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2004 EO CPE TextCredit Counseling OrganizationsByDebra Cowen and Debra KaweckiOverviewIntroductionCredit counseling organizations provide valuable services to the public. Theyeducate consumers about better money management techniques, promote debtreduction strategies, and help their clients avoid bankruptcy and its financialconsequences. However, some credit counseling organizations prey on thevulnerability of the clients they are supposed to be helping.The purpose of this article is to raise awareness that there is a potential forabuse by credit counseling organizations that have received or are requestingclassification as organizations described in IRC 501(c)(3).In this articlePart I of this article discusses the Credit Repair Organizations Act, thefederal government's response to abuses in the credit repair industry. Whenconsidering applications from credit counseling organizations, it is importantto keep in mind that in general the Credit Repair Organizations Act doesnot apply to IRC 501(c)(3) organizations. The federal statutory schemerelies on the determination by the Service that an organization qualifies fortax-exempt status.Part II of this article discusses two states’ efforts to protect consumers fromfinancial fraud. The states' regulatory schemes do not apply to IRC501(c)(3) organizations. The states are also relying on the determination bythe Service that an organization qualifies for tax-exempt status.Part III discusses the Model Codes adopted by two voluntary creditcounseling certification organizations. These Codes provide a model forexempt credit counseling organizations.Part IV discusses qualification of credit counseling organizations under IRC501(c)(3) and IRC 501(c)(4). It examines revenue rulings and court cases.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 1

Overview, ContinuedIn this article,continuedPart V discusses the type of development recommended when considering anapplication for exemption from a credit counseling or credit servicing agency.Part VI is the ConclusionPart VII is the Addendum. The Addendum contains a copy of the CreditRepair Organizations Act and samples of consumer alerts from state attorneysgeneral and the Federal Trade Commission. This information is helpful whenconsidering the distinction between legitimate credit counseling agencies andillegal credit repair services.Table ofcontentsThis article contains the following topics:TopicOverviewPart I: Federal Efforts Protecting Consumers Against FinancialFraud· The Credit Repair Organizations Act· The Federal Trade Commission ActPart II: State Efforts in Protecting Consumers Against FinancialFraudPart III: Voluntary Credit Counseling Agency CertificationPart IV: Qualification for Exemption under IRC 501(c)(3)Part V: Exemption Applications Case DevelopmentPart VI: ConclusionPart VII: Addendum· The Credit Repair Organizations Act· Consumer AlertsCredit Counseling Organizations – CPE 2004-1, page 2See Page13589121621242534

Part I: Federal Efforts in Protecting Consumers AgainstFinancial FraudIntroductionThe Service developed its position on credit counseling agencies in the1960s. If an agency primarily provided information, exemption underIRC 501(c)(3) was considered appropriate. The need to review thissubject stems from recent concern that certain organizations, describingthemselves as educational credit counseling agencies, may be engaged inactivities that are not described in IRC 501(c)(3).This article discusses both credit counseling agencies and credit repairorganizations.·A credit counseling agency educates the consumer as its principalactivity. It may also assist the consumer in consolidating debt andnegotiate between debtors and creditors to lower interest rates andwaive late and over-limit fees.·Credit repair involves claims that the agency can restore credit in ashort period of time. Certain credit repair practices are illegal.The states' attorneys general warn that restoring credit is a lengthyprocedure, and claims to do it quickly may involve identity theftand other illegal practices.The federal statutory scheme and that of many states and privatecertifying organizations rely on the Service's determination that anorganization is exempt under IRC 501(c)(3). If an organization candemonstrate that it is exempt under IRC 501(c)(3), it usually avoids allregulatory requirements.Because the Service's determination of exemption is central to bothfederal and state regulatory enforcement programs, the determinationspecialist must examine applications for exemption with a heightenedawareness. The following discussion and the development questions aredesigned to review the published guidance in light of changes in the fieldof credit counseling and credit repair.Credit Counseling Organizations – CPE 2004-1, page 3

