Financial Institutions: Issues Regarding the Tax-Exempt Status of Credit Unions
Released: 2005-11-03T00:00:00

Letter

Background

Credit unions have historically occupied a unique niche among financial institutions. Credit unions differ from other depository institutions because they are (1) not-for-profit entities that build capital by retaining earnings (they do not issue capital stock), (2) member-owned cooperatives run by boards elected by the membership, and (3) tax- exempt. Like banks and thrifts, credit unions have either federal or state charters. Federal charters have been available since 1934, when the Federal Credit Union Act was passed. States have their own chartering requirements. As of December 2004, the federal government chartered about 62 percent of the slightly more than 9,000 credit unions and states chartered the remainder. Both federally and state-chartered credit unions are exempt from federal income taxes, with federally chartered and most state-chartered credit unions also exempt from state income and franchise taxes.

Another distinguishing feature of credit unions is that they may serve only an identifiable group of people with a common bond. More specifically, credit union membership may be based on one of three types of common bond: single, multiple, or community. For example, a group of people that share a single characteristic, such as a common profession, could constitute the “field of membership” for a single-bond credit union. Field of membership is used to describe all the individuals and groups, including organizations, which a credit union is permitted to accept for membership. More than one group having a common bond could constitute the membership of a multiple-bond credit union. And, persons or organizations within a well-defined community, neighborhood, or rural district could form a community-bond credit union. Further, credit unions can offer members additional services made available by third-party vendors and by certain profit-making entities with which they are associated, referred to as credit union service organizations (CUSO).

Rationale for the Historical Tax Exemption of Credit Unions

The tax-exempt status of credit unions originally was predicated on the similarity of credit unions and mutual financial institutions; however, while Congress did not always cite its reasons for continuing this exemption, recent legislation mentions the cooperative structure and service to persons of modest means as reasons for reaffirming their exempt status. The Revenue Act of 1913 exempted domestic building and loan associations (now called “savings and loans”), and mutual savings banks not having a capital stock represented by shares, from federal income tax. Further, the Revenue Act of 1916 exempted from taxation cooperative banks without capital stock organized and operated for mutual purposes and without profit. However, credit unions were not specifically exempted in either of these acts. Their tax-exempt status was addressed directly for the first time in 1917, when the U.S. Attorney General determined that credit unions closely resembled cooperative (mutual savings) banks and similar institutions that Congress had expressly exempted from taxation in 1913 and 1916.

The Federal Credit Union Act of 1934 authorized the chartering of federal credit unions. The stated purpose of the act was to “establish a further market for securities of the United States and to make more available to people of small means credit for provident purposes through a national system of cooperative credit, thereby helping to stabilize the credit structure of the United States.” The 1934 act did not specifically exempt federal credit unions from taxation. In 1937, the act was amended to exempt federal credit unions from federal tax and limit state taxation to taxes on real and tangible personal property. Two reasons were given for the exemption: (1) that credit unions are mutual or cooperative organizations operated entirely by and for their members; and (2) that taxing credit unions on their shares, much as banks are taxed on their capital shares, places a disproportionate and excessive burden on the credit unions because credit union shares function as deposits.

The Revenue Act of 1951 amended section 101(4) of the 1939 Internal Revenue Code to repeal the tax-exempt status for cooperative banks, savings and loan societies, and mutual savings banks, but it specifically provided for the tax exemption of state-chartered credit unions. While the act’s legislative history contains extensive discussion of the reasons why the tax-exempt status of the other mutual institutions was revoked, it is silent regarding why the tax exempt status of credit unions was not also revoked.

The Senate report accompanying the Revenue Act of 1951 stated that the exemption of mutual savings banks was repealed in order to establish parity between competing financial institutions. According to the Senate report, tax-exempt status gave mutual savings banks the advantage of being able to finance growth out of untaxed retained earnings, while competing corporations (commercial banks) paid tax on income retained by the corporation. The report stated that the exempt status of savings and loans was repealed on the same grounds. Moreover, it stated that savings and loan associations were no longer self-contained mutual organizations, for which membership implied significant investments over time, risk of loss, heavy penalties for cancellation of membership or early withdrawal of shares, and in which members invested in anticipation of becoming borrowers at some time. Instead, investing members were simply becoming depositors who received relatively fixed rates of return on deposits that were protected by large surplus accounts, and borrowing members dealt with savings and loans in the same way as other mortgage lending institutions.

