Credit Union Taxation in Utah

Credit Union Taxation in Utah A Report from the Utah Taxpayers Association January 30, 2003

Credit Union Taxation in Utah A Report from the Utah Taxpayers Association Executive Summary Background - Original Purpose and Function of Credit Unions Credit unions were created to allow people of small means to pool their resources and lend money to each other. Since these groups were underserved and were unable to obtain credit through normal means, an income tax exemption was established to increase access to credit for people of small means. In qualifying for the exemption, credit union membership was to be limited to membership with a common bond, typically workers in the same company or industry. As a consequence of the common bond requirement, credit unions spent very little on marketing or expansion and did not recruit membership from the general public. Since credit unions had one primary purpose - providing credit to underserved populations-credit unions did not offer a full range of financial services. Some Credit Unions Have Evolved Many credit unions still limit their membership to the traditional common bond definition, but some have departed from the original purpose. A few very large credit unions no longer resemble the original credit unions for which the taxexempt status was created. The large credit unions now serve the general population with few restrictions on membership. The traditional common bond no longer exists for some credit unions whose membership is open to a majority of the state's population. These large credit unions are no longer focusing on the underserved people of small means. In fact, the average credit union member has a higher income and net worth than the average bank customer, and instead of primarily focusing on providing credit as credit unions did originally, many credit unions are providing a full range of services. The result of this evolution is clear. These credit unions act and operate just like banks but do not pay corporate income taxes. The Issue: Tax Equity and Credit Union Subsidies In Utah, three credit unions have experienced dramatic growth at the expense of banks as well as small credit unions. Tax exempt retained earnings have financed much of this growth, an advantage that credit unions have over banks. Banks are required to pay 35% federal taxes and 5% state taxes on profits while credit unions pay 0% on their retained earnings. Member ownership, as opposed to shareholder ownership, is not a justification for tax exempt status. Mutual savings banks are required to pay taxes as are member-owned cooperatives. 2

Utah Taxpayers Association Position The Utah Taxpayers Association supports lower taxes and a tax policy that encourages economic growth and competitive equity. In light of these goals, the Taxpayers Association advocates the following policy: 1. Require credit unions that operate like banks and compete against banks to pay the same taxes as banks 2. Offset any state tax revenue increase created by taxing credit unions with a dollar-for-dollar reduction in other taxes. 3

Credit Union Taxation in Utah A Report from the Utah Taxpayers Association The purpose of this report is to explain the reasons for the Utah Taxpayers Association s support of the Resolution Alliance s initiative to resolve Utah's Credit Union / Bank issue and to encourage the Utah Legislature to address the inequity of taxing banks but not their large credit union competitors. History of Credit Union Tax Exemptions A credit union is a nonprofit cooperative association of individuals with a common bond that distinguishes the credit union members from the general public, usually the members' occupation, association or community. Originally, credit unions simply accepted financial deposits from their members with which they made unsecured personal loans to them, but now credit unions provide a full range of financial services. Each credit union member has an equal vote in election of officers of the organization, which govern the management of the credit union. Credit unions were first organized in Germany in the 1800s to enable financial independence in the working class by providing low cost credit. The first U.S. credit union was chartered by the state of New Hampshire in 1909. Others soon followed in Massachusetts and other parts of New England. As credit unions spread in number across the United States, they remained small organizations, offering limited services to their narrowly defined membership base. Credit unions were granted a federal income tax exemption in 1917 because they resembled cooperative banks which already were exempt, and to enable them to give credit to people of "small means." States also granted exemptions to credit unions. The idea was that under-served groups of people who worked together or otherwise knew each other could pool their resources and lend money to each other because they were often unable to gain credit elsewhere. This enabled credit unions to economically serve their limited membership with very basic savings accounts and consumer loans. Traditionally, any earnings were used to provide better savings and borrowing rates, or were distributed back to the members of the credit union in the form of dividends. These tax exemptions are a significant economic benefit. For example, an exemption from today s state and federal income tax rates of 5% and 35%, respectively on a credit union s retained earnings, gives credit unions a marked competitive advantage over banks whose profits are taxable. However, before the early 1970 s this exemption was not viewed as anticompetitive because credit unions served specific, limited groups of persons who shared a common bond, often working for the same company or industry. Credit unions also provided only a limited array of financial services. Thus, credit unions were not competing with other taxpaying financial institutions. 4