Part I: Federal Efforts in Protecting Consumers AgainstFinancial Fraud, ContinuedFederalLegislationThe Federal Trade Commission enforces at least two statutes that apply tothe activities of credit counseling and credit repair organizations.·The Credit Repair Organizations Act became effective on April 1,1997, and is directed to the credit repair industry.·The FTC Act, a statute of more general application, applies to theoperations of both credit repair organizations and credit counselingorganizations.Bankruptcy reform legislation was proposed in 2002 and remains aconcern of Congress. Under the proposals that were considered, the roleof credit counseling organizations in the bankruptcy process would besignificantly enhanced.·The proposed legislation provided that an individual may not file apetition for bankruptcy under Chapter 11 of the Bankruptcy Codeunless he has sought assistance from an approved nonprofit budgetand credit counseling agency. The United States trustee orbankruptcy administrator in each judicial district would berequired to compile a list of approved credit counseling agencies.·In the event similar legislation passes, there is likely to be aninflux of new nonprofit credit counseling organizations setting upbusiness across the country and seeking exemption under IRC501(c)(3).Credit Counseling Organizations – CPE 2004-1, page 4

Part I: Federal Efforts in Protecting Consumers AgainstFinancial Fraud - The Credit Repair Organizations ActIntroductionCongress has taken steps to protect citizens against the worst of the creditrepair scams in the Credit Repair Organizations Act, [15 U.S.C. §§ 1679 etseq.] The Act seeks to ensure that prospective buyers of credit repair servicesare provided with the information necessary to make an informed decision,and to protect the public from unfair or deceptive advertising and businesspractices by credit repair organizations.Definition of aCredit RepairOrganizationThe Act defines a credit repair organization as:any person who uses any instrumentality of interstate commerce orthe mails to sell, provide, or perform (or represent that they will sell,provide, or perform) any service, in return for the payment of moneyor other valuable consideration, for the express or implied purpose of (i) improving any consumer's credit record, credit history, or creditrating; or(ii) providing advice or assistance to any consumer with regard toany activity or service in clause (i).The Act excludes from the definition of a credit repair organization:·any nonprofit organization which is exempt from taxationunder IRC 501(c)(3).This strong federal expression of consumer protectioncan be defeated by an erroneous determination that anorganization is exempt under IRC 501(c)(3). It iscrucial, therefore, that the Service make every effort toadequately develop all the facts and circumstancesregarding an applicant's operations.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 5

Part I: Federal Efforts in Protecting Consumers AgainstFinancial Fraud - The Credit Repair Organizations Act,ContinuedFull disclosureWrittenContractThe Act requires full disclosure regarding consumer rights before anycontract for credit repair services is executed. A written statement mustbe provided and signed by all prospective customers, and must be retainedby the credit repair organization for at least two years after the statementis signed. Consumers must be advised:·They may dispute inaccurate information in their credit reportby contacting the credit bureau directly.·There is no right to have accurate, current, and verifiableinformation removed from a credit report unless it is over sevenyears old. Bankruptcy information can be reported for ten years.·They have a right to sue a credit repair organization thatviolates the Credit Repair Organizations Act.·They have the right to cancel a contract with any credit repairorganization for any reason within three business days from thedate it was signed.A written contract is also required and must:1. specify the terms and conditions of payment, including the totalamount of all payments to the credit repair organization or anyother person2. contain a full and detailed description of the services to beperformed by the credit repair organization for the consumer,including:(A) all guarantees of performance; and(B) an estimate of the time required for the performance of theservices3. contain the credit repair organization's name and principalbusiness addressContinued on next pageCredit Counseling Organizations – CPE 2004-1, page 6