Credit unions, unlike many other participants in the financial services market, are exempt from Federal and most State taxes because they are member-owned, democratically operated, not-for-profit organizations generally managed by volunteer boards of directors and because they have the specified mission of meeting the credit and savings needs of consumers, especially persons of modest means.

Arguments for and against Taxation of Credit Unions

At various times, the executive branch has proposed taxing credit unions, generally endorsing the creation of a “level playing field” among financial institutions in which organizations engaged in similar activities would be taxed similarly. Proponents of taxation contend that larger credit unions compete with banks in terms of the services they provide. Proponents also have questioned the extent that credit unions have remained true to their historical mission of providing financial services to persons of modest means. In response, opponents of the taxation of credit unions have argued that credit unions remain distinct organizationally and operationally from other financial institutions, providing their membership with services they would not receive from other institutions. Opponents also have argued that taxation would hinder the ability of credit unions to build capital (which is restricted to retained earnings), jeopardizing their safety and soundness. Finally, opponents have argued that other depository institutions, particularly smaller banks, also have opportunities for tax and regulatory relief such as S-corporation status. Some studies have attempted to quantify potential tax revenue from repealing the tax exemption, with estimates ranging from $1.2 billion to $3.1 billion, depending on the fiscal year considered, tax rates used, and other underlying assumptions.

Arguments for Taxation

Unlike income retained by most other financial institutions, income retained by credit unions is not taxed until it is distributed to members. Thus, tax exemption allows credit unions to utilize untaxed retained earnings to finance expansion of services. Proponents of taxing credit unions claim that this ability to use untaxed retained earnings provides credit unions with a competitive advantage over banks and thrifts. In 1978, the Carter administration proposed that the tax-exempt status of credit unions be gradually eliminated to mitigate this advantage and establish parity between credit unions and thrift institutions. The administration also argued that the relaxation of rules regarding field of membership criteria, the expansion of credit union powers, and the rising median income of credit union members indicated that credit unions were no longer true mutual institutions serving low-income workers excluded from banking services elsewhere.

In 1984, the Department of the Treasury (Treasury) report to the President included a proposal to repeal the tax exemption of credit unions, which also argued that the exemption gave credit unions a competitive advantage over other financial institutions and its repeal would “eliminate the incentive for credit unions to retain, rather than distribute, current earnings.” In 1985, the Reagan administration proposed taxing credit unions with more than $5 million in gross assets, but would have maintained the exemption on credit unions with less than $5 million of gross assets, since it was reasoned that taxing small credit unions would significantly increase the administrative burden for a relatively small revenue increase. Similarly, in the budget for fiscal year 1993 the first Bush administration proposed taxing credit unions with assets of more than $50 million.

More recent arguments for the taxation of credit unions note the strong growth rates among large credit unions, which tend to offer a wider array of services. As a result, taxation proponents argue that larger credit unions compete with banks in terms of the services they provide and the households to which they provide these services. They question both the extent to which credit unions serve people of modest means and pass on their tax subsidy to members. While limited data are available to evaluate the income of credit union members—which precludes any definitive conclusion— some studies, including one of our own, indicate that credit unions serve a slightly lower proportion of households with low and moderate incomes than banks. We discuss this issue in more detail later in this statement.

Arguments against Taxation

Arguments against repealing the tax exemption for credit unions assert that the exemption does not offer competitive advantages and that it is justified by the unique services credit unions offer and by their capital structure. As we reported in 1991, credit unions as organizations are exempt from federal and state income taxes. However, the income that their members receive is taxed. Members who receive dividends on share accounts are taxed on that income, just as depositors at commercial banks are taxed on interest income from savings or checking accounts. If credit unions distribute all income to shareholders and do not retain earnings at the entity level, all income will be taxed at the individual level. In this case, credit unions would have little tax advantage relative to taxable mutual financial institutions, whose income is taxed once at either the individual or entity level.

