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Bellco Credit Union v. United States
Citations: 735 F. Supp. 2d 1286; 105 A.F.T.R.2d (RIA) 1778; 2010 U.S. Dist. LEXIS 33047; 2010 WL 1435352Docket: 1:08-mj-01071
Court: District Court, D. Colorado; April 2, 2010; Federal District Court
Bellco Credit Union is involved in a legal dispute with the United States regarding its obligation to pay unrelated business income tax (UBIT) on income generated from specific products and services: credit life and credit disability insurance, financial services, and accidental death and dismemberment insurance. The court previously ruled that Bellco was not liable for UBIT on income from financial services and that income from First Choice Credit Union, which Bellco merged with in 2003, is taxable. However, the court reserved judgment on the tax liability for the other two insurance products until trial. The trial, which began on December 7, 2009, focused on liability issues, and the court has now issued its findings of fact and conclusions of law. Bellco, organized under Colorado law, operates as a cooperative association aimed at promoting savings and providing low-interest credit to its members. It is owned by its members and does not have shareholders; profits are utilized to benefit members through higher deposit rates, lower loan rates, and additional services. As a credit union, Bellco must maintain at least seven percent of its assets in capital, which must be built from retained profits. Bellco is generally exempt from federal income tax under 26 U.S.C. 501(c)(14)(A) but is subject to UBIT on income from activities not substantially related to its exempt purposes, as defined in 26 U.S.C. 512-513. The litigation involves tax years 2000, 2001, and 2003, during which Bellco paid a total of $199,293 in taxes: $18,946 for 2000, $56,317 for 2001, and $124,030 for 2003. Bellco earned income from credit life and disability insurance and accidental death and dismemberment insurance. Specifically, for 2000, income included $551,048 from direct loans, $43,466 from indirect loans, $145,795 from CUILA profits, and $199,295 from accidental death and dismemberment insurance. Despite incurring tax liabilities during these years, Bellco did not file timely tax returns, believing its income was not taxable. It was only in 2007 that the IRS requested Bellco to file forms reporting unrelated business income tax (UBIT) for 2000-2005. Bellco complied, paid the taxes, and later submitted amended returns claiming that the income was not subject to UBIT, seeking a refund, which initiated the current litigation. Credit life insurance, offered by credit unions for nearly a century, pays off a loan balance upon the borrower’s death, while credit disability insurance covers loan payments if the borrower becomes disabled. These insurance products, collectively referred to as "Credit Insurance," have minimal underwriting requirements compared to typical insurance, do not require full health examinations, and are offered during the loan application process. The majority of Bellco's Credit Insurance income arises from a Direct Lending Program, where members authorize monthly premium collections based on a fixed rate per thousand dollars of the outstanding loan balance. Bellco shifted its Credit Insurance provider from CUNA Mutual Insurance Society to Minnesota Life in the early 1990s due to high loss ratios under the former, which prompted substantial increases in premium rates. Minnesota Life offered a lower rate and a training and support program that successfully increased sales of Credit Insurance, leading to improved profitability of the Direct Lending Program. Claims made by Bellco members were funded through these profits, resulting in lower insurance costs due to a broader risk pool. Bellco aimed to minimize costs, expand insurance coverage among borrowers, and achieve reasonable profits. After partnering with Minnesota Life, Bellco reduced premium rates and enhanced the benefits of its credit disability insurance, changing from a 30-day non-retroactive benefit to a 14-day retroactive benefit, which resulted in broader coverage and more generous payouts for members. Additionally, Bellco generated income through an Indirect Lending Program at automobile dealerships, allowing members to obtain loans directly at the dealership while maintaining the same interest rate as if applying through the credit union. This program was distinct from the Direct Lending Program, as dealership employees handled the sale of Credit Insurance. In the mid-1990s, Bellco and other credit unions established this program through agreements with dealerships, enforcing a restriction that prevented dealers from marking up loan rates. The program was initially managed by an auto brokerage firm, Aimbridge, but in 2003, the credit unions purchased it and established the Credit Union Indirect Lending Association (CUILA) to gain more control. Bellco holds approximately 38% ownership