Part I: Federal Efforts in Protecting Consumers AgainstFinancial Fraud - The Credit Repair Organizations 4. contain a conspicuous statement in bold face type, in immediateproximity to the space reserved for the consumer's signature on thecontract, which reads as follows: "You may cancel this contractwithout penalty or obligation at any time before midnight of the3rd business day after the date on which you signed the contract.See the attached notice of cancellation form for an explanation ofthis right."The statutory scheme provides further protection for consumers with a listof prohibitions. The Act prohibits credit repair organizations, as well astheir employees and agents, from:·misrepresenting the organization's services·making or enticing consumers to make untrue or misleadingstatements either to the credit reporting agencies or to the consumer'screditors·advising consumers to attempt to change their credit identities·accepting payment or other valuable consideration for theirservices in advance of fully performing those services.Civil PenaltiesThe Act includes civil penalties for violations and procedures foradministrative enforcement by both the FTC and the states.Waiver ofRightsA consumer cannot waive his rights under the Act.·Any waiver of any protection afforded by the Act is treated as void,and contracts that are not in compliance with the Act's provisions maynot be enforced by any federal or state court.Credit Counseling Organizations – CPE 2004-1, page 7

Part I: Federal Efforts in Protecting Consumers AgainstFinancial Fraud – The Federal Trade Commission ActThe FederalTradeCommissionActThe FTC Act [15 U.S.C. §§ 41 et seq.] is a statute of more generalapplication than the Credit Repair Organizations Act. It prohibits "unfairor deceptive acts or practices in or affecting commerce." This generalproscription applies to the operations of both credit repair companies andcredit counseling agencies. It is not clear, however, whether IRC501(c)(3) organizations will come under the FTC Act enforcementumbrella.Credit Counseling Organizations – CPE 2004-1, page 8

Part II: State Efforts in Protecting Consumers AgainstFinancial FraudStateLegislativeAction:CaliforniaCalifornia is just one example of the many states that have taken steps toprotect consumers against the worst of the credit repair scams. In 1993, theCalifornia legislature imposed strict standards on credit service organizationsand the credit repair industry. The Act, (Civ. Code §§ 1789.12, 1789.16),provides prospective buyers of credit repair services with the informationnecessary to make an intelligent decision regarding the purchase of thoseservices. It aims to protect the public from unfair or deceptive advertisingand business practices. It defines credit services organizations (also known as"CSOs" or "credit repair services") as organizations that promise any of thefollowing services for a fee to:1. improve a buyer's credit record, history, or rating2. obtain a loan or other extension of credit for a buyer3. provide advice or assistance to a buyer with regard to either of theabove.CSORequirementsThe Act requires a CSO to register with the California Attorney General'sOffice and obtain a 100,000 surety bond before starting to do business inthe state. The CSO must give each prospective client an informationstatement and a written contract spelling out its services before providingany services, and must complete all services within six months.ProhibitionsThe statutory scheme provides further protection for consumers with a listof prohibitions. The most important of these is that CSOs are not allowedto charge "up-front fees." All services must be completed before any feecan be collected. The Act also prohibits a CSO from:1. charging referral fees for referral to other agencies if the creditterms offered are substantially the same as those available to thegeneral public, or are the same as the buyer could have obtainedwithout the CSO's assistanceContinued on next pageCredit Counseling Organizations – CPE 2004-1, page 9

Part II: State Efforts in Protecting Consumers Against Financial Fraud,ContinuedProhibitions,continued2. encouraging a buyer to make false or misleading statements to aconsumer credit reporting agency, or to any present or potentialcreditor, for the purpose of improving his credit rating3. advising a buyer to create a new credit record by using a newname, address, social security number, or employee identificationnumber4. engaging directly or indirectly in any course of business thatwould operate as a fraud or deception upon any persons inconnection with its servicesCivil andCriminalPenaltiesThe Act includes criminal and civil penalties for violations. The state attorneygeneral, district attorneys, and city attorneys may prosecute any violation as amisdemeanor and may also seek injunctive relief. In addition, a buyer who isinjured by a CSO's violation of the Act or breach of contract may recoveractual damages at least equal to the amount paid to the CSO, plus costs andreasonable attorneys' fees. He also may seek injunctive relief and may beawarded punitive damages.The Act DoesNot Apply toIRC 501(c)(3)Organizations:The Act does not apply to:·certain individuals and institutions that are already regulated. Theseinclude: licensed and regulated lenders or creditors; FDIC-insured banksand savings institutions; licensed proraters and real estate brokers;licensed attorneys who are not directly affiliated with a CSO; and brokerdealers who are registered with the U.S. Securities and ExchangeCommission.·Most significantly, the Act does not apply to nonprofit organizationsthat have received a final determination from the Service that theyare exempt under IRC 501(c)(3) and are not private foundations.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 10

Part II: State Efforts in Protecting Consumers Against Financial Fraud,ContinuedCalifornia IsNot AloneWe have not done a state-by-state survey of consumer protection schemes.California and the states included in the Addendum are representative of whatis happening as states awaken to the nationwide problem within the debtconsolidation/credit repair industry. The states are leading the way byidentifying the worst of the abuses as well as adopting legislation to regulatethe industry.Knowledge of the latest applicable state laws and licensing regulations willhelp determination specialists distinguish educational credit counselingorganizations from credit repair organizations that may be performingactivities that are not charitable.Credit Counseling Organizations – CPE 2004-1, page 11

Part III: Voluntary Credit Counseling Agency CertificationModel CodesThe Model Codes described in this section are voluntary. We discuss themhere because they provide a model for exemplary credit counselingorganizations and are helpful in guiding the development and consideration ofapplications for exemption under IRC 501(c)(3).NationalFoundation forCreditCounseling(NFCC) A Model CodeThe National Foundation for Credit Counseling (NFCC) is an independentnot-for-profit organization dedicated to establishing voluntary standards forthe credit counseling industry. The NFCC Council on Accreditation (COA) isan independent not-for-profit organization. COA accredits over 4,000programs throughout the United States and Canada, including nearly 200credit counseling services. An organization need not be a member of theNFCC to be accredited by COA. Once an agency is accredited, COA certifiesthat the agency uses the appropriate checks and balances to protect theconsumer.OnlyBefore even being considered for accreditation by the COA, a creditcounseling agency must meet certain minimum requirements:IRC 501(c)(3)OrganizationsMay BeAccredited·must be exempt under IRC 501(c)(3)·services must be provided according to best practice standards·all applicable licenses required by the state and locality in which itoperates must be secured·the agency must have operated for at least one year·the agency must be an organization. Individuals are not eligible forcertification.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 12

Part III: Voluntary Credit Counseling Agency Certification, ContinuedThe BestPracticeStandardsRequired byCOAThe best practice standards required by COA include:·The agency must have its operating and trust accounts audited annually.·The agency must be licensed, bonded and insured.·The agency must support and deliver a variety of consumer educationprograms.·The agency must meet all consumer disclosure requirements as set forthby the U.S. Federal Trade Commission.·Client debt management plans must include a detailed review of currentand prospective income, as well as present and anticipated financialobligations. In addition, the plan must represent the client’s best effort inpayment of all debts, and assure that all lines of credit are closed.·Funds are disbursed at least twice per month, and funds are disbursedpromptly in emergencies.·An agency discontinues a client's debt management plan after twoconsecutive missed payments and notifies the creditor of thisdiscontinuation within 10 days.·Creditors receive fair and equitable distribution of funds, and the agencyoffers electronic funds transfer to those creditors that request it.·Clients have a variety of deposit options including electronic methods,and are offered immediate correction of improper postings.·Persons with immediate needs are served immediately or referred toanother organization for immediate service.·Each consumer receives an assessment of how he/she got into financialtrouble, a comprehensive financial plan, and a written action plan.·Clients receive (at minimum) a quarterly statement.·Clients are encouraged to increase deposits if their financial situationimproves so they may speed the liquidation of their debt.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 13

Part III: Voluntary Credit Counseling Agency Certification, ContinuedAssociation CA)The Association of Independent Consumer Credit Counseling Agencies(AICCCA), another national membership organization established to promotequality and consistent delivery of credit counseling services, has also adoptedindustry standards. The standards are similar to those adopted by the NFCCand are voluntary.AICCAStandardsSome of the standards adopted include:OnlyIRC 501(c)(3)OrganizationsMay BeAccredited·Must provide a community resource for educational materials andinformation concerning personal finance and debt issues.·Must be an IRC 501(c)(3) organization.·Must be licensed in any state (that has a licensing procedure) in which itconducts business and adhere to all licensing requirements.·Must maintain a satisfactory rating with the Better Business Bureau.·Must begin resolution of client complaints within 10 days of notification.·Must have an independent board of directors, the majority of whichcannot be compensated employees of the agency or related by blood ormarriage to other board members or employees.·Must have operated continuously in the state in which it is organized forat least one year.·Must maintain a permanent physical business location and not operatesolely out of a post office box.·Must meet all applicable state licensing, registration, bonding andstatutory requirements.·All counselors must receive proper training within one year.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 14

Part III: Voluntary Credit Counseling Agency Certification, ContinuedAICCCAStandards,continued·Counselor compensation cannot be based on the outcome of thecounseling process.·All services must be made available to the public regardless of ability topay.·Fees for debt management plans must not exceed a maximum set-up feeof 75, nor will fees exceed 50 per month for maintenance of the plan.Credit Counseling Organizations – CPE 2004-1, page 15

Part IV: Qualification for Exemption under IRC 501(c)(3)ServicePrecedentThe Service addressed credit counseling agencies when they first entered themarketplace in the 1960s. The revenue rulings issued at that time provideexamples of a credit counseling agencies exempt under IRC 501(c)(4) andIRC 501(c)(3).Rev. Rul.65-299The Service recognized a credit counseling service (agency) open to thegeneral public as exempt under IRC 501(c)(4) in Rev. Rul. 65-299,1965-2 C.B. 165. The agency was incorporated as a nonprofit corporation toassist families and individuals with financial problems and to help reduce theincidence of personal bankruptcy. The agency did not limit its services tothose in need of such assistance as proper recipients of charity.The agency:·employed specialists to interview applicants, analyze the specificproblems involved, and counsel applicants on the payment of their debts·arranged a monthly distribution to creditors based on the debtor's abilityto pay·communicated with creditors and, with the creditors' consent, set up planswhich debtors agreed to follow·made its facilities available for debtors to make their monthly pro ratadistributions to creditors·made no loans to applicants nor negotiated loans on their behalf·charged nominal fees to cover postage and supplies for its monthlyprorating services·charged no fees for the counseling service·relied upon voluntary contributions from local businesses, lendingagencies, and labor unions to cover its costs of operations.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 16

Part IV: Qualification for Exemption under IRC 501(c)(3), ContinuedRev. Rul.69-441A credit counseling service (agency) was recognized as exempt under IRC501(c)(3) in Rev. Rul. 69-441, 1969-2 C.B. 115. This agency limited itsservices to low-income individuals and families with financial problems. Itsboard of directors was comprised of representatives from religiousorganizations, civic groups, labor unions, business groups, and educationalinstitutions.The agency:·provided educational information to the general public on budgeting, buyingpractices, and the sound use of consumer credit through the use of films,speakers, and publications·assisted low-income individuals and families with financial problems byproviding them with individual counseling and, if necessary, by establishingbudget plans·serviced the budget plan by allowing the debtor to voluntarily make fixedpayments through the agency; holding the funds in a trust account anddisbursing the funds on a partial payment basis to the creditors, whoseapproval was obtained in advance·made no loans to debtors or negotiated loans on their behalf·charged no fees for counseling services or proration services - the debtorreceived full credit against his/her debts for all amounts paid·relied upon voluntary contributions, primarily from the creditorsparticipating in the organization's budget plans, for its supportThe Service distinguished the facts in this ruling from the facts in Rev. Rul. 65299 that held the organization was exempt under IRC 501(c)(4):·The agency in Rev. Rul. 65-299 was not engaged in any educationalactivities.·The agency in Rev. Rul. 65-299 did not limit its assistance to acharitable class -- families or individuals in need of such assistance asproper recipients of charity.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 17

