WEST PALM BEACH, Fla. – When the Internal Revenue Service comes knocking, people get nervous. Credit unions and credit union groups throughout the country are on edge about a flurry of IRS audits of state-chartered credit unions to determine whether they should be paying Unrelated Business Income Tax (UBIT). The Unrelated Business Income Tax only applies to tax-exempt entities, and in the case of credit unions, only state-charters. Federal charters are considered instrumentalities of the federal government and thus exempt. It is designed to tax non-profits for income they generate that is substantially unrelated to their primary purpose. The IRS has three criteria for UBIT: (1) It is a trade or business, (2) it is regularly carried on, and (3) it is not substantially related to the furtherance of the exempt purpose of the organization. Any organization that has $1,000 or more in gross income that meets all of these criteria is required to file IRS Form 990-T. The problem say credit union groups is no one is clear on exactly what constitutes UBIT, and the IRS has been slow to provide clarification. Further, the things that the IRS is raising as potentially falling under UBIT are quite scary because many are core, traditional activities of a credit union. These include credit life/disability insurance, credit/debit interchange income, ATM fees, check sales, non-deposit financial services, and others. Audit Activity is at an All-Time High One of the hardest hit states has been Connecticut, where almost all of the state's 50 state charters have been audited for UBIT. By law the IRS can not comment on audits, so it's a wait and see game for the results, but there are early warning signs. "We have gotten word that some credit unions are getting notices from the IRS saying the taxes are due. There's a lot of concern that the playing field is no longer level and that it discourages if not impairs the ability of a state-chartered credit union to operate equally with federals on what have become traditional lines of business, whether it's debit and credit cards and standard loan products like credit life and disability," said Howard Pitkin, Director of Financial Institutions for Connecticut. Next to Connecticut, Alabama is seeing the most UBIT activity, but Colorado, Texas and Wisconsin have all had audits. Some say UBIT is nothing new, but according to NASCUS, there have been more credit union UBIT audits in the past two years than the total in 10 years prior. Colorado Financial Services Commissioner David Paul, who said this is the first time he has seen CU audits in the state, believes this is an important dual chartering issue. "It is absolutely unfair. This tax potentially only applies to state chartered credit unions, when federal credit unions that are engaged in the same activities are treated differently. It's ridiculous," said Paul. NASCUS President/CEO Doug Duerr said this is an issue that needs the entire industry's attention. NASCUS recently sent out a UBIT Quick Guide to every state charter in the country to alert them of UBIT. "We don't want credit unions to be like deer caught in the headlights," said Duerr. "I don't know what has spurred the concentration in Connecticut, but I wouldn't be surprised to see these audits spread around the country." The potential, said Duerr, is state charters and federal charters offering the same exact products, but being treated differently by the IRS. Duerr uses what he calls his classic example of a church bake sale. He likens UBIT on state charters to taxing one church on its cake sale, but not the church across the street of another denomination. The dual chartering issue is obviously important, but Duerr and others say the UBIT standard, or lack thereof, is also critical."You can't open up the history of private opinion letters issued by the IRS to know what is taxable. You can't go looking to court law either," said Duerr. While there is dialogue going on with the IRS, the agency has issued no information on what is or isn't UBIT for credit unions. Credit union groups tried to get a legal opinion from the IRS on its Technical Advice Memorandum 9548001 issued back in 1995.That memorandum states, to the chagrin of credit unions, that credit life and disability insurance is taxable under UBIT. This is a product over 60% of credit unions offer, so the implications are dramatic. Back in 1997 CUNA Mutual and NASCUS, working with a law firm, submitted to the IRS their reasoning for why credit life and disability did not fall under UBIT. As of press time, the IRS had still not responded. CUNA Mutual President/CEO Mike Kitchen said CUNA Mutual has so far spent $1 million on UBIT, and costs are rising. "We plan to spend up to another half million on behalf of credit unions in the coming months and expect that it will take up to $2 million to manage this matter in the next couple of years," said Kitchen. Much of that money is for outside legal experts. If credit unions are counting on swift action by the IRS to resolve the UBIT issue, they may be in for a rude awakening, said Leslie Ellis, President/CEO of the $400 million Credit Union One in Anchorage, Alaska. For three years her CU was receiving large federal income tax bills from the IRS. "Somehow we fell into the IRS bucket. We never paid anything. They were wrong, but it took us three years and a lot of help from KPMG (the CU's accounting firm) just to get that worked out," said Ellis. "And that seemed like an easy one for the IRS to fix. We even sent them the Federal Credit Union Act. UBIT could be much worse." Ellis' CU is now dealing with UBIT. Credit Union One is filing UBIT on certain activities, namely non-member ATM fees, brokerage services, and income from a service bureau data processing arrangement it has with a smaller CU. Though she believes much of what the CU is filing is not UBIT, she said KPMG insisted that the CU file. "We don't really believe we owe anything. We took an aggressive approach with credit life and disability, refusing to submit for that. Basically we had to offer up something to satisfy KPMG. If I had to give in on something it was ATM surcharges, even though we think they are related," she said. Elllis said fortunately the UBIT lines of business are running at a loss so there's no bill yet, but that will likely change in coming years. "I think it's a disgrace. I'm livid about it. It's not fair for just state-charters to be dealing with this. We've been hearing for years that CUNA is working on this, but I don't even know if it's on their radar yet." Ellis also noted that UBIT is a major operational issue because all employee hours, equipment and other things relating to a UBIT business line have to be tracked separately for tax purposes. Federal Implications Are Lurking Although this is not a federal-charter issue, NCUA Chairman Dennis Dollar is wary of UBIT. "Let's face it, any time the specter of credit union taxation raises it's ugly head, it's important for everyone. When you tax credit unions you reduce their net worth. The only way credit unions build net worth is through retained earnings. They can't issue stock, can't issue bonds. Credit unions are a unique animal in the taxation world, and we want to make sure IRS knows this," said Dollar. Dollar said NCUA has been communicating with the IRS on this issue, but as independent agencies, neither agency is going to just accept what the other agency tells them. "We think we have a good relationship, but they're not going to go by our tax interpretation, as we might not accept an IRS ruling," he said. Many believe that even though NCUA is the regulator of FCUs, the IRS should look to them as the single source to determine what are a CU's core products and services. This would bring NCUA's Incidental Powers into the mix, which has a very specific list of what's permissible. Interestingly, the IRS-NCUA relationship has grown recently with the IRS partnering with NCUA on its Access Across America initiative and with the IRS trying to get its own Volunteer Income Tax Assistance program into more credit unions. The IRS is even showing up with booths in exhibit halls at CU events, Dollar noted. What concerns Dollar the most is the IRS not recognizing that credit unions have evolved over the years. "The IRS is looking at credit unions with a 1970s viewpoint. They're saying that when credit unions were small and had a single employer field of membership with one branch located in the basement of a plant, that is the same type of credit union that is in the marketplace in the year 2003," said Dollar. "We all know that credit unions have evolved largely to maintain the long-term safety and soundness as not-for-profit financial cooperatives. They must be able to diversify both who they serve and what products they can offer. If you limit a CU to a very narrow field of membership and limited services then the marketplace will leave credit unions in the dust," said Dollar. UBIT is not just for credit unions. Over the years there have been numerous battles between the IRS and non-profits, especially trade associations. CUNA, NAFCU, and NASCUS, all with an interest in UBIT in terms of CUs, deal with the tax in their own shops. "NAFCU pays UBIT. We pay it on advertising and other things. I think it's unfortunate the IRS is taking such a narrow view of what is substantially related to a credit union's tax-exempt purpose," said NAFCU President/CEO Fred Becker. Becker joked that as a "recovering" lawyer, he understands how complex things may get with UBIT, especially with terms like "substantially related" being up for interpretation. "Admission fees to a tax-exempt museum are not taxable, but if the museum has a restaurant that makes sales to the general public, that's subject to UBIT. The museum cafeteria used by patrons and staff is not. It becomes subjective," said Becker. Becker said this issue does point out the beauty of the dual chartering system. "I think the IRS is incorrect in how they're examining what is substantially related to the purpose of a credit union. At the same time, this is what makes the system so great. All the charters have different powers and rights. In some states there are very wide open community charters not found in the federal system," said Becker Why Now? With UBIT having been on the books since 1950, why all of a sudden is IRS getting interested in credit unions? Many believe it's about money. The federal deficit is growing and UBIT could help generate new revenue. "It's been off their radar screen for some time. Why