in CUILA, reflecting its historical participation in the Indirect Lending Program. CUILA selected Minnesota Life to provide insurance for indirect loans, similar to Bellco's Direct Lending Program. Colorado regulations mandated that automobile dealers offer Credit Insurance on indirect loans as a "single premium" product, requiring borrowers to make a lump sum payment at loan initiation, which was typically financed rather than paid out of pocket. This single premium approach resulted in higher costs compared to monthly declining premiums used in direct loans. Bellco earned a 4.5% commission on all Credit Insurance premiums from the Indirect Lending Program, with dealerships motivated primarily by profit. Bellco's income from Credit Insurance also included a distributive share of CUILA's profits, which comprised a 10% commission from selling Credit Insurance on indirect loans to members of affiliated credit unions. However, CUILA's main revenue sources were loan processing fees and potential investment income. Record-keeping issues from a computer system conversion obscured detailed income sources for 2000 and left around $50,000 of Credit Insurance income unaccounted for in 2001. Credit Insurance offers benefits to borrowers by providing peace of mind, ensuring debts are settled upon death or disability, and protecting assets from repossession. For credit unions, it mitigates the risk of loan defaults, thus preserving capital and avoiding the challenges of debt collection in unfortunate circumstances. Claims from Minnesota Life have amounted to hundreds of thousands of dollars over the years. Bellco was unable to quantify the fiscal benefits of its credit insurance at trial, as it could not determine how many loans would have defaulted without insurance coverage. Testimonies indicated that many delinquencies were due to non-insurable events such as job loss, illness, and divorce, rather than insurance coverage. In 2003, the payouts from credit insurance accounted for only 2% of total loan write-offs, totaling approximately $300,000. Anecdotal evidence supported the notion that credit insurance can provide real benefits, as illustrated by a member whose auto loan was paid off by insurance following her husband's death. In terms of premium rates and loss ratios, credit unions in Colorado, unlike other financial institutions, must maintain a loss ratio of 40% or higher. The prima facie rate for individual credit life insurance was set at $0.59 per $1,000 of coverage. Bellco charged a lower premium of $0.39 per $1,000, resulting in savings for its members compared to the prima facie rate. For joint policies, the premium was $0.62 per $1,000, and for credit disability insurance, it ranged from $1.15 to $1.29 per $1,000. Overall, Bellco's rates were among the lowest compared to other credit unions, demonstrating a competitive pricing strategy. Bellco maintained a loss ratio below the 40% threshold during the relevant tax years, with specific loss ratios for 2000 at 42% for credit life and 28% for credit disability, leading to a combined ratio of 33%. In 2001, the ratios were 56% for life, 27% for disability, and a combined 38%. By 2003, the ratios shifted to 41% life, 7% disability, and a combined ratio of 20%. The loss ratio, which compares claims paid to premiums collected, is calculated retrospectively due to the unpredictability of claims. Bellco's own loss ratios displayed significant variability post-litigation, reaching 62% in 2004 and as low as 6% in part of 2006. Adjustments to rates and benefits, such as changing from a 30-day non-retro benefit to a 14-day retro benefit, were implemented to maintain the loss ratio near the 40% requirement. Bellco's low premium rates were essential for compliance with this threshold. Additionally, Bellco considered transitioning to a "debt cancellation" product to avoid regulatory challenges associated with the 40% loss ratio, although they did not face any significant issues with the ratio itself. In terms of Accidental Death and Dismemberment Insurance (AD&D), Bellco provided a cash benefit for accidental death or dismemberment. The AD&D program was operated through Affinion Benefits Group, which Bellco worked with under standard marketing agreements that were not negotiated by Bellco. Affinion was responsible for directing the marketing strategy and covering all related costs as per their Joint Marketing Agreement established in 2002. Bellco's obligations under the agreement were initially portrayed as extensive, requiring the provision of necessary marketing information for a direct marketing strategy and coordination of mailings. However, testimony revealed that these responsibilities were more limited, primarily involving the supply of a member mailing list and the approval of marketing materials and mailing dates. The AD&D operation functioned as a "turn key operation," with Affinion handling the majority of the work. Affinion financed the marketing mailings, which included a