Note: The Financial Brand takes no position on whether credit unions should- or should not have federal tax exemptions. This article simply examines the underlying reasons and arguments for the tax exemption.
Requirements aren’t the same as reasons
The most common argument asserts that credit unions are tax-exempt because they are not-for-profit. Technically this is correct because taxes aren’t owed when there is no income. (Non- and not-for-profit organization’s must reinvest all their income in ways that exclusively benefit of the organization and/or its members.)
There is a significant difference between legal “requirements” and justifiable “reasons.” The reason credit unions are tax-exempt isn’t because they are not-for-profit. Actually, it’s the other way around. Congress requires all tax-exempt organizations be either non-profit or not-for-profit. Not-for-profit status is a requirement for federal tax-exemptions, not the reason behind it. It defines who gets the tax exemption, not why.
Can anyone create any kind of non- or not-for-profit business? No. Could you launch a non-profit porn shop? Obviously no. There are only special kinds of organizations that Congress deems worthy of tax exemptions and that’s because they provide some manner of valuable social service. In exchange for a tax exemption, they require these organizations to be non- or not-for-profit.
Other requirements commonly offered as reasons
Congress prohibits not-for-profit organizations from having private ownership. They can’t issue stock. And their boards of directors can’t personally benefit in any taxable way. In order to qualify for tax exemptions, an organization must conform to the structure of not-for-profits as defined by Congress. That’s why credit unions are member-owned and have volunteer boards.
Could someone start a member-owned chain of gas stations with an all-volunteer board and qualify for a tax exemption? No. It isn’t about member-ownership.
It’s not about “democratic principles” either. Credit unions often cite their democratic principles when justifying their tax-exempt status, but taxed corporations — with their shareholder votes — embrace the same ideals. Democracy is wonderful, but it makes no difference to an organization’s tax status.
Tax codes shed some clues
A review of IRS tax codes relevant to credit union taxation clearly reveals the legal criteria — who qualifies for a tax exemption — while giving us glimpses about the underlying rationale — the “why.”
Credit union scholars trace the origins of the industry’s tax exemption back to the First World War. Under Title VIII of the War Revenue Act of October 1917, Congress notes that “co-operative building and loan associations which are organized for the benefit of their members” (among other organizations) would not be subject to levies related to the cost of the war in Europe. But this arcane reference applies specifically to the levying of war stamp taxes and nothing more.
In 1934, Congress passed the Federal Credit Union Act, which in turn became Federal law 12 U.S.C. Chapter 14. The only section dealing with taxation, § 1768, says “Federal credit unions and their income shall be exempt from all taxation.” But this merely acknowledges that federal credit unions get a federal income tax exemption. No further explanation is provided.
The section of Federal law concerning not-for-profits, 26 U.S.C. 501(c)(14), states that credit unions must “operate without profit and for the mutual benefit of its members.” This is simply a restatement of the conditions organizations must meet in order to qualify for tax exemptions. Credit unions, just like every other not-for-profit organization, are required to return all gains back to its constituents. It’s a requirement imposed by Congress.
The next significant chunk of legislation can be found in the Revenue Act of 1951, where Congress revoked the tax-exempt status of building and loan associations, cooperative banks and mutual savings banks, while simultaneously adding specific language exempting credit unions. Authorities on banking tax codes believe these thrifts lost their tax exemption because they were actively competing with commercial banks for public savings and real estate loans. When Congress felt they were no longer providing a wider public service, they became taxed like for-profit commercial banks.
Nearly 30 years later in a 1979 report, the IRS theorized that “the reasons for removal of tax exempt status for mutual savings banks and savings and loan associations was their fundamental departure from the principles and purposes of their formation.”
In the report, the IRS explores the reasons Congress might have treated credit unions differently. “A major reason for the establishment of credit unions in this country was to provide their members with a source of personal loans, in small amounts and for a short term, which generally were difficult to obtain from other financial institutions,” the IRS noted.
“Another characteristic normally distinguishing credit unions from other financial institutions,” the IRS continued, “is the fact that credit unions rarely advertise.”
“Had credit unions resembled taxable financial institutions,” the 1979 IRS report concluded, “it seems probable that Congress might not have continued their exempt status.”
But at the time, the IRS acknowledged fundamental differences between credit unions and other financial institutions, and thus treated them differently with respect to the application of tax laws. The most significant distinction noted by the IRS was the requirement for “a meaningful, written, and enforced common bond for its members, typically including: (1) employees of a particular business or institution, (2) members associated in a particular organization, or (3) residents of a well-defined neighborhood or community.” But these are more requirements, not reasons.
Social service justifies tax exemptions
Every nonprofit and not-for-profit organization in the U.S. fulfills some sort of civic or social role. These are often purely benevolent organizations, many of which are supported entirely by volunteers and/or donations. Look at the list of not-for-profit organizations and you’ll find religious, charitable, scientific, amateur and literary groups. There are civic leagues, social clubs and chambers of commerce. These not-for-profit organizations “do good stuff” in communities that other taxed organizations don’t or won’t — e.g., things like fighting to prevent cruelty to children and animals. That’s why Congress determined they were worthy of tax exemptions. When the U.S. government wants to provide a social service to the American people, Congress can either fund a governmental department or it can give private organizations tax breaks.
Looking back to 1934 when Congress passed the Federal Credit Union Act, you find that the purpose of credit unions was to make credit available to people of small means through a national system of cooperative credit, and to encourage thrift through cooperative saving.
In 1997, the chairman of CUNA affirmed this social directive in his testimony before the Committee On Banking & Financial Services. “[Credit unions] are the only financial institutions chartered with the social mission of making loans available to people of small means and teaching the benefits of thrift.”
When Richard Nixon signed Executive Order #11580 giving the NCUA its official seal in 1971, he expressly noted credit unions’ mission included the “cultivation of thrift, encouragement to save regularly, granting of loans for provident purposes at a reasonable interest rate, and budget and consumer counseling.”
As Andrew Reschovsky, a professor at the University of Wisconsin-Madison, summarizes, “The core issue [concerning taxation] is whether credit unions fulfill a public purpose, such as providing access to credit markets for families, individuals and businesses that commercial banks do not lend to.”
The reason behind credit unions tax exemption has everything to do with themes like “people of modest means,” “loans for provident purposes,” “teaching thrift” and “financial education.” By offering loans to those who might not otherwise have access to credit, Congress feels credit unions provide a public service that is as necessary as any other social program it might subsidize — something Americans need, not unlike the Centers for Disease Control or U.S. Department of Housing & Urban Development.
It’s smart for credit unions to talk about their structure — that they are not-for-profit, member-owned, democratic financial cooperatives — both for marketing and political reasons. From a branding perspective, it helps reassure credit union members and the general public that credit unions aren’t in it for the money; no one’s in it to get rich. It also helps credit unions justify and explain claims of “better rates, fewer fees and great service.” From a political perspective, it gives voters and their Congressional representatives warm fuzzies credit unions can use to insulate themselves from undesirable legislation. But the structure of credit unions is not why they have tax exemptions.