In 2005 and in previous testimonies, trade and industry groups and private individuals presented arguments supporting the tax-exempt status of credit unions, maintaining that tax-exempt status is justified because credit unions provide unique services, such as small loans, financial counseling, and low-cost checking accounts that for-profit financial institutions are unable or unwilling to provide. They stated that taxing credit unions would lead credit unions away from their mutual, nonprofit orientation and structure, leading to reductions in these types of services. They also testified that taxation would hinder credit unions in building reserves, and since credit unions do not have the ability to raise capital through the sale of stock, their safety and soundness would be jeopardized. They argued that while the number of large credit unions has grown over the last 10 years, they hold a relatively small share of overall depository institution assets. Opponents also argued that there is no clear rationale for targeting larger credit unions because, regardless of asset size, larger credit unions retain a distinct organizational structure and must still adhere to limits on their field of membership as sanctioned by Congress. Furthermore, they argued that larger credit unions, relative to smaller credit unions, were more stable and efficient and therefore better able to offer programs targeted to low- and moderate-income households.

Opponents of credit union taxation also have argued that other financial institutions are not without tax privileges and tax relief. Specifically, credit union trade organizations have pointed out that an increasing number of banks have converted to S-corporation status and, thereby, have avoided paying corporate income taxes. In general, U.S. tax law treats corporations and their investors as separate taxable entities. Corporate earnings are taxed first at the corporate level and again at the shareholder level, as dividends if the corporation distributes earnings to shareholders, or as capital gains from the sale of stock. In contrast, the earnings of S- corporations are taxed only once at the shareholder level, whether or not the income is distributed. Corporations that elect Subchapter S status are subject to certain restrictions on the number of shareholders and capital structure. For example, an S-corporation may not have more than 75 shareholders, all of whom must be U.S. resident individuals (except for certain trusts and estates) and may issue only one class of stock. Prior to 1996, banks and other depository institutions could not elect S-corporation status. A provision of the Small Business Job Protection Act of 1996 repealed this prohibition.

Like credit unions, mutual thrifts are owned by their depositors and their equity is derived from retained earnings. Mutual thrifts are permitted a tax deduction for amounts paid or credited to their depositors as dividends on their accounts if the amounts may be withdrawn on demand (subject only to the customary notice of intention to withdraw). These dividends are taxed only at the depositor level, whether they represent interest or a return on equity, so that mutual thrifts are taxed only on retained earnings. Further, some farmer’s cooperatives are allowed additional tax deductions for dividends on capital stock and distributions to patrons. The earnings of a cooperative generally flow through to the patron and are taxed once at that level. Finally, some other similar entities, like rural electric associations and telephone cooperatives are tax-exempt.

Estimates of the Potential Tax Revenues from Taxing Corporations Vary Widely Based on the Source and Underlying Assumptions

Governmental entities have attempted to estimate the potential revenue to the federal government from repealing the tax exemption that ranged from $1.2 billion to $1.6 billion on an annualized basis. In a 2001 report, the Department of the Treasury estimated potential revenue between $1.2 billion and $1.4 billion annualized over the five year period from 2000-2004, and $1.4 and $1.6 billion over the ten-year period from 2000 to 2009, if all credit unions were taxed. More recently, in Analytical Perspectives, Budget of the United States Government Fiscal Year 2005, Treasury estimated the potential tax revenue from repealing the credit union tax exemption at $7.88 billion from fiscal years 2005 through 2009, or $1.58 billion on average annually. However, according to Treasury officials, the 2005 Analytical Perspectives estimate did not account for any behavioral changes in response to taxation by credit unions in contrast with estimates from their earlier 2001 study. The Joint Committee on Taxation in a February 2005 Congressional Budget Office report estimated that taxing credit unions with assets greater than $10 million dollars would potentially raise $6.5 billion from fiscal years 2006 through 2010, or $1.3 billion on average annually over that five year period.

Nongovernmental entities have produced estimates that tend to be higher than the estimates generated by government agencies. A study issued by the Tax Foundation, which was funded by the Independent Community Bankers of America, estimated the potential revenue from taxing all insured credit unions to be as high as $3.1 billion per year when averaged over the 10-year period from 2004 to 2013. Another private study conducted by Chmura Economics & Analytics for the Jefferson Institute for Public Policy estimated the revenue from taxing all credit unions to be $1.89 billion in 2002, when the same corporate tax rate as banks paid was applied to credit unions (in categories differentiated by asset size). In reviewing these studies, we note that assumptions vary on the tax rates imposed and the response of credit unions to the imposition of taxes (such as distributing higher dividends, lowering loan rates, or increasing deposit rates, which would reduce taxable income and therefore potential tax revenue). However, large credit unions, though small in numbers, are responsible for a disproportionate amount of the potential tax revenue as compared with small credit unions.

Historical Distinctions between Credit Unions and Other Depository Institutions Have Continued to Blur

Since 1992, credit unions have become less distinct from other depository institutions of similar size, particularly in terms of the products and services offered by larger credit unions. Between 1992 and 2004, the total assets held by federally insured credit unions more than doubled, while the total number of federally insured credit unions declined. As a result of the increase in total assets and the decline in the number of federally insured credit unions, the credit union industry has seen an increase in the average size of its institutions and a slight increase in the concentration of assets. Total assets in federally insured credit unions grew from $258 billion in 1992 to $647 billion in 2004, an increase of 150 percent. During this same period the number of federally insured credit unions fell from 12,595 to 9,014. As of the end of 1992, credit unions with more than $100 million in assets represented 4 percent of all credit unions and 52 percent of total assets; as of the end of 2004, credit unions with more than $100 million in assets represented about 13 percent of all credit unions and 79 percent of total assets. From 1992 to 2004, the 50 largest credit unions (by asset size) went from holding around 18 percent of industry assets to around 24 percent of industry assets.

This industry consolidation contributed to a widening gap between two distinct groups of federally insured credit unions—larger credit unions, which are relatively few in number and provide a wider range of services, and smaller credit unions, which are greater in number and provide more basic banking services. Figure 1 illustrates institution size and asset distribution in the credit union industry, with institutions classified by asset ranges. As of December 31, 2004, the 2,873 smallest credit unions— those with $5 million or less in total assets—constituted almost one-third of all credit unions but slightly less than one percent of the industry’s total assets. Conversely, the 98 credit unions with assets over $1 billion (up to just under $23 billion) held 33 percent of total industry assets but represented just 1 percent of all credit unions. In our 2003 report, we noted that as of December 31, 2002, 71 credit unions with assets over $1 billion held 27 percent of total industry assets.

As credit unions’ assets have grown in recent years, credit unions have generally shifted to larger loans such as mortgages. Between 1992 and 2004, the amount of first mortgage loans held grew from $29 billion to $130 billion, while that of new vehicle loans increased from $29 billion to $71 billion and that of used vehicle loans increased from $17 billion to $85 billion. In terms of the relative importance of different loan types, we compared the growth in the amounts of various loan types relative to credit unions’ assets over the same period. Amounts held in first mortgage loans grew from around 11 percent of assets in 1992 to around 20 percent of assets in 2004, while amounts held in used vehicle loans grew from just under 7 percent to slightly more than 13 percent.

As shown in figure 2, larger credit unions generally held relatively larger loans (e.g., first mortgage loans) than smaller credit unions, which generally held relatively more small loans (e.g., used vehicle loans). Since 1992, the amount of first mortgage loans held relative to assets has more than doubled for credit unions with over $1 billion in assets, from around 12 percent to over 25 percent of assets, while it has grown less than 40 percent for credit unions with less than $100 million in assets, from around 9 percent to slightly more than 12 percent of assets.

The discrepancy between smaller and larger credit unions is more apparent through an analysis of more recently collected data on more sophisticated product and service offerings, such as the availability of automatic teller machines (ATM) and electronic banking (see table 1). While less than half of the smallest credit unions offered ATMs and one- third offered transactional websites, nearly all larger credit unions offered these services.

Despite the growth in credit union assets over recent years, the credit union industry remains much smaller than the banking industry, with credit unions representing around 6 percent of total assets of both industries. For example, at the end of 2004, the largest credit union had nearly $23 billion in assets, while the largest bank, with $967 billion in assets, was larger than the entire credit union industry combined.

Although credit unions are on average much smaller than banks, larger credit unions and banks of comparable size tend to offer the same products and services (see fig. 3). In particular, nearly all banks and larger credit unions reported holding first mortgage loans, while a majority of the smaller credit unions did not.

The Extent to Which Credit Unions Serve Persons of Modest Means Is Not Definitively Known because of Limited Data and Lack of Indicators

While credit union fields of membership have expanded, the extent to which they serve people or communities of low or moderate incomes is not definitively known. In 1998, CUMAA affirmed preexisting NCUA policies that had allowed credit unions to expand their field of membership and include underserved areas. After the legislation was passed, NCUA revised its regulations to enable credit unions to serve larger communities or geographic areas. As they have become larger and begun offering a wider variety of services, questions have been raised about whether credit unions are more likely than banks to serve households with low and moderate incomes. However, limited comprehensive data are available to evaluate the income of credit union members. Our assessment of available data —the Federal Reserve’s 2001 Survey of Consumer Finances (SCF) and other studies—provided some indication that, compared with banks, credit unions served a slightly lower proportion of households with low and moderate incomes. Although NCUA has undertaken initiatives to enhance the availability of financial services to individuals of modest means, as of October 15, 2005, it had not implemented our 2003 recommendation to develop indicators to evaluate the progress credit unions made in reaching the underserved.