Part IV: Qualification for Exemption under IRC 501(c)(3), ContinuedCASE LAW:ConsumerCreditCounselingService ofAlabama v.U.S.The Consumer Credit Counseling Service and the Credit Counseling Centers(Agencies) were umbrella organizations made up of numerous individualcredit counseling centers. Both had been recognized as exempt under IRC501(c)(3).·The Agencies provided information to the general public through theuse of speakers, films, and publications on the subjects of budgeting,buying practices, and the sound use of consumer credit. The Agenciesalso provided counseling on budgeting and the appropriate use ofconsumer credit to debt-distressed individuals and families. They didnot limit these services to low-income individuals and families. TheAgencies charged a nominal fee of up to 10 per month for some oftheir services, but waived the fee in instances where payment wouldwork a financial hardship.·The Agencies received the bulk of their support from government andprivate foundation grants, contributions, and assistance from laboragencies and the United Way of America. An incidental amount oftheir revenue was from the counseling fees. This was consistent withthe fact that only 12 percent of the professional counselors’ time wasspent on debt management programs as opposed to education. Thebalance of time was devoted to the educational programs.·The Agencies were controlled by a community board of directors.The boards were required to have at least a 60 percent representationof the general public. The Agencies were not controlled by or thecaptive of any creditor.CreditCounselingCenters ofOklahoma v.U.S.In 1976, relying on Rev. Ruls. 65-299 and 69-441, the Service notified theAgencies that it had made a mistake and was reclassifying them under IRC501(c)(4). What followed are two pivotal declaratory judgment (IRC 7428)cases: Consumer Credit Counseling Service of Alabama v. United States, 782 U.S.T.C. 9660 (D.D.C. 1978) and Credit Counseling Centers of Oklahoma,Inc. v. United States, 79-2 U.S.T.C. 9468 (D.D.C. 1979).Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 18

Part IV: Qualification for Exemption under IRC 501(c)(3), ContinuedCASE LAW,continuedService PositionCourts'HoldingsThe reasons given by the Service for revocation of the IRC 501(c)(3) statuswere:·the Agencies were not organized and operated exclusively forcharitable or educational purposes·the debt management services were not limited to low-incomeindividuals or families·fees were charged for the services rendered.The courts did not agree with the Service and directed verdicts for theplaintiffs. The courts held that:·Organizations that are charitable and educational in nature aredescribed in IRC 501(c)(3). Providing information regarding thesound use of consumer credit is charitable because it advanceseducation and promotes social welfare within Reg. 1.501(c)(3)1(d)(2). These programs are also educational because they instruct thepublic on subjects useful to the individual and beneficial to thecommunity. Reg. 1.501(c)(3)-1(d)(3)(i)(b).·The counseling assistance programs are likewise charitable andeducational in nature. Since the community education and counselingassistance programs are the Agencies' primary activities, the Agenciesare organized and operated exclusively for charitable and educationalpurposes.·The debt management and creditor intercession activities are anintegral part of the Agencies' counseling function, and thus arecharitable and educational undertakings. Even if this were not thecase, these credit intercession activities are incidental to the Agencies'principal functions.Continued on next pageCredit Counseling Organizations – CPE 2004-1, page 19

Part IV: Qualification for Exemption under IRC 501(c)(3), ContinuedCourts'Holdings,continued·The law does not require that an organization must perform its exemptfunctions solely for the benefit of low-income individuals to qualifyunder IRC 501(c)(3). Organizations may be properly designatedunder IRC 501(c)(3) notwithstanding the fact that the general public isserved.·Nonetheless, the Agencies do not charge a fee for the programs thatconstitute their principal activities. A fee may be charged for a servicethat is an incidental part of an agency's function, but even where a feeis so charged it is nominal. Moreover, even this nominal fee is waivedwhere payment would work a financial hardship.Credit Counseling Organizations – CPE 2004-1, page 20

Part V: Exemption Applications Case DevelopmentA Critical EyeThe public, the federal government, and the states give greatweight to the Service's determination of exemption. Thus, it isessential to review applications for exemption (Form 1023/1024)with a critical eye. Because credit repair activities may be illegal,a careful review of applications from credit counselingorganizations and credit repair or debt management organizationsis necessary. Any case in which there is a concern that theorganization, or any organizations in which its founders, officersor directors have an int

required to compile a list of approved credit counseling agencies. In the event similar legislation passes, there is likely to be an influx of new nonprofit credit counseling organizations setting up business across the country and seeking exemption under IRC 501(c)(3). Credit Counseling Organizations - CPE 2004-1, page 4