Federally-chartered credit unions first appeared during the depression with the 1934 Federal Credit Union Act. Like state chartered credit unions, they grew in number but remained limited in their size and services until 1971 when the National Credit Union Share Insurance Fund was established. This deposit insurance gave the public greater confidence in the financial security of credit unions, similar to the earlier Federal Deposit Insurance Corporation (FDIC) for banks. Prior to credit union share insurance, the safety of each member's deposit depended on knowing the character and reliability of credit union members applying for loans. By reducing the risk to members of both federal and state credit unions through share insurance, members made larger deposits in their credit union savings accounts. At the same time, the common bond became less important and credit unions began to grow more rapidly. However, credit union members tended to use both credit unions and banks because, by design, not all financial services were available at their credit unions. They used credit unions for savings and personal loans and banks for checking accounts and other loans. But in 1978 and 1980 Congress authorized credit unions to offer mortgage loans and transaction (checking) accounts. Credit unions quickly began to look like full-service financial institutions. As share insurance eliminated the need for credit unions to personally know each member and as credit unions added more services, credit union membership grew rapidly and the size of some credit unions began to rival that of many banks. Tax advantages have helped credit unions grow faster than taxable institutions by allowing tax-free capital accumulation. Tax-Free Growth Today's credit unions offer credit cards, ATMs, money market accounts, mutual funds, home equity lines of credit, discount brokerage services and insurance. The growth in the industry has been dramatic, both nationally and in Utah. According to the Credit Union National Association, in 1950 credit unions in the United States had total assets of $ 1.0 billion, loans of $680 million and 4.6 million members. By 1970, assets reached $18.0 billion, loans totaled $14.1 billion and membership rose to 22.8 million. By 1990, assets reached $221.8 billion, loans totaled $141.9 billion and there were 61.6 million members. By 2001, assets reached $514.7 billion, loans totaled $330.9 billion and credit unions boasted an amazing 81.6 million members. The credit union industry has also grown larger in relation to the size of banks. In 1980, credit unions comprised 3.6% of the nation's total bank and credit union assets. By 1995, that share has nearly doubled to 6.8%. As of 2001, credit union market share was 7.1%. According to Forrester Research, credit unions continue to gain in popularity. Credit unions were named as primary financial provider by 16% of consumers in 2002 (tied with "small, local banks"), up 9 percentage points from 2001, the largest gain among 11 categories of financial service providers. The study showed that average household income and assets of a credit union customer are greater than customers of small, local banks. The average credit union member had annual household income of $62,000 and had average assets of 5

about $175,000. For people claiming small banks as their primary financial services provider, annual household income stood at$56,000 and average assets at $153,000, according to the Forrester Research study. Since the mid- 1960s, the trend in Utah and nationally, has been fewer, but larger credit unions. There are 132 credit unions in Utah today, down from 341 in 1966. In 1966 the average Utah credit union had 540 members and assets of $410,000. Following an industry trend of consolidation, the average Utah credit union today has over 9,500 members and assets of $52.3 million. As of December 2001, Utah credit unions have 1.26 million members, assets of $6.9 billion, deposits of $6.1 billion and loans of $5.3 billion. At current growth rates, in ten years Utah credit unions could have 1.7 million members, assets of $18 billion, deposits of $15.8 billion and loans of $13.8 billion. At the end of this report are a chart and two graphs showing the historical growth of state and federal credit unions in Utah. These are taken from the Credit Union National Association's website at: http://www.cuna.org/data/cu/research/stats/long_run.html The chart entitled, "Utah Totals Statistics" shows a year by year history of the number of Utah federal and state credit unions, members, total savings, total loans, total reserves and total assets. The first graph, entitled "Number of Members at Utah Credit Unions 1939-2001" shows the relatively flat growth of federal credit union membership in Utah compared to the rapid growth of statechartered credit union membership in the Beehive State. The second graph, entitled "Assets at Utah Credit Unions 1939-2001" shows historical asset growth of federal and state chartered credit unions in Utah. Following the availability of share insurance in 1970 and then in 1980 due to the availability of transaction (checking) accounts and a full range of financial services Utah state chartered credit union assets expanded rapidly. In the mid 1980s the lack of enforcement of the limited field of membership for state chartered credit unions produced exponential growth in state chartered credit union assets. At the same time, while federal credit union regulators strictly enforced field of membership restrictions, federal credit union assets remained quite flat. (The scale on the left side of the graphs relate to the federal and state amounts while the scale on the right relate to the combined federal and state totals). In recent years federal and state regulators have liberalized or ignored the common bond requirements that had previously justified the non-taxability of credit union retained earnings. As a result, credit unions today typically have memberships made up of multiple groups of people. With credit unions now having 75 million members and membership penetration of 36% of U.S. adults, it is now apparent that many credit unions serve the general public. Additionally, it is questionable whether credit unions today primarily serve people of "small means" which originally justified the credit union tax exemption. In fact, the Credit Union National Association (CUNA) 2002 National Member Survey Report stated that credit union "... members have higher average household incomes than do nonmembers." The report also noted "... credit unions relatively low member penetration level among lower-income consumers." The 6

