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Volume 7, Issue 3, 2007   Federal Reserve Bank of Dallas

New Scrutiny for Consumer Credit Counseling Industry

In recent years, there has been much concern about the quality and ethics of some credit counseling entities. Critics say that it is often impossible for people to distinguish between nonprofit counseling agencies that act in the best interest of consumers and for-profit debt management companies that masquerade as nonprofits but provide little or no help to clients.

Some credit counseling agencies offer debt management plans, in which consumers make a single consolidated payment that the agency uses to pay off the client's unsecured debts. Under such plans, creditors often agree to reduce the debtor's interest rates or waive certain fees and contribute a small percentage of its profit to the counseling agency to help fund its expenses.

Unscrupulous credit counseling companies often direct those seeking help to expensive debt management plans that leave them in worse financial condition.

Two recent developments are making it easier for consumers to identify reputable nonprofit agencies: (1) the Internal Revenue Service's Credit Counseling Compliance Project, which addresses abuses by tax-exempt credit counseling organizations, and (2) the Bankruptcy Abuse Prevention and Consumer Protection Act, which establishes a certification program for credit counseling agencies.

These government actions, combined with oversight and standardization from industry organizations, benefit consumers by enabling them to more easily identify agencies that work in their best interest and are certified to provide them with quality financial education.

Credit Counseling Compliance Project

In response to growing concerns about credit counseling industry abuses, the IRS initiated a campaign to educate the industry and public about these problems, aggressively examine abusive agencies that pose as nonprofits and more rigorously determine if an organization is in fact a nonprofit.

In 2004, the IRS's Credit Counseling Compliance Project began by identifying 63 of the largest tax-exempt organizations offering credit counseling and debt management programs. When reviewing a credit counseling agency, the IRS investigates whether the organization is primarily engaged in educational purposes consistent with 501(c)(3) tax-exempt status. For example, it looks at how an organization markets its services, interviews clients, develops recommendations and trains counselors to determine if its objective is to improve people's knowledge and skills to manage their personal debts.

According to a report by the Government Accountability Office, between January 2005 and March 2007 the IRS revoked or terminated the federal tax-exempt status of 19 credit counseling agencies and proposed revocations for an additional 28. The IRS reports that abuses included failing to provide education, operating as a commercial business and serving not the clients but the private interests of directors, officers and related entities. As the IRS continues to check for compliance, its criminal investigation division has accepted a number of referrals.

To prevent additional abusive credit counseling agencies from obtaining nonprofit tax-exempt status, the IRS now has a more stringent process for reviewing applications. In 2005 and 2006, it reviewed 110 applications and denied tax-exempt status to 30 of them. Another 58 applications did not receive tax-exempt status because they failed to answer questions raised or withdrew their applications. As of May 2006, only three credit counseling organizations had qualified as 501(c)(3) organizations.

A report on the IRS Credit Counseling Compliance Project, dated May 15, 2006, is available online at http://ftp.irs.gov/pub/irs-tege/cc_report.pdf PDF documentoff-site link.

To determine if a credit counseling agency is a nonprofit organization, go to http://apps.irs.gov/app/pub78 off-site link.

Bankruptcy Abuse Prevention and Consumer Protection Act

The Bankruptcy Act, which took effect in October 2005, fundamentally changed the consumer bankruptcy system.

  • It requires debtors to have a credit counseling session before they file for bankruptcy. The counseling agency analyzes the person's current financial condition and the factors that led to it and provides an individualized budget analysis and assistance in developing an appropriate action plan.
  • It requires those who have filed to take a more extensive financial literacy course that covers budgeting, money management, credit usage and consumer protection before they are discharged from bankruptcy.

The Bankruptcy Act set standards for credit counseling providers and charged the Justice Department's Trustee Program with establishing a formal certification process for consumer credit entities to provide pre- and postbankruptcy counseling. By October 2006, the program had certified 153 credit counseling agencies and 268 debtor education providers. A list of approved agencies is at www.usdoj.gov/ust/eo/bapcpa/ccde/index.htm off-site link.

The bankruptcy law requires credit counseling agencies to meet minimum requirements to ensure that they are qualified and to prevent abusive practices. They must:

  • be nonprofit organizations under state law. About 94 percent of certified credit counseling agencies have tax-exempt status under section 501(c)(3) of the Internal Revenue Code.
  • have an independent board of directors with the majority of members not benefiting financially from the outcome of the counseling services.
  • charge reasonable fees.
  • provide full disclosure about fees, debt management plans and other services.
  • provide trained counselors with adequate experience.
  • provide for the safekeeping and payment of clients' funds (if they enter a debt repayment plan), including auditing the trust accounts annually and bonding employees.
  • have adequate financial resources to provide continuing support over the life of any repayment plan.

More information on bankruptcy credit counseling is available in GAO-07-203, "Bankruptcy Reform: Value of Credit Counseling Requirement Is Not Clear," at www.gao.gov/new.items/d07203.pdf PDF documentoff-site link.

Industry Standards

Two organizations represent and provide standardization for nonprofit credit counseling organizations: the National Foundation for Credit Counseling off-site link and the Association of Independent Consumer Credit Counseling Agencies off-site link. Both are recognized for requiring high standards for their members, being accredited by the Council on Accreditation and publicizing their fees up front.

According to the leadership of both organizations, none of their members have had their nonprofit status revoked by the IRS. And Nick Jacobs, spokesperson for the NFCC, adds: "The increased scrutiny and attention paid by the IRS have significantly improved reliability [of credit counseling agencies] for consumers. It has helped distinguish between the good and bad actors."

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e-Perspectives, Volume 7, Issue 3, 2007

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The views expressed are the authors' and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System. Articles may be reprinted on the condition that the source is credited and a copy is provided to the Community Development Office.

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