Credit Unions Can Serve More People and Larger Areas because CUMAA Permitted NCUA to Continue Preexisting Policies That Expanded Field of Membership

In 1998, the Supreme Court ruled against NCUA’s practice of permitting federally chartered credit unions based on multiple bonds. Subsequently, Congress passed CUMAA, which specifically permits multiple-bond credit unions. The act permits these credit unions to retain their current membership and authorizes their future formation. Figure 4 provides additional information on the percent and assets of federally chartered credit unions by bond type. While multiple-bond credit unions have constituted on average slightly under 50 percent of all credit unions since 2000, they tend to be larger than the other two types of credit union bonds in terms of asset size. For example, at year-end 2004, multiple bond credit unions made up 45 percent of the total number of federal credit unions but represented 57 percent of federal credit union assets.

In addition to permitting multiple-bond credit unions, CUMAA further qualifies the definition of community bond. The act adds the word “local” to the preexisting requirement that community-based credit unions serve a “well-defined community, neighborhood or rural district,” but provides no guidance on how “local” or any other part of this requirement should be defined. However, after the passage of CUMAA, NCUA revised its regulations to make it easier for credit unions to serve increasingly larger areas (e.g., entire cities or counties). As a result, NCUA approved a community-based charter application in July 2005 covering Los Angeles County with a potential membership of 9.6 million.

Limited Comprehensive Data Are Available to Evaluate Income of Credit Union Members

While it has been generally accepted that credit unions historically have emphasized service to people with modest means; currently, there are no comprehensive data on the income characteristics of credit union members, particularly those who actually receive loans and other services. Industry groups and consumer advocates have debated which economic groups benefit from credit union services, especially in light of the credit unions’ exemption from federal income taxes. As stated in our 1991 report, and still true, none of the common-bond criteria available to federally chartered credit unions refer to the economic status of their members or potential members.

Information on the extent to which credit unions are lending and providing services to households with various incomes is scarce because NCUA, industry trade groups, and most states (with the exception of Massachusetts and Connecticut) have not collected specific information describing the income of credit union members who obtain loans or benefit from other credit union services. Credit unions—even those serving geographic areas—are not subject to the federal Community Reinvestment Act (CRA), which requires banking regulators to examine and rate banks and thrifts on lending and service to low- and moderate- income neighborhoods in their assessment area. Consequently, NCUA and most state regulators do not require credit unions to maintain data on the extent to which loans and other services are being provided to households with various incomes.

Federal Reserve Board Data Suggest That Credit Unions Serve a Slightly Lower Proportion of Low- and Moderate-Income Households Than Do Banks

Our prior work, which included an analysis of data from the Federal Reserve Board’s 2001 SCF, suggested that credit unions overall served a lower percentage of households of modest means (low- and moderate- income households combined) than banks. More specifically, while credit unions served a slightly higher percentage of moderate-income households than banks, they served a much lower percentage of low-income households. We combined the SCF data into two main groups— households that primarily and only used credit unions versus households that primarily and only used banks. As shown in figure 5, this analysis indicated that about 36 percent of households that primarily and only used credit unions had low or moderate incomes, compared to 42 percent of households that used banks. Moreover, our analysis suggested that a greater percentage of households that primarily and only used credit unions were in the middle and upper income grouping than the proportion of households that primarily and only used banks.

We also looked at each of the four income categories separately. As shown in figure 6, this analysis suggested that the percentage of households in the low-income category that used credit unions only and primarily (16 percent) was lower than the percentage of these households that used banks (26 percent). In contrast, more moderate- and middle-income households were likely to use credit unions only and primarily (41 percent) than banks (33 percent). Given that credit union membership traditionally has been tied to occupational- or employer-based fields of membership, that higher percentages of moderate- and middle-income households using credit unions is not surprising.

We also attempted to further explore the income distribution of credit unions members by separately analyzing households that only used credit unions or banks from those that primarily used credit unions or banks. However, the results were ambiguous and difficult to interpret, due to the characteristics of the households in the SCF database. For example, because such a high percent of the U.S. population only uses banks (62 percent), the data obtained from the SCF is particularly useful for describing characteristics of bank users but much less precise for describing smaller population groups, such as those that only used credit unions (8 percent).

Other relatively recent studies—notably, by the Credit Union National Association and the Woodstock Institute—generally concluded that credit unions served a somewhat higher-income population. The studies also noted that the higher income levels could be due to the full-time employment status of credit union members. Officials from NCUA and the Federal Reserve Board also noted that credit union members were likely to have higher incomes than nonmembers because credit unions are occupationally based. A National Federation of Community Development Credit Unions representative noted that because credit union membership is largely based on employment, relatively few credit unions are located in low-income communities. However, without additional research, especially on the extent to which credit unions with a community base serve all their potential members, it is difficult to know whether the relative importance of full-time employment is the primary explanatory factor.

NCUA Has Established Initiatives That Target Low-Income Individuals and Underserved Areas

NCUA recently has established two initiatives to further enhance the availability of financial services to individuals of modest means: the low- income credit union program and expansion into underserved areas. According to NCUA, its Low Income Credit Unions (LICU) program is designed to assist credit unions whose members are of modest means in obtaining technical and financial services. LICUs grew in number from more than 600 in 2000 to nearly 1,000 by the end of 2004. To obtain a low- income designation from NCUA, an existing credit union must establish that a majority of its members meet the low-income definition. According to NCUA, credit unions that meet this criterion are presumed to be serving predominantly low-income members. Also, newly chartered credit unions can receive low-income designation based on the income characteristics of potential members.

Credit unions that receive a low-income designation from NCUA are measured against the same standards of safety and soundness as other credit unions. However, NCUA grants benefits that other credit unions do not have, including: greater authority to accept deposits from nonmembers such as voluntary health and welfare organizations; access to low-interest loans, deposits, and technical assistance through participation in NCUA’s Community Development Revolving Loan Fund; ability to offer uninsured secondary capital accounts and include these accounts in the credit union’s net worth for the purposes of meeting its regulatory capital requirements; and a waiver of the aggregate loan limit for member business loans.

NCUA has stated that one of its goals is to encourage the expansion of membership and make quality credit union services available to all eligible persons. It has done so in part by allowing credit unions to expand into underserved areas in recent years, from 40 in 2000 to 564 in 2004 (see fig. 7).

CUMAA and NCUA’s Interpretive Ruling and Policy Statement (IRPS) 03-1, the Chartering and Field of Membership Manual, allows credit unions to include in their fields of membership, without regard to location, communities in underserved areas. The Federal Credit Union Act defines an underserved area as a local community, neighborhood, or rural district that is an “investment area” as defined by the Community Development Banking and Financial Institutions Act of 1994—that is, experiencing poverty, low income, or unemployment. In order to expand into an underserved area, credit unions must receive approval from NCUA by demonstrating that a community qualifies as an investment area. Credit unions must also provide a business plan describing how the underserved community will be served. Finally, although the underserved and LICU initiatives are intended to help serve the underserved, NCUA does not collect data such as overall income levels of individuals using specific credit union products.

NCUA Has Not Fully Implemented Our Recommendation to Develop Indicators to Evaluate Credit Union Progress in Reaching the Underserved

Although NCUA has targeted underserved individuals and areas, in our 2003 report on credit unions we found that NCUA had data on potential— but not actual—membership of low- and moderate-income individuals in underserved areas adopted by credit unions. We recommended that NCUA use tangible indicators, other than potential membership, to determine whether credit unions have provided greater access to credit union services in underserved areas.

As of October 15, 2005, NCUA had not adopted any indicators. According to NCUA, it has established a working group to study credit union success in reaching people of modest means. NCUA indicated that the working group was exploring meaningful measures of success for this objective, determining how to best quantify the measures with available or readily obtainable data. The working group has also been evaluating the impact of other regulations, such as the Privacy of Consumer Financial Information, on the collection and use of such data. According to NCUA officials, as of October 15, 2005, the working group had not issued its report or recommendations.

Credit Unions Lack Transparency on Executive Compensation and Larger Credit Unions Do Not Have to Report on Effectiveness of Internal Controls

Most credit unions are not subject to IRS and other federal reporting requirements that would disclose information such as executive compensation and assessments of internal controls for financial reporting—information that can enhance public confidence in tax-exempt entities. Public availability of key financial information (that is, transparency) can provide incentives for ethical and effective operations as well as support oversight of the tax-exempt entities. At the same time, the disclosure of such information helps to achieve and maintain public trust.

Recognizing the importance of transparency for tax-exempt entities, Congress made returns of the IRS Form 990 (Return of Organizations Exempt from Income Tax) into publicly available documents. Since tax exemptions are granted to entities so that they can carry out particular missions or activities that Congress judges to be of special value, the public availability of Form 990 promotes public oversight. Most tax- exempt organizations, other than private foundations with gross receipts of $25,000 or more, are required to file Form 990 annually. The form contains information on an organization’s income, expenditures, and “activities” including compensation information for officers, directors, trustees, and key employees. IRS also uses these forms to select organizations for examination.

However, most credit unions do not individually file Form 990. In 2002 and 2003, credit unions filed 1,435 and 1,389 Form 990s, respectively. On August 23, 1988, IRS issued a determination that annually filing Form 990 was not required for federal credit unions because of their status as tax- exempt organizations under section 501(c)(1) of the Internal Revenue Code. Depending on the state, some state-chartered credit unions file through a group filing process. For these states, IRS receives only the names and addresses of individual credit unions. As a result, scrutiny of the compensation of credit union executives and other key personnel is difficult. As you are aware, we have ongoing work in this and other areas, and we hope to provide you with additional information on the compensation of credit union executives and officials as part of this follow-up work.

As noted in our 2003 report, the Federal Credit Union Act, as amended, requires credit unions with assets over $500 million to obtain an annual independent audit of financial statements by an independent certified public accountant. But, unlike banks and thrifts, these credit unions are not required to report on the effectiveness of their internal controls for financial reporting. Under FDICIA and its implementing regulations, banks and thrifts with assets over $500 million are required to prepare an annual management report that contains: a statement of management’s responsibility for preparing the institution’s annual financial statements, for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and for complying with designated laws and regulations relating to safety and soundness; and management’s assessment of the effectiveness of the institution’s internal control structure and procedures for financial reporting as of the end of the fiscal year and the institution’s compliance with the designated safety and soundness laws and regulations during the fiscal year.

Additionally, the institution’s independent accountants are required to attest to management’s assertions concerning the effectiveness of the institution’s internal control structure and procedures for financial reporting. The institution’s management report and the accountant’s attestation report must be filed with the institution’s primary federal regulator and any appropriate state depository institution supervisor, and must be available for public inspection.

The reports, with their assessments and attestations on internal controls, allow depository institution regulators to gain increased assurance about the reliability of financial reporting. Also as we stated in our 2003 report, the extension of the internal control reporting requirement to credit unions with assets over $500 million could provide NCUA with an additional tool to assess the reliability of internal controls over financial reporting.

Moreover, bank and thrift reporting requirements under FDICIA are similar to the public company reporting requirements in the Sarbanes- Oxley Act of 2002. Under Sarbanes-Oxley, public companies are required to establish and maintain adequate internal control structures and procedures for financial reporting; the company’s auditor is also required to attest to, and report on, the assessment made by company management on the effectiveness of internal controls. As a result of FDICIA and the Sarbanes-Oxley Act, reports on management’s assessment of the effectiveness of internal controls over financial reporting and the independent auditor’s attestation on management’s assessment have become normal business practice for financial institutions and businesses.

In a letter dated October 2003, NCUA’s Chairman stated that while the Sarbanes-Oxley Act does not apply specifically to federal credit unions, certain provisions may be appropriate to consider for some federal credit unions. Federal credit unions are encouraged (but not required) to consider the guidance provided and are urged to periodically review their policies and procedures as they relate to matters of corporate governance and auditing.

Mr. Chairman, this concludes my prepared statement. I would be pleased to respond to any questions you or other Members of the committee may have.

Contact and Acknowledgments

For further information regarding this testimony, please contact Richard Hillman at (202 512-8678) or hillmanr@gao.gov. Individuals making key contributions to this testimony include Janet Fong, May Lee, John Lord, Harry Medina, Jasminee Persaud, Barbara Roesmann, and Richard Vagnoni.

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