report also disclosed that the remedy to a "shortage in peak borrowers" is "to attract more members and/or get more loans into the hands of existing members." The CUNA membership survey report disclosed that "... credit union members, compared to nonmembers are more likely to be employed full-time, less likely to be retired, more likely to have a college degree, and more likely to own their home," hardly a discription of people of small means. Most Utah credit unions have changed significantly over the years, but nearly all of them are still relatively small institutions that serve a limited field of membership. However, there is a handful of credit unions which have used their tax exemption to enable them to expanded rapidly and compete head-to-head with banks. These credit unions are larger than most banks and serve geographic boundaries that include most of the population of the state. They offer every banking service provided by other taxpaying financial institutions. They have expanded rapidly, spending millions of dollars on mass media advertising and political initiatives, and they retain millions of dollars in earnings, which they use to expand their presence in the marketplace, rather than to serve a specific group of members. Certainly, massive marketing to facilitate aggressive expansion and pursuit of market share is not unusual or improper for most businesses. Most consumers understand the reasons for radio and TV advertisements for tax-paying businesses. But when consumers across the state can sing the advertising jingles for tax exempt credit unions which were organized to serve limited numbers of people of small means having a common bond, one must question the appropriateness of such advertising and the motivation for their market expansion. Aggressive marketing is highly unusual for most other non-profit, taxexempt institutions that enjoy the same tax status as a charitable organization, especially when they offer the same services provided by tax-paying businesses. It is clear that some leaders of the credit union industry intend to erase the limits on their field of membership. Norman D'Amours, Chairman of the National Credit Union Administration said, "I think there will be a day when anyone will be able to belong to any credit union, anywhere." His statement would be wholly acceptable if the 40% credit union tax advantage were erased. The Court Ruled That Credit Unions Were Acting Outside the Law Utah courts ruled in 1998 that the State Department of Financial Institutions had inappropriately administered the state s credit union law for more than 15 years. During that time, a few credit unions took advantage of their tax-exempt status to grow rapidly. Three credit unions are now among the financial institutions in Utah which operate well beyond what was once envisioned for state or federally chartered credit unions. These largest credit unions are now far larger than most banks, are free to provide services to most of the state s population, and are clearly in direct competition with tax-paying financial institutions. In 1999 the Utah Legislature passed compromise legislation to rein-in credit 7

unions that were operating outside their field of membership. Rather than allowing the courts to enforce the existing law, The Utah Bankers Association and the Utah Credit Union League agreed to a compromise that expanded the allowable geographic areas of service but did nothing to solve the question of credit union taxability or to address the common bond requirement for credit union members. In essence, the compromise "grandfathered" much of the credit union expansion which the court had ruled was illegal. Still, there currently is no bright-line test for taxability of Utah credit unions and the field of membership "limits" give some credit unions as many as seven mostly metropolitan counties containing an overwhelming majority of the state's population -- hardly a "limited" membership base initially required for the tax exemption. It should be remembered that savings and loans, mutual savings banks and cooperatives lost their tax-exempt status in 1951 when Congress decided these institutions had become more like other profit-seeking financial institutions. It is clear that the large, full-service credit unions that exist today were not envisioned when the tax exemption was written into law. Many large credit unions today closely resemble mutual savings banks which are now taxable. Additionally, Canada began taxing credit unions in 1972 and credit unions in that country have continued to prosper. Two U.S. Presidents, Carter and Reagan unsuccessfully called for congress to repeal the credit unions' tax exemption. Additionally, the states of Alabama, Florida, Indiana, Maryland, Missouri, Nebraska and Oklahoma impose state income or franchise taxes on credit unions. In defense of their tax exemptions, the Utah Credit Union League has argued that removing the exemption would be a tax increase on 1.2 million Utah credit union members. The League has also pointed out that a credit union's only purpose is to serve their member-owners while banks are motivated by profit and not necessarily the best interests of their customers. If profits are bad and member-ownership is good, then perhaps the government should provide tax exemptions for member-owned grocery stores, member-owned automobile dealerships, member-owned clothing stores, and member-owned electronics/appliance stores. Utahns could save a lot of taxes through such taxfree cooperatives. Putting the Genie Back In the Bottle -- Creating Tax Equity The Utah Taxpayers Association supports the efforts of the Resolution Alliance, headed by former U.S. Senator Jake Garn (Republican) and former Salt Lake Mayor Ted Wilson (Democrat) to find a solution to the growing inequity of a few very large, untaxed credit unions. The Utah Taxpayers Association encourages Congress and the Utah Legislature to address this fundamental issue of tax equity. While the Utah Taxpayers Association s main mission is to keep taxes low and ensure government efficiency, the organization recognizes that one of the most important ways to promote lower tax rates is to ensure that everyone is paying their fair share. The first principles of tax policy require that similarly situated persons or businesses be treated equally. Absent fundamental fairness in tax policy, citizens and business owners will quickly lose confidence in government 8

while decisions in the marketplace will be distorted. The Taxpayers Association in recent years has spoken out on the inequities of allowing municipal enterprises such as city electrical utilities, fitness centers and golf courses to be tax free while their private sector counterparts are required to build taxes into their rates. The Association has supported legislation calling for the Tax Review Commission to recommend how to correct these inequities. The Association believes that by ensuring that all competitors are subject to the same tax policies, taxes are distributed over as broad a base as possible, keeping taxes relatively low for all businesses and individuals. On the other hand, when taxes are applied unevenly among competitors, giving one an advantage over another, consumer preference is distorted, business activity is shifted from taxable institutions to tax exempt institutions, the tax base is eroded and taxes rise for everyone else. Given the history of credit unions and Utah s largest credit unions dramatic departure from the traditional role, legislators should consider the role of state government in allowing the significant inequities that have developed in Utah s financial services marketplace. Congress established the tax-exemption for state and federally chartered credit unions, but it was careful to limit the ability of taxexempt federally chartered credit unions to compete with tax-paying banks. However, historically, state regulators have not been as careful in their administration of the state charter. They have allowed certain state chartered credit unions to expand well beyond the limits contained in state law and beyond the corresponding limits that have applied to federal credit unions. The Utah Taxpayers Association believes the original credit union tax subsidy was justified on retained earnings which resulted from credit union savings accounts and loans for people of "small means." But we find little justification for exempting from federal and state taxes other financial activities of credit unions where they compete head to head with taxpaying entities. For credit unions that are actively competing in every way with other taxpaying financial institutions, the subsidy represents an unfair and dangerous use of government s power to tax. The subsidization of credit union activities that go beyond basic savings accounts and loans to persons who otherwise could not afford to get credit results in government tax policy that artificially influences decisions of consumers shopping for financial services. At the same time, it undermines the state's tax base at a time of budget shortfalls and a crisis in education funding. The Utah Taxpayers Association believes that credit unions which provide a full range of financial services and expand their fields of membership to the point of active competition with other taxpaying financial institutions should be subject to state and federal income taxes on the earnings they retain to underwrite their expansion. If the goal of the subsidy is to lower the cost of credit, it should be offered to every institution that provides credit. However, in Utah's current tax and budget climate, extending the exemption to banks would not be politically feasible. Thus, taxing large, competitive credit unions may be the only viable way to provide equity. However, since Utah Taxes are already 9th highest among the fifty states, the Association believes any revenues raised through this equalization should be used to lower overall taxes, not grow government. 9

The Utah Taxpayers Association believes it is incumbent upon the Utah Legislature and Congress to re-establish equity between credit unions and taxable financial institutions. The competitive activity of credit unions must be limited, or they must be subject to the same state and federal tax obligations as their taxable competitors. 10

11

12