income tax.3 In the case of exempt credit unions, there must be a substantial causal relationship between the conduct of the activity in question and the promotion of thrift among members or the provision of low-cost credit to members. The TAMs All the exempt credit unions in the TAMs maintained savings accounts and share draft accounts for their members. They also made loans to low-income members and loans in small amounts, all types of loans which would not be available from a for-profit bank. The organizations claimed that they needed to become full-service financial institutions to remain financially stable and continue to provide the low-cost credit. Accordingly, the organizations carried on several other income-producing programs, including the sale of various types of insurance, a car buying service, and the sale of checks. The National Office advised that almost all the organizations' non-traditional credit union activities were unrelated trades or businesses subject to taxation. The credit unions involved in the TAMs made available to their members numerous types of insurance, including life, disability, health, cancer, dental, and guaranteed auto protection insurance. One type of insurance offered by the credit union in TAM 200709072, for example, was accidental death and disability (AD&D) insurance. In return for marketing and administering the insurance program, the underwriter paid the credit union up to 33% of gross premiums collected. The National Office reasoned that the provision of AD&D insurance does not encourage savings by the insureds. Moreover, the sale of the insurance does not benefit the members of a credit union as a whole. A member without a loan could purchase the insurance. A borrower was not obligated to use the proceeds from a policy to satisfy the debt. The sale of the insurance did not contribute to the mutuality of the credit union arrangement, an essential basis for exemption. Also in TAM 200709072, the credit union offered, but did not require, credit disability insurance in connection with certain loan programs. If the borrower becomes unable to work, the insurer will repay a member's loan from the credit union up to $50,000. Rather than focusing on the benefit to the membership of avoiding defaults on loans, the National Office focused on the benefit to individual members who purchased the insurance. The National Office acknowledged that the credit union derived some benefit from the credit disability insurance but considered the primary benefit to be the production of income. In TAM 200710017, the IRS ruled that the sale of a single category of insurance was related to a credit union's exempt purposes. The credit union required members with car loans to carry automobile insurance. As a condition of a car loan, the organization required the borrower to agree to purchase collateral protection insurance (CPI) if proof of other insurance could not be furnished. The credit union was the beneficiary under the policy. The sale of CPI was substantially related to the credit union's exempt purpose of providing access to credit for its members. The CPI in PLR 200710017 resembles the credit disability insurance in TAM 200709072 in that a borrower's debt would be repaid to avoid a default. The way to reconcile the different treatment of the two types of insurance may be the voluntary aspect of purchasing the credit disability insurance compared with the mandatory condition of purchasing the CPI. One of the few activities discussed in the TAMs that was treated as related for purposes of the unrelated business income tax (UBIT) was the sale of checks. The credit unions marketed the checks of a particular company in exchange for a 20% commission on sales. Members were allowed, however, to purchase checks from any vendor. The commissions represented less than one percent of the credit unions' gross income. The National Office stated that allowing depositors access to their funds was a “critical and central” exempt function of a credit union. Thus, the commissions on the sale of checks were not included in UBTI. Summary of Results in the TAMs Based on the 2007 TAMs, the IRS considers the following activities to be related to the exempt purposes of a mutual credit union: • Sale of checks to members; • Sale of CPI; • Interchange income derived in connection with credit card and check card programs. The following activities of mutual credit unions were ruled to be unrelated to their exempt purposes: • Sale of all types of insurance, except CPI; • Offering a car buying service; • Sale of car warranties; • Offering access to financial services performed by another company. Conclusion The results reached by the IRS in the TAMs represent a compromise between the credit unions, who argue that all their income should be exempt, and those who want the exemption for mutual credit unions repealed altogether. Income from activities that do not directly encourage savings or provide low-cost credit is treated as UBTI. In contrast, income is not subject to taxation if derived from activities that relate closely to the core savings and lending exempt purposes of a mutual credit union. Whether the application of the UBIT in the TAMs will satisfy the proponents of repealing the exemption for credit unions remains to be seen. For the Future There are three potential credit union issues to watch for in the future: First, a credit union that paid unrelated business income tax on income derived from the sale of credit life, credit disability, and automobile insurance has filed a suit for refund, claiming that the insurance activities are substantially related to its exempt purposes.4 The credit union is unlikely to prevail because: (1) its position requires a lenient interpretation of §501(c)(14), which does not seem warranted in view of the potential unfair competition with taxable insurance providers; and (2) the sale of insurance is almost always an unrelated business activity of any exempt organization. Second, it would seem that, if mutual credit unions expand their unrelated business activities too much, they may risk loss of exemption because they are not organized and operated for mutual purposes and without profit. In other words, the unrelated business activities may completely take over the mutuality features. Nevertheless, the IRS seems to recognize an organization as a credit union for purposes of §501(c)(14) if it is a credit union under state law.5 The efforts of the IRS concerning credit unions have emphasized the application of the unrelated business income tax rather than the question of eligibility for exemption. Third, all the favorable rulings are based on a close connection between promoting thrift and providing low-cost credit to those unable to obtain loans from traditional sources. There may be a question raised as to whether modern exempt credit unions actually do provide the type of credit on which the exemption is based. To show that the rationale for their exempt status has not become obsolete, credit unions may have to compile statistics showing that they do actually make a substantial number of loans to low-income members, in small amounts, or to those in underserved areas. For more information, in the Tax Management Portfolios, see Freitag, 874 T.M., Unrelated Business Income Tax, and in Tax Practice Series, see ¶6710, The Unrelated Business Income Tax. 1 Alabama Central Credit Union v. U.S., 646 F. Supp. 1199, 1201 (N.D. Ala. 1986). 2 See U.S. H.R. Committee on Ways and Means Hearing on Review of Credit Union Tax Exemption (Nov. 3, 2005). 3 The technical advice memoranda referred to in the text are: TAMs 200725047-057; TAMs 200717030-036; TAMs 200710017-019; and TAMs 200709072-073. TAM 9548001 is an earlier memorandum reaching the same conclusions. 4 Community First Credit Union v. U.S., (No. 1:08-cv-00057) (E.D. Wis.) (Doc 2008-4921). 5 La Caisse Populaire Ste. Marie v. U.S., 563 F.2d 505 (1st Cir. 1977) (credit union eligible for exemption even though it offered some services usually offered by other financial institutions because the organization was recognized as a credit union under the applicable state law).

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