letter signed by Bellco's CEO and bearing its logo, although Affinion's contact number was listed. Bellco also engaged in in-branch promotions using materials provided by Affinion, which were displayed concurrently with mailings. Before any solicitation, Bellco's employees reviewed and approved marketing materials to ensure brand consistency, as emphasized by testimonies from Bellco executives regarding the importance of maintaining their communication style. Lists of members for solicitation were created by Bellco based on criteria from Affinion, ensuring compliance with privacy regulations through a "basic scrub" to remove private information and exclude individuals on the "do not call" list. Bellco's privacy statement reinforced its commitment to controlling member information, supported by contracts signed with service providers for data processing, which Affinion financed despite the contracts being between Bellco and the providers. Members could opt into AD&D coverage by submitting forms included in the solicitation, with specific instructions for returning the forms to either Bellco or Affinion, depending on the coverage selected. Affinion processed member applications for insurance coverage, issuing certificates upon acceptance. Affinion handled claims for Accidental Death & Dismemberment (AD&D) insurance, while Bellco managed billing and collection of premiums quarterly through an Automated Clearing House (ACH) program, similar to other recurring payments. Bellco was responsible for identifying accounts with insufficient funds but did not issue "insufficient funds" notices, which were sent by Affinion. Although solicitation materials instructed members to contact Affinion, many viewed Bellco as their primary contact, leading Bellco to prepare its call center staff with information about the AD&D program. Call center employees provided only basic details and referred more complex inquiries to Affinion, confirming the legitimacy of the offers and basic coverage details. Bellco did not engage in actual sales or marketing of the AD&D product. Regarding time spent on the AD&D program, Bellco recorded 683 hours in 2003, but these records were not contemporaneous. Following an IRS notification in 2007 about re-calculating tax filings, Bellco reconstructed the time employees spent on various unrelated business income tax (UBIT) products, including AD&D, through manager surveys. The allocation of time was challenging, with Bellco estimating aggregate time spent on all UBIT products, ultimately dividing it equally among six products while half was attributed to member financial management. Of the total 683 hours recorded, 150 were attributed to Bellco executives, with an additional 17 hours for finance and accounting tasks, and 2 hours for reconciling ACH payment issues. Training for new employees on AD&D versus Credit Insurance accounted for 36 hours. The Bellco call center, which handled all member inquiries including those regarding AD&D, accounted for the majority of the hours at 480. Bellco received compensation for its involvement in the AD&D program through an "administrative allowance," calculated as a 30% commission on premiums from members who opted for coverage beyond the free $1,000. However, this amount was reduced by premiums owed for those who only selected the $1,000 coverage, resulting in a net payment. Additionally, Bellco earned a "marketing bonus" of $275,000 in installments as an incentive for renewing its exclusive contract with Affinion. The legal question centers on whether Bellco's income from Credit Insurance and AD&D is subject to Unrelated Business Income Tax (UBIT). The Revenue Act of 1950 established tax rules for income unrelated to a tax-exempt organization's primary purposes to prevent abuses by tax-exempt entities engaging in profit-making. Income can avoid UBIT if it is "substantially related" to the organization's purposes or categorized as "royalties." Bellco contends that its Credit Insurance income qualifies for UBIT exemption under the former criterion, while its AD&D income falls under the latter. As the taxpayer seeking a tax refund, Bellco carries the burden of proving its entitlement to such a refund. Credit life and disability insurance income is subject to Unrelated Business Income Tax (UBIT) under the Internal Revenue Code if it arises from an "unrelated trade or business," defined as activities not substantially related to an organization's charitable or educational purposes. The determination of taxability for Bellco's Credit Insurance income hinges on three criteria: (1) whether the activities constitute a trade or business, (2) whether these activities are regularly carried on, and (3) whether they are substantially related to Bellco's exempt purposes. While it is agreed that the activities are regularly conducted, the focus is on the "substantially related" aspect. The regulations stipulate that "substantially related" means a causal relationship between the business activities and the achievement of exempt purposes, with a significant contribution required. The assessment of this relationship varies based on specific facts and circumstances. Bellco’s tax-exempt purposes are identified as promoting thrift among its members and providing access to credit at fair rates. The Court examines whether Bellco's activities generating Credit Insurance income—specifically the Direct Lending Program, Indirect Lending Program, and CUILA profit sharing—significantly contribute to these identified goals. Bellco claims the Direct Lending Program aligns with both purposes, particularly emphasizing its connection to the lending function through the integration of Credit Insurance with loan terms. However, the Court expresses skepticism regarding the connection to lending, questioning how the insurance product’s relation to the loan terms facilitates making loans at favorable rates for members. Bellco argues that Credit Insurance reduces loan collection costs and protects its earnings and capital from "bad loans," thereby preserving capital and enabling the provision of more loans. However, the regulations prohibit claims that income is substantially related to exempt purposes simply based on its usage rather than the activity generating it. Bellco further contends that Credit Insurance aids the lending function by alleviating members' repayment burdens in cases of death or disability, an argument that is somewhat valid. Nonetheless, the Court concludes that Bellco has sufficiently demonstrated that Credit Insurance substantially promotes member thrift, defined as sound financial management. The insurance allows borrowers to protect their families and assets against unforeseen events, providing peace of mind for a marginal cost. Testimony from a member corroborated the value of this insurance in easing financial burdens after a spouse's death. Additionally, the insurance is conveniently offered alongside loans with less stringent eligibility criteria and lower premiums compared to other institutions. The Court finds that providing members with accessible insurance options contributes to careful financial management. The government's assertion that Credit Insurance is a "bad deal" based on a loss ratio below 40% and its claim that this indicates unnecessary sales is not persuasive. The Court argues that a low loss ratio simply reflects that the insurance was purchased by individuals who had not yet needed it, rather than being a definitive measure of promoting thrift. Bellco did not target individuals unlikely to make insurance claims to reduce its loss ratio, contrary to any claims made. Instead, evidence indicates a lack of stringent health assessments typical of other insurers, which could inflate premiums for higher-risk applicants. The loss ratio for Bellco fluctuated significantly between 2000 and 2006, ranging from 2% to 86%, suggesting that the lower loss ratios observed in certain years might not be indicative of a profit-maximizing strategy but rather statistical anomalies. The Court finds that a low loss ratio alone does not prove that Credit Insurance was unrelated to Bellco's thrift functions. The government argues that the low loss ratio implies Bellco could reduce premiums, thereby enhancing the thrift aspect of its insurance. However, the Court maintains that it cannot question Bellco's business decisions regarding pricing. While Bellco's customers paid less for Credit Insurance compared to other institutions, the fluctuation in loss ratios suggests prudent business judgment in maintaining premium levels to avoid future spikes. The government's argument, primarily supported by expert witness Birny Birnbaum, is weakened by his admission that he believed Credit Insurance could never promote thrift, undermining his claim of relative overpricing and casting doubt on the credibility of his assessment. The Court determined that Credit Insurance is significantly related to Bellco's thrift function, despite Bellco not reducing premium rates. The government contended that Bellco's Direct Lending Program aimed primarily at profit, disqualifying it from UBIT exemption. Bellco countered that cases concerning profit motives involve different tax-exempt entities and that profit motivation is irrelevant. Even if the "primary motivation" test were applicable, the Court found it unmet. Bellco acknowledged a profit motive to fund interest on deposits and provide affordable loans but provided evidence that profit was not the primary reason for offering Credit Insurance. Although Bellco switched insurance providers to enhance profitability, the decision was mainly to avoid premium increases and expand member access, not driven by profit. The government's claim about Minnesota Life managing loss ratios to meet a state minimum was rejected, as there was no evidence that Bellco aimed to limit loss ratios. The Court concluded that Bellco successfully demonstrated that its Credit Insurance supports its tax-exempt goal of promoting thrift, rendering the income from the Direct Lending Program exempt from UBIT. The Indirect Loans Credit Insurance operates similarly to that of the Direct Lending Program, promoting thrift by protecting assets and providing convenience to members. The government pointed out that the Indirect Lending Program's single premium product is costlier and that participating automobile dealerships are profit-driven. However, these distinctions did not persuade the Court that the Indirect Lending Program is not substantially related to Bellco's thrift function. Credit Insurance sold through the Indirect Lending Program, while potentially more expensive than that from the Direct Lending Program, was easily accessible to borrowers, providing them assurance that their families would not inherit unpaid loan debts in the event of death or disability. Although automobile dealers may have been motivated by profit, there is no evidence that this affected Bellco. Bellco, via CUILA, prohibited dealerships from marking up loan rates to extract additional profits. Consequently, the Court determined that the Credit Insurance was closely aligned with Bellco's thrift purpose. Bellco is seeking a refund of UBIT on income it reported as its share of CUILA's Credit Insurance profits. However, there was no substantial evidence presented at trial to confirm that this income specifically derived from Credit Insurance sales, as opposed to CUILA's other business activities. Testimony from Bellco’s CEO and director of finance indicated that the income information provided by a CUILA executive was unverified, and without clear evidence regarding the income calculations, the Court found Bellco did not meet its burden to justify the refund. In addition, Bellco's tax returns for 2000 and 2001 included unspecified income classified as Credit Insurance income, but a system conversion in early 2001 led to the loss of detailed records. The director acknowledged that other revenue streams might have been included in these figures, leading the Court to conclude that Bellco had not demonstrated this income's relation to its tax-exempt purposes. Regarding Accidental Death and Dismemberment (AD&D) insurance, Bellco did not assert that this insurance was related to its lending function. Instead, it argued that income from Affinion, which paid for the rights to use Bellco's name to solicit members, should be considered "royalties" exempt from UBIT under the Code. The term "royalties" is not defined in the Code, so the Court will rely on its ordinary meaning to determine its applicability to this situation. Both parties base their arguments on the Ninth Circuit's Sierra Club opinion, which analyzes the royalties issue. The term "royalties" is defined as payments to property owners for allowing the use of their property, typically a percentage of profits or a fixed amount per item sold. The key question is whether the income in question constitutes a royalty—generated from passively permitting use of intangible property like goodwill or customer lists—or payment for services rendered, which would render it taxable. The legal standard is not absolute; income from intangible products may not be classified as royalties if the provider actively marketed them. Minimal services do not automatically negate royalty status, and certain activities to protect or exploit intangibles do not alter the payment's nature. The critical assessment is whether the tax-exempt entity performed enough work to classify the income as royalties or too much work for it to be considered unrelated business income (UBIT). Congress aimed to prevent tax-exempt entities from unfairly competing with taxable corporations through UBIT, particularly in commercial ventures rather than passive royalties. The court notes that while it is difficult for charities to unfairly compete through royalties, competition could arise if income is primarily based on promotional services rather than the use of the charity's name. The court will evaluate Bellco's income from its AD. D program by considering all relevant facts and circumstances. The government argues that Bellco's substantial time investment (683 hours) indicates the income is for services rather than royalties. While this raises significant concerns, upon closer examination, much of Bellco’s effort was directed at maintaining its goodwill and protecting member privacy rather than actively promoting the program. The Court determined that Bellco's involvement with the Accidental Death and Dismemberment (AD&D) program was limited and primarily focused on protecting its intangible assets, thus classifying the income as royalties rather than taxable services. Although Bellco logged 480 hours at its call center responding to member inquiries about the AD&D program, this work was incidental and not part of the agreements with Affinion; the call center staff were directed to refer substantive questions to Affinion. Bellco's main activities included reviