CUs: The last of the mutuals

Credit unions stay true to founding principles while S&Ls lose their tax exemption in 1951

Credit unions' first official tax exemption came from a U.S. attorney general's opinion in 1917: "It appears that they are substantially identical with domestic building and loan associations or cooperative banks `organized and operated for mutual purposes and without pro fit' ...."

Why did credit unions retain their exemption when savings and loan (S&L) associations and mutual savings banks lost theirs in the Revenue Act of 1951? Essentially, because credit unions retained their mutual, not-for-profit status, while Congress said the S&Ls and mutual savings banks did not.

Aside from government efforts to increase revenue, most pressure for removing credit unions' federal income tax exemption comes from banks and thrift institutions. They argue that it's unfair competition for credit unions to be exempt from income taxes because they have to pay.

"Commercial banks used that argument for many years against the mutual savings banks, cooperative banks, and S&Ls. And it worked. Now they all direct the argument at credit unions," said attorney Donald J. Melvin in a 1981 study on credit unions' tax exemption.

Why did that argument work? Congress looked at the structure of mutual savings banks and found perpetual boards of trustees and depositors who were considered creditors with no ownership rights, such as being able to elect directors at open meetings.

When Congress looked at S&Ls in 1951, it found that investing members were simply depositors. In earlier days, S&Ls dealt only with members who bought shares in the association in order to borrow someday.

A 1951 Senate Finance Committee report states: "The mutuality argument assumes that, in the long run, the investments of each member are equal to the debts he has owed the organization. It also assumes that the membership in each organization is fixed and that eventually each member will receive a proportionate share of the accumulated earnings of the organization. These assumptions might have been valid for the original S&L associations which terminated after they had fulfilled their purposes for the original membership groups. They are not generally valid, however, for the present day associations, where investing members may never contemplate becoming borrowers and where the organizations are permanent and a member has no right to a share in the undistributed earnings upon withdrawal."

If it weren't for other differences between S&Ls and credit unions, that excerpt from the Senate Finance Committee report could present a dangerous precedent for credit unions. The early building and loan associations disbanded once each member had a home, and members split any remaining undistributed earnings. But S&Ls in 1951 had taken on lives of their own.

There were-and still are-several other key differences between S&Ls and credit unions. Credit unions are organized under cooperative, democratic principles that provide each member one vote, regardless of the amount of shares each one holds. By 1951, S&Ls were giving their depositors a number of votes corresponding to the number of shares they held. And many used proxy voting, which practically guaranteed management control. Some had converted to stock charters.

A Jan. 10, 1962, memo from CUNA Managing Director H. Vance Austin to Abe Dash at CUNA's Washington office points out the differences. Dash had told Austin that the S&Ls would be seeking CUNA's political support to defend S&Ls' tax status.

In reply, Austin wrote: "So far as [the mutual savings banks and S&Ls] are actually mutuals, we will do our darnedest to defend the nontaxability of the cooperative or mutual way of doing business. It is my understanding that most of the mutual savings banks are actually mutuals. But I am certain that many of the S&Ls are a long way from the mutuals that they all were originally, and that they still like to pretend that they are.

"As you know, many of the S&Ls are completely owned stock corporations,. and some owners are making a killing from operating them. The old Ben Franklin type was a mutual, and this is the image they still want the public as a whole to have of them. They were completely 'cooperative' so far as all income taxes were concerned, and as they have grown away from the cooperative manner of doing business, they have still held on to their nontax-paying status.

"Many people who understand all of the financial institutions are pointing out that they do not any longer belong to their members, but that they are actually profit corporations and should pay the profit income tax that goes with profits coming from doing business with other than the members!

"And, their threat that if they become taxed they will help put a tax on us doesn't frighten us a bitfor credit unions do business only with members, and whatever net margins there are go to the members in proportion to the business done by the members with the corporation [credit union] in the form of either dividends on the shares or patronage refunds on the interest paid. In other words, ours is still a "pure" status-the S&Ls are far from being pure, but still want the public [and particularly the lawmakers] to think of them as pure."

