TREASURY INSPECTOR GENERAL FOR TAX
ADMINISTRATION
Abuses in the Tax-Exempt Credit
Counseling Industry Are Being Addressed, but Further Actions Are Needed to
Ensure Overall Industry Compliance
May 2006
Reference Number: 2006-10-081
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
Phone Number /
202-927-7037
Email Address
/ Bonnie.Heald@tigta.treas.gov
Web Site / http://www.tigta.gov
May 22, 2006
MEMORANDUM FOR COMMISSIONER, TAX EXEMPT AND GOVERNMENT ENTITIES DIVISION
FROM: Michael R. Phillips /s/ Michael R. Phillips
Deputy Inspector General for Audit
SUBJECT: Final Audit Report – Abuses in the Tax-Exempt Credit Counseling Industry Are Being Addressed, but Further Actions Are Needed to Ensure Overall Industry Compliance (Audit # 200510020)
This report presents the results of our review of the Exempt Organizations (EO) function’s efforts to oversee the tax-exempt credit counseling industry. The overall objective of this review was to assess the EO function’s efforts to address abusive activities by tax-exempt credit counseling organizations.
Synopsis
The EO function of
the Tax Exempt and Government Entities Division has responsibility for ensuring
charitable or other tax-exempt organizations are in compliance with the Internal
Revenue Code (I.R.C.). The EO function
has two primary programs for ensuring compliance, the Determinations Program
(reviewing requests from organizations seeking tax-exempt status) and the
Examinations Program (reviewing information about existing organizations).
To qualify as a tax-exempt credit counseling organization under I.R.C. § 501(c)(3),[1] the organization must limit its services to low-income customers or, as its primary activity, provide education to the public on how to manage personal finances. However, according to the Commissioner of Internal Revenue, the focus of the credit counseling industry has shifted over the past several years from providing education or charitable service to inappropriately enrolling debtors in proprietary debt management plans[2] and credit-repair schemes for a fee. These activities may be disadvantageous to the debtors and are not consistent with the requirements for tax exemption. Congress and the Commissioner of Internal Revenue have expressed their concern that many credit counseling organizations are in violation of I.R.C. § 501(c)(3) requirements.
The IRS has begun to address abuses by tax-exempt credit counseling organizations, including revoking tax-exempt status for some organizations. However, the accuracy of the IRS’ inventory system should be improved to ensure future efforts can adequately cover this industry.
Starting in Fiscal Year 2003, EO function management took actions to begin to address abuses by tax-exempt credit counseling organizations. Specifically, the EO function created a multifaceted strategy to combat abuses in the industry and designated a team of EO function personnel to oversee the strategic management of its compliance efforts. Also, EO function management added a specialized review of the applications for tax-exempt status from credit counseling organizations. In addition, the EO function Examinations office initiated a broad examination effort of high-risk tax-exempt credit counseling organizations. Further, the Internal Revenue Service (IRS) has partnered with the Federal Trade Commission, the National Association of State Charity Officials, and other industry trade associations to address industry concerns and establish an ongoing dialogue with outside stakeholders. Finally, at the end of our fieldwork, the EO function provided us with a working draft of a strategic plan which establishes current and future plans to address abuses in the tax-exempt credit counseling industry.
However, based on our review of the draft strategic plan and discussions with EO function personnel, we believe the plan should contain more specific guidelines to improve the accuracy of the IRS’ inventory system related to credit counseling organizations. An accurate inventory system of the population of tax-exempt credit counseling organizations will enable the IRS to ensure its efforts can adequately cover this industry. Specifically, 162 (21 percent) of the 788 organizations contained on the EO function inventory of credit counseling organizations may not have the proper identification code for tax-exempt credit counseling organizations. In addition, an initial IRS analysis conducted in 2004 determined that 96 organizations included in a preliminary universe of credit counseling organizations may be inaccurate. However, 89 of these organizations were still included on the EO function’s current inventory of 788 credit counseling organizations at the end of our fieldwork. Further, a February 2005 administrative decision to change the coding used to close certain types of credit counseling applications resulted in inconsistent credit counseling data on the IRS’ inventory system.
As part of the Credit Counseling Compliance Project, EO function management has developed some guidelines on how to process requests for tax-exempt status from credit counseling organizations. However, these guidelines were generally informal in nature, and some were shared with applicable EO function personnel either verbally or via email. In addition, the EO function was not ensuring all advance ruling cases related to credit counseling organizations were always reviewed by the specialized Determinations office group to identify any potential abuses, as required by EO function procedures.
Recommendations
We recommended the Director, EO, take the necessary actions to ensure the EO function inventory system contains accurate information related to tax-exempt credit counseling organizations and finalize and implement the draft strategic plan for addressing current and future credit counseling activities. We also recommended the Director, EO, update and formalize application processing procedures and related training guides to ensure the consistent processing of applications for tax-exempt status by credit counseling organizations.
Response
EO function management agreed with our three recommendations. EO function management will review codes for the credit counseling population to ensure they are accurate and develop procedures to review incoming referrals to ensure they are accurately coded. In addition, EO function management issued a directive discontinuing the use of a specific activity code and will update its inventory records to ensure an accurate and complete population.
EO function management is also finalizing and implementing a strategy to address credit counseling abuses in the future to ensure compliance in the industry and that any new organizations are appropriately reviewed. EO function management will incorporate training guidelines on reviewing credit counseling applications and updated Internet training into a formal training package. Finally, EO function management issued a directive to reemphasize the use of procedures for processing specific types of credit counseling cases. Management’s complete response to the draft report is included as Appendix V.
Copies of this report are also being sent to the IRS managers affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Daniel R. Devlin, Assistant Inspector General for Audit (Headquarters Operations and Exempt Organizations Programs), at (202) 622-8500.
Appendices
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix V
– Management’s Response to the Draft Report
The practice known as “credit counseling” was initiated during the mid-1960s in an effort to stem the growing volume of personal bankruptcies. Initially, credit counseling organizations were community-based, nonprofit organizations that provided a full range of counseling, often in face-to-face meetings. Trained counselors would advise consumers on how to remedy their current financial problems, counsel them on budget planning, and educate them on how to avoid falling into debt in the future. To qualify as a tax-exempt credit counseling organization under Internal Revenue Code (I.R.C.) Section (§) 501(c)(3),[3] the organization must limit its services to low-income customers or, as its primary activity, provide education to the public on how to manage personal finances. However, according to the Commissioner of Internal Revenue, the focus of the credit counseling industry has shifted over the past several years from providing education or charitable service to inappropriately enrolling debtors in proprietary debt management plans[4] and credit-repair schemes for a fee. These activities may be disadvantageous to the debtors and are not consistent with the requirements for tax exemption.
Another factor in the growing concern about abuses in this industry is that I.R.C. § 501(c)(3) organizations are often excluded from coverage under Federal Trade Commission (FTC) rules, as well as State and local consumer protection laws. This combination of exemption from income tax and exemption from consumer protection laws may be one of the primary reasons for the increase in the number of credit counseling organizations seeking tax-exempt status since Fiscal Year (FY) 2000. Congress and the Commissioner of Internal Revenue have expressed their concern that many of these credit counseling organizations are in violation of I.R.C. § 501(c)(3) requirements.
The Exempt Organizations (EO) function of the Tax Exempt and Government Entities Division has responsibility for ensuring charitable or other tax-exempt organizations are in compliance with the I.R.C. The EO function has two primary programs for ensuring compliance, the Determinations Program (reviewing requests from organizations seeking tax-exempt status) and the Examinations Program (reviewing information about existing organizations). In general, an organization that wants to be recognized as tax exempt under I.R.C § 501(c)(3) must apply to the Internal Revenue Service (IRS) for a determination of its status by completing an Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code (Form 1023). If the organization’s application and supporting documents establish that it meets the particular requirements of I.R.C. § 501(c)(3), the EO function will issue a determination letter to the organization to affirm the organization is exempt under I.R.C. § 501(c)(3). In addition, the EO function Examinations office has responsibility for identifying and reviewing allegations of potential noncompliance with the I.R.C. by tax-exempt organizations.