they're moving forward now, we don't know, but you'd have to suspect the budget problems," said Hal Carroll, a partner with McGladrey and Pullen who has been helping clients deal with UBIT. Others believe the bankers may be to blame. "I think the bankers love this issue. One of the big mysteries is what their role in encouraging it has been. We can't document that they have or they haven't," said CUNA's General Counsel Eric Richard. Keith Leggett, Chief Economist for the American Bankers Association, said the bankers are not behind the UBIT focus, but he's glad the IRS is looking into it. "I was traveling on business in the Denver airport. There was a credit union ATM there which surcharged. If I had used it they would have derived revenue from me even though I'm not a member of the credit union. That's an extension beyond the purpose of the credit union. If you're a membership organization how is offering a service to the public at large part of your purpose?" said Leggett. Leggett also disagrees with the federal instrumentality argument for excluding FCUs. "Clearly there is a justification for the application of UBIT on federals, especially when you look at their expansion and incidental powers," said Leggett. He believes the IRS is doing this because of the growth of non-profits in general. "The percentage of non-profit firms in the economy is growing. They're not just looking at credit unions, they're looking at all non-profits." Credit unions that are hit with UBIT audits and receive a UBIT bill from the IRS have options, say experts. "They shouldn't just react to a letter from the tax authority. They should make sure they do a thorough investigation of the issue before they act. If they file a tax return that says a service is unrelated, today it might not result in any tax, but five years from now it might and that credit union has set precedent," said Carroll. Since it's such a complex issue CUNA Mutual, CUNA and NASCUS, all part of a coalition working on UBIT, are advising CUs to contact at least one of them prior to deciding to pay or not to pay UBIT. CUNA is also advising CUs to contact their leagues if the IRS comes calling. How Will the Industry React? As for the industry's response to UBIT, so far the major players have taken a relatively low public profile, but that could all change. There are three possible solutions to this problem agreed upon by the coalition. "One would be the litigation route. The other would be the administrative route, and a third would be a legislative solution," said Rob Rusch, Vice President & Deputy General Counsel in CUNA Mutual's Legal-Emerging Issues area. CUNA, which has the biggest voice politically, says these options all have pluses and minuses. "We want to make sure our strategy is carefully crafted. The ramifications of a misstep are horrendous. We are thinking through our strategy from the three points," said Mary Dunn, CUNA's SVP of Regulatory Advocacy. The administrative/regulatory option would be low-profile, but could be a long and expensive process as so far the IRS hasn't budged on requests for opinions on certain products. The legislative issue could ignite a large public taxation debate about credit unions in general and get the bankers yelling even louder, said Richard. However on the plus side credit unions have been successful in pushing their legislative agenda. While CUNA said it is gearing up for all three options behind the scenes, the most practical option right now may be the judicial route. Richard believes credit unions have a strong case, but they need a plaintiff. "As I understand it there are two ways to challenge in court a tax matter. One is to refuse to pay the tax, and let the IRS sue you or you sue the IRS in U.S. District Court," said Richard. "Some credit union has to pay this tax and sue for a refund in order for a case to be pursued. You want to pick the right one, you have to find the right plaintiff," said Richard. Given that stipulation, Richard said a timetable for judicial action is hard to predict. For now the UBIT coalition continues to work at the administrative level. Richard believes the UBIT standard for CUs could be quite simple – anything financially related. "Gramm-Leach-Bliley said banks can do any service that is financial in nature. That's a pretty good test for what might not be subject to UBIT. If it's financial in nature it's substantially related to the business of the credit union," said Richard. The word "substantially" is in the IRS' definition for UBIT, and Richard, a lawyer, said "substantially" doesn't mean 100% or perfectly, so Richard's proposed "financial in nature" test is reasonable, he believes. Another reason the UBIT fight may be so vital is CUNA is hearing that some states might be looking to enact a state-level UBIT. If IRS is successful on UBIT, states will have a stronger motive to do so. Like Dollar, Dunn is also concerned about IRS' credit union IQ. "When we sat down with the IRS we found they didn't quite understand the role of credit unions and didn't really understand the range of services that credit unions offer on a daily ongoing basis. That lack of misunderstanding is an underlying foundation of their policy," said Dunn. -

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