The S&Ls were seeking political allies to defend their tax status in 1962 because, although they lost their tax exemption in 1951, the tax formula essentially left them taxfree until 1962. "S&Ls were not subject to a tax liability on additions to bad debt reserves until such reserves reached 12% of their total savings account balances. Thus, in 1962, insured S&Ls paid out only $3.1 million in federal income taxes, or 0.4% of net income, while maintaining reserves and profits of $6.1 billion," according to the Melvin study.

The Revenue Act of 1962 changed the bad debt allowance to equal either 60% of taxable income or the amount needed to bring the reserve on real property to 3% of such loans. Most S&Ls used the 60% method. Then the Revenue Act of 1969 changed the 60% to 40% over a 10-year period. The result was that S&Ls would be subject to higher tax rates than banks, according to Melvin. He further notes the taxation of mutual savings banks paralleled that of S&Ls.

"There's an important lesson for credit unions here," says CUNA President/Chief Executive Officer Daniel A. Mica. "The lesson is not to cave in to some simple form of taxation for any reason, because once that happens, your tax rates can be increased."

CU exemption codified

When the S&Ls and mutual savings banks lost their exemption in 1951, state-chartered credit unions needed to get a specific exemption written into the Internal Revenue Code because their exemption was based on their similarity to entities that were now taxed. (Federal credit unions were exempt under the Federal Credit Union Act.)

The 1917 attorney general ruling served as the basis of state credit unions' tax exemption until the Revenue Act of 1951, which became the first tax act to mention credit unions. It provided a tax exemption to: "credit unions without capital stock organized and operated for mutual purposes and without profit."

Subsequent revenue rulings in 1969 and 1972 confirmed that credit unions must be operating in accordance with a state or federal credit union act to qualify for a tax exemption. The Tax Reform Act of 1969 levied an unrelated business income tax on state-chartered credit unions that grossed $1,000 or more a year from unrelated business. Federal credit unions remained exempt from this tax.

Rep. Noah Mason, R-Ill., introduced a bill in 1951 that would have repealed credit unions' tax exemption. Mason spent 15 years trying to tax credit unions and cooperatives. He was a champion of the National Tax Equality Association (NTEA). Ironically, NTEA was a tax-exempt organization. Its initial target was cooperatives. As donations began to wane, NTEA struck out at credit unions as well, picking up contributions from loan companies, according to H.B. Yates, CUNA's secretary in 1952.

CUNA and the leagues-the Illinois League in particularlaunched a campaign in 1951 that not only preserved credit unions' tax exemption, but also defeated a plan to make credit unions withhold income taxes from members' dividends. CUNA Managing Director Thomas W. Doig argued a credit union should not be taxed because:

1. It renders a social and economic service to the entire population without profit;

2. It's a voluntary association of citizens who unite to perform a public service;

3. It performs a service in a field that no existing agency desires to cover at the same price;

4. It's the only effective antidote for usury;

5. It operates for service-not for profit;

6. The income tax is based on the philosophy that income is profit. In this sense, a credit union has no income and should pay no tax.

Commercial banks discover consumer lending

There was relative peace among financial institutions in the 1930s and 1940s. Banks served businesses, S&Ls provided home loans, and credit unions offered consumer loans. When banks discovered installment lending, however, they found credit unions and S&Ls already in the market.

John O. Elmer, chair of the ABA's installment credit committee, spoke before the credit competition workshop at the 89th annual ABA convention in Washington, D.C., on Oct. 8, 1963. Elmer was senior vice president, Wells Fargo Bank, San Francisco.

Elmer's remarks explain the situation: "Commercial banks have a history of slow starts in installment lending, followed by the great surge of activity in the middle 1940s. Today, banks hold 40.2% of all consumer installment credit. The appeal of installment credit to commercial banks is largely twofold: These loans provide undeniably the highest gross return on the investment and appear to provide the highest net return.

"The transition of banking from an institution serving primarily commercial enterprise to one serving the general public is radical and far-reaching ... you get most of your new business from existing customers ... if you handle dealeroriginated business, you can bring customers into your bank.

"The people tended to be younger wage earners. Of very great importance to us is the fact that the first part of the wartime and postwar population explosion is just beginning to reach maturity and will create consumer credit demands far beyond present levels.

"Four competitive developments: First and most important is the continued growth of the credit union movement; second, expansion of captive finance and leasing companies in the automobile field; third, revolving credit charge accounts in retail stores; fourth, S&Ls' entry into consumer installment credit. The weakness of the captive companies is the tendency to overliberalize credit and terms for the direct purpose of achieving sales objectives. Catalog businesses now make mail order personal loans. The fourth, and very serious form of competition, is the growing demand of S&Ls for permission to enter the installment loan field. The potential of this competitive threat is, in my opinion, ultimately greater than that from credit unions."

So credit unions and S&Ls stood in banks' way. In 1951, there were almost 6,000 S&Ls, of which 93% were mutually owned. At the end of 1996, there were only 1,300 S&Ls, of which only 40% were mutually owned. And pending bank reform legislation could force the remaining S&Ls to convert to bank charters.

Once the S&Ls were taxed, bankers shifted their focus to credit unions, even though they were hardly a threat. In 1960, there were 20,000 credit unions, but together they held only $5 billion in savings, or an average $250,000 per credit union.

"Credit unions today are to commercial banking what the S&Ls were a generation ago. We must work, therefore, to limit the scope of credit union operations to their original purpose. In informing legislative sources, stress should be laid on limiting the definition of the common bond, on tax preferences accorded credit unions, and on the ability and willingness of commercial banks today to meet all the financial needs of the `little man,' " said Nat S. Rogers, president, Deposit Guaranty Bank & Trust Co., Jackson, Miss., at the 1963 ABA convention. Rogers was also a member of ABA's committee on credit unions.

The ABA tried to do just that by issuing its "Characteristics of Appropriate Common Bond." That definition would have discarded the community charter and limited credit unions' common bond to: "a) employment within an individual plant, office, or firm, or b) affiliation with a local religious or fraternal organization; in all cases coupled with an environment affording an opportunity for personal acquaintance and frequent personal relationship with each other."

ABA unleashed speakers to travel the country whipping local bankers into a frenzy over credit unions. Perhaps the biggest blowhard to hit the bankers' banquet circuit was Carl E. Bahmeier Jr., who in 1960 was with the South Dakota Bankers Association before becoming executive manager of the California Bankers Association.

Bahmeier spoke at the Montana Bankers Association convention in June 1960, saying: "Now, remember, these were the days in which your great-grandfathers were running banks and would no more make a loan on a personal basis than the man in the moon. If a person came in to ask for a personal loan, they would throw him literally and bodily out of the institution. This was the day and the era in which people borrowed money who were poor, who were workers, who were clerks, who were in the factories, and for their entire lives stayed in debt to the loan sharks.

"We asked for the competition of S&Ls, we asked for competition of credit unions, and when they get too big, then we come to the trade association secretaries, like Bob [Wallace of the Montana Bankers Association] and the ABA and say, `These guys are too powerful. Legislate them out.'

"Now, you let the credit union people get into the military, scattered all over the world, and second, you let them get into government employees, and they are going to have a built-in lobby that you people will never beat. This is their one goal."

On credit unions' effort to get payroll deduction for federal employees, Bahmeier said, "If they can get this through Congress-which will permit them to take their savings so it is automatic-then, brother, some of you fellows who have been playing golf at 2:30 in the afternoon are really going to work until 5 o'clock at night. I can tell you that ahead of time."

On support from the American Federation of Labor and Congress of Industrial Organizations (AFLCIO), Bahmeier said, "Walter Reuther the other day stood before a congressional committee and said, `We in labor believe that credit unions are essential to the growth of labor, and we will do everything in our power to defend, expand, and promote their activity.'

"Now don't sell these boys short. But in political action, I've had some dealing in Congress. The bankers look like Sunday school Baptists compared with the AFLCIO. These boys know the score. They know how to operate, and they've got the pressure and they know how to put it on and how to take it off. They've got a built-in gimmick. Business won't stand up to credit unions because they are scared to death of the labor reaction, so we just don't have this thing."