An April 2003 report[5] from the Consumer Federation of America and the National Consumer Law Center estimates nearly 9 million people in financial trouble contact credit counseling organizations annually. According to IRS records, 1,081 potential credit counseling organizations initially applied to the IRS for tax-exempt status between October 1, 2003, and October 18, 2005. As of November 2005, IRS inventory records listed 788 approved tax-exempt credit counseling organizations. Revenue reported for Tax Year 2000 for this tax-exempt industry was approximately $1 billion.
This review was performed at the Tax Exempt and Government Entities Division Headquarters in Washington, D.C.; the Cincinnati, Ohio, Area Office; and the EO Examinations office field office in Mountainside, New Jersey, during the period May through October 2005. The audit was conducted in accordance with Government Auditing Standards. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
As a result of concerns raised by internal and external stakeholders that many credit counseling organizations were abusing their tax-exempt status, the EO function designated this issue as one of its highest priorities in FY 2004 and initiated a Credit Counseling Compliance Project. Based on our discussions with EO function management and review of applicable documentation, we determined that, starting in FY 2003, EO function management took actions to begin to address abuses by tax-exempt credit counseling organizations. Specifically, the EO function created a multifaceted strategy to combat abuses in the industry and designated a team of EO function personnel to oversee the strategic management of its compliance efforts. In FY 2004, EO function management added a specialized review of the applications for tax-exempt status from credit counseling organizations. In addition, the EO function Examinations office initiated a broad examination effort of high-risk tax-exempt credit counseling organizations. Further, the IRS has partnered with the FTC, the National Association of State Charity Officials, and other industry trade associations to address industry concerns and establish an ongoing dialogue with outside stakeholders. Finally, at the end of our fieldwork, the EO function provided us with a working draft of a strategic document which establishes its plans to address abuses in the tax-exempt credit counseling industry, covering both ongoing work and additional areas needing coverage in the future.
The EO function has improved its process for reviewing applications
for tax-exempt status by credit counseling organizations
In October 2003, the EO function initiated changes to its application process to ensure increased scrutiny of organizations requesting tax-exempt status for credit counseling activities. Specifically, EO function management required that EO function personnel at the Cincinnati Determinations office identify all applications for tax-exempt status received from credit counseling organizations, assign a unique tracking code on its inventory system for these applications, and forward the applications to a new, specialized group for detailed review. This specialized group, trained in credit counseling issues, was responsible for reviewing all applications from credit counseling organizations to determine whether tax-exempt status should be approved. This group conducts a determination review that includes Internet research to determine if the proposed activities of the organization are in line with the application. If additional information is required, the specialized group sends the organization an inquiry letter to more fully develop the facts and circumstances of the case. This inquiry letter was specifically updated for credit counseling activities and has been further refined since the initiation of the Credit Counseling Compliance Project to provide additional data to help in the determination process. If no evidence of potential abuse exists, this group will approve the organization’s request for tax-exempt status and issue a positive determination letter to the organization.
If evidence of potential abuse exists, additional analysis will be performed to determine if tax-exempt status should be denied. Prior to October 2003, EO function Determinations office specialists could deny any requests for tax-exempt status based on the facts contained in the application and issue a denial letter to the organization without further review. However, starting in October 2003, as part of the Credit Counseling Compliance Project, EO function management revised the denial process for credit counseling organizations to ensure consistency in determining the denial. Specifically, if the specialized group identified potential abusive activity, the credit counseling application request was sent to the EO Technical office in Washington, D.C., for further scrutiny. The EO Technical office consists of senior EO function management with significant experience in exempt organizations law who were trained in credit counseling issues. The EO Technical office is responsible for providing technical advice and assistance on exempt organizations issues by responding to specific requests from EO function personnel and other Government organizations. If the EO Technical office determines the organization does not meet the requirements under I.R.C. § 501(c)(3), a letter is sent to the organization proposing denial of the application. As of September 30, 2005, the EO Technical office had reviewed 119 potentially abusive applications. Of these:
· Eighteen were denied.
· Ten were proposed for denial (pending administrative action).
· Seven were withdrawn by the organization.
· Forty-four were closed due to insufficient information.[6]
· Two were approved and given tax-exempt status.
· Seven were reclassified as nonabusive and returned to the specialized group for review.
· Thirty-one were still being reviewed.
At the end of our fieldwork, EO function management was
proposing these applications would no longer be required to be sent to the EO Technical
office. Instead, EO function management
was proposing all requests for tax-exempt status by credit counseling
organizations be worked to resolution, including denial if appropriate, by the
specialized group in Cincinnati, Ohio, because they believed EO
Determinations office personnel now had the skills and resources necessary to
work these cases to resolution. After
our fieldwork ended, EO Technical office management advised us that, beginning
in mid-January 2006 for a 6-month period, they plan to coordinate with the EO
function Quality Assurance group to perform a mandatory review of the cases
closed by the specialized group. At the
end of this period, the process will be evaluated to determine if the EO
Technical office will need to continue to perform mandatory review of these
cases.
The EO function has initiated a broad examination effort of
potentially abusive credit counseling organizations
The EO function has initiated a broad examination effort of the credit counseling industry. Due to complex issues involving credit counseling organizations and the need to examine related for-profit entities,[7] if they are used, the Credit Counseling Compliance Project is being worked by combining EO function personnel with compliance personnel from the IRS Small Business/Self-Employed and Large and Mid-Size Business Divisions, as well as staff from the Office of Chief Counsel.
Based on our interviews and review of applicable documentation, the EO function has identified 62[8] tax-exempt credit counseling organizations for examination to determine if these organizations are operating within the scope of their tax-exempt status. According to the EO function, the 62 credit counseling organizations represent approximately 61 percent of the total estimated revenues[9] of the tax-exempt credit counseling organizations that have filed required annual information returns. As shown in Figure 1, a significant level of noncompliance had been identified as of September 30, 2005. For example, none of the examinations completed by the end of our fieldwork had determined the organizations were operating in accordance with their exempt purpose. In addition, 35 examinations had resulted in the tax-exempt status being revoked, the revocation was pending, or the organization had been referred for consideration by the Criminal Investigation function. This unusually high noncompliance rate may have resulted because the majority of these examinations were initiated after referrals from external sources, such as Attorneys General of various States, the FTC, media leads, and other third parties. EO function management’s goal is to complete 60 of the examinations by December 31, 2006. Examination completion dates for two newly assigned cases were unknown as of January 2006.
Figure
1: Status of IRS Examinations of 62 Credit
Counseling Organizations As of September 30, 2005
|
Status of the 62 Credit Counseling Organizations Selected for
Examination |
Number of Cases |
Estimated Annual Revenues[10]
for the Organizations Being Examined, by Status of Examination |
Percentage of the Estimated Annual Revenues[11]
Compared to the Entire Tax-Exempt Credit Counseling Industry ($990,281,021
Annually) |
|
|
Case Assigned but Not Started |
9 |
$59,265,379 |
6% |
|
|
Examination Ongoing |
18 |
$151,608,832 |
15% |
|
|
Closed – Tax-Exempt Status Revoked |
6 |
$4,097,044 |
.4% |
|
|
Examination Completed – Revocation of Tax-Exempt Status Proposed |
21 |
$354,446,191 |
36% |
|
|
Referred to the Criminal Investigation Function for Potential Fraud |
8 |
$36,717,417 |
4% |
|
|
Total Inventory: |
62 |
$606,134,863 |
61% |
Source: EO function
Examinations office status reports.
The IRS has coordinated with outside stakeholders to increase
awareness of potentially abusive tax-exempt credit counseling activities
During the past several years, the IRS has provided outreach efforts related to questionable activities performed by credit counseling organizations. The IRS has also acted to establish an ongoing dialogue with other organizations to coordinate enforcement actions and share limited information. These outreach efforts have helped to educate the public about the IRS’ efforts to increase compliance in the credit counseling industry, as well as inform tax-exempt credit counseling organizations of the standards that must be met to maintain tax-exempt status. Specifically, the IRS has:
· Partnered with the FTC and Attorneys General from various States to issue a consumer alert in October 2003 through a news release and fact sheet to warn consumers some credit counseling organizations are engaging in questionable activities. The news release warns the public of high fees or required “voluntary contributions” that, with high monthly service charges, may add to their debt and defeat their efforts to pay bills.
· Conducted presentations at various credit counseling trade association conferences to inform participants about the IRS’ credit counseling initiative and to open a dialog with participants.
· Conducted presentations in 2003 and 2005 to the American Bar Association and discussed potential problems relating to the credit counseling industry.
· Prepared a Continuing Professional Education article on credit counseling organizations for EO function personnel and posted the article on the Tax Exempt and Government Entities Division public web site on January 13, 2003, to raise awareness of potential abuses by credit counseling organizations and discuss the qualifications for credit counseling organizations under I.R.C. § 501(c)(3).
· Developed an informational training video in conjunction with the Attorneys General from various States and the FTC that discussed potential abuses within the credit counseling industry. This video was broadcast within the IRS on March 5, 2003, and April 22, 2003, shared with the States, and sent to Congressional staff.
· Initiated meetings in FY 2004 with the United States Bankruptcy Trustees office to discuss the impact of the Bankruptcy Abuse and Consumer Protection Act of 2005[12] (signed into law on April 20, 2005) on tax-exempt credit counseling organizations.
· Held discussions with three trade associations in August 2005 to obtain concerns related to the credit counseling industry.
· Sponsored practitioner telephone forums on changes made to the application for tax exemption and IRS observations on the new applications received (e.g., what types of information are typically missing or omitted from the applications).
IRS management has revised tax forms and prepared plans to help address credit counseling abuses in the future
The IRS has revised two key forms which should help the effort to address abuses in tax-exempt organizations, including credit counseling organizations. In October 2004, the IRS issued a revised Form 1023, which is used for all types of organizations seeking tax exemption under I.R.C. § 501(c)(3). The revised Form added questions focusing on the relationship between the applicant and any management or servicing entities with which it does business. The additional information will be used to assist EO function personnel to more easily evaluate the credit counseling organization’s application by disclosing the relationships the applicant has with for-profit entities.
The IRS also revised the Return of Organization Exempt From Income Tax (Form 990) in 2004 to specifically require tax-exempt organizations to disclose whether they provide credit counseling, debt management, credit repair, or debt negotiation services. This information will help identify organizations that have added credit counseling activities after having established tax-exempt status as a different kind of charitable organization. This revised annual information return was effective for all Forms 990 filed for Tax Year 2004. A planned revision to the 2005 Form 990 includes a further request that tax-exempt organizations list the top five highest paid independent contractors for other than professional services.[13] This additional information may also help to identify possible abuses in the credit counseling industry, including relationships between board members or executives and independent contractors who are being paid for substantial work.
Further, EO function management has prepared a draft strategy detailing future plans to address the problems in the tax-exempt credit counseling industry. This strategy was developed to expedite the examination of cases open at the time the strategy document is finalized, streamline the approach for future Determinations and Examinations office reviews of credit counseling organizations, and ensure consistency on all credit counseling cases worked by the EO function. This strategy includes the development of additional analytical tools that will be used by Examinations and Determinations office personnel to evaluate key issues common to tax-exempt credit counseling organizations to determine if the organizations are operating within I.R.C. § 501(c)(3) guidelines and to take any necessary steps to ensure compliance. The draft strategy was initially scheduled to be prepared by March 1, 2005. However, this strategy was still in draft status and not yet approved as of October 2005. EO function management attributed the delay in obtaining final approval to the complexity of the issues involved.