A 'Perfect Storm' of Policy Decisions Threatens Personal Bankruptcy Laws

WASHINGTON – It may be the most frequently enacted legislation in America — that is, the law of unintended consequences.

This time, there are three separate policies in process of being enacted by Congress, the Internal Revenue Service (IRS), and state legislatures that combined, could result in the option of declaring personal bankruptcy being denied to Americans in most states just as personal debt and bankruptcy rates are reaching historic highs.

All three policies involve the credit counseling industry. Credit counseling agencies (CCAs), are typically nonprofit organizations which assist consumers overwhelmed by debt. In general, CCAs provide two services for consumers. One, they educate consumers about how to better manage their finances. And two, they set up debt management plans (DMPs) under which they receive payments from consumers and distribute those payments among their creditors. Often, by enrolling in a DMP, consumers receive concessions from their creditors such as lower interest rates, fee waivers and other benefits which make it easier for them to pay their bills.

The credit counseling industry was created decades ago by creditors who have initiated, funded and historically controlled a large number of agencies under the umbrella of the National Foundation for Credit Counseling. The goal of creditors in creating the NFCC has been to collect at-risk debt and avoid the losses that would result from having a debtor declare bankruptcy. In recent years, a number of independent, non-NFCC agencies have also come into existence.

The “perfect storm” scenario involves three areas of policymaking:

One: The IRS Has Begun A Potentially Widespread Rejection of CCAs’ “Nonprofit” Tax Status.

This past year, the IRS began tightening its scrutiny of the nonprofit tax status of credit counseling agencies. In some recently made public letters rejecting the nonprofit tax status of particular agencies the IRS makes it clear that it doesn’t buy the argument that using credit counseling to collect debts for creditors is a legitimate “nonprofit” activity, and could wipe out the “nonprofit” tax-exempt status of virtually the entire industry.

In the letters, the IRS essentially makes the case that the creditor funding and the creditor benefits of debt management plans (DMPs) effectively make credit counseling agencies debt collectors, not charities. The members of the largest credit counseling association, the National Foundation for Credit Counseling (NFCC), for example, collectively receive two-thirds of their funding from creditors. That funding, as determined by the IRS in these letters, is essentially payment for debt collection services, which it does not consider to be a tax-exempt activity.

If the principles spelled out in the IRS letter were applied industry- wide, it could have the effect of wiping out virtually the entire credit counseling industry. That’s because virtually the entire industry is composed of nonprofit, tax-exempt CCAs which rely heavily on creditor “fair share” funding provided in exchange for servicing DMPs.

Two: Congress Is Working on Bankruptcy Reform Legislation that Requires Consumers to Receive Credit Counseling Before Declaring Bankruptcy.

Bankruptcy reform bills that have previously advanced in Congress have included a mandate that consumers receive credit counseling before they can declare bankruptcy. With a new Congress reconvening next year, bankruptcy reform legislation could move forward again, and could include the credit counseling mandate.

Three: Most States Currently Mandate Credit Counseling Agencies To Be “Nonprofit.”

Currently, a majority of states have laws on the books that only allow nonprofits to provide credit counseling or debt management services, or otherwise prohibit taxpaying businesses and individuals from providing those services on a “for-profit” basis.

Potential Outcome: A “Perfect Storm” Effectively Outlaws Personal Bankruptcy in Most States.

These three separate actions by the IRS, Congress and state legislatures could create a “perfect storm” scenario where federal law prohibits individuals from declaring bankruptcy unless they receive credit counseling first, and the IRS strikes down the nonprofit tax status of the credit counseling industry, while most states prohibit anything but “nonprofit” credit counseling. That leaves consumers with no option for credit counseling, and hence, no option to declare bankruptcy.

A similar “storm” occurred in Oklahoma this past year, where legislation aimed at regulating payday loans required frequent payday loan consumers to receive credit counseling. The policy failed when the state’s largest CCCS agency refused to provide service to meet the demand of payday loan consumers. In the end, the Oklahoma legislature gave up on enforcement and repealed the credit counseling mandate.

The Coalition for Responsible Credit Practices (CRCP) believes policymakers and consumers should be aware of the potential combined impact of these policies. The Coalition believes these problems could be avoided if Congress creates national regulatory standards for the industry and opens the industry nationwide to taxpaying, for-profit financial professionals such as accountants, financial planners, estate planners, small businesses and others who can provide credit counseling on a for-profit basis.