Quoting a history teacher, Bahmeier said, " `The greatest thing we ought to have in the world is a few high-class funerals.' Of course, I shudder to say this about a man who is my elder, but [Rep. Wright] Patman would be high on my list among those who would be in that category. Patman, the other day, got up in Congress. He talked for an hour and 20 minutes, and what was his concluding statement? His concluding statement was, `Gentlemen of the House, credit unions are the poor people's bank. Once you take that away from them, they'll never have a chance to live in this economic jungle.' What a bunch of poppycock!

"We know they are cooperative. We know they are a little bit on the Fabian socialism side. But we don't have any other understanding .... In the next five or six years, they will become so powerful, so politically potent, so politically active as with the S&Ls that you will never get legislation against them."

Bahmeier pointed out that: a) Banks didn't want to serve wage earners, and b) banks got the competition they deserved. As to credit unions' political clout, that was questionable.

CUNA and the U.S. Department of Agriculture announced a plan in 1963 to bring credit unions to unbanked rural communities. The ABA's committee on credit unions enlisted some members of Congress to pressure the secretary of agriculture to ditch the plan after it had been announced publicly. It worked. The ABA clearly demonstrated who had the most political clout.

CUs win share draft victory Credit unions throughout their history have had to fight to maintain their tax exemption and fight for each new power over bankers' objections. The big fight in the mid1970s was over share drafts. Credit unions needed a demand deposit account in an era when the government and private industry were promoting direct deposit of Social Security and government pension benefits and private payroll checks. Credit unions needed to provide members access to their money if they expected members to deposit benefits or payroll checks with them.

Because banks were the sole proprietors of noninterest-bearing demand deposit accounts, credit unions sought to draft from dividend-bearing accounts, hence the name share drafts. In other words, credit unions would offer the same transaction-and pay dividends.

When credit unions issued share drafts, banks refused to honor them. That led to court battles in at least half a dozen states, and the issue wasn't settled until credit unions received share draft authority in the Depository Institution's Deregulation and Monetary Control Act of 1980.

That battle is another example that the bankers' objective all along has been to stymie credit unions in any way they can.

"Looking back at the history of bank/credit union relations, any rational person might conclude that what the bankers have done is set a clear pattern to harass the credit union movement at every juncture," says CUNA President Mica.

Over the years, bankers have conveniently forgotten their own words. For instance, their positions on taxation and field of membership contradict each other. The ABA position on credit union field of membership is to restrict it to the narrowest possible definition. But on taxation, bankers argue credit unions should be taxed because the tax exemption benefits only those people privileged to be credit union members and not the general public.

"Credit unions offer special advantages to those privileged to belong, while denying the same advantages to equally deserving outsiders. It is, therefore, unfair to the public as well as to competing banks and other lending agencies to use taxpayers' money to subsidize credit unions," reads point No. 5 of a 1973 advertisement placed by the Bankers Committee to Eliminate Favoritism to Credit Unions.

Bankers also have a history of branding credit union volunteers and staff as unprofessional and questioning their ability to manage financial institutions. Yet when the Credit Union Executives Society formed in 1962 "to bring professional development to credit unions," Nat Rogers of the ABA's committee on credit unions observed, "Thus, preparation is under way for unlimited credit union deployment into the broad financial arena, a radical departure from the original principle of self-help by a group bound together by close personal association."

"For years, the ABA has criticized credit unions because they're operated by 'untrained' volunteers. Now they're criticizing credit unions for training volunteers and paid employees. Apparently, we can do no right either way we go," said CUNA Managing Director J. Orrin Shipe in response.

Next month: Multiple-group memberships was a policy born out of adversity-one of the worst recessions in modern times, during the early 1980s. With business closings and downsizings, NCUA interpreted the Federal Credit Union Act to permit multiple membership groups, each with its own common bond. The pragmatic interpretation stemmed credit union failures and protected the share insurance fund.

-Eugene Johnson is editor of credit union newsletters in CUNA's credit union and consumer publications department.

Copyright Credit Union National Association, Inc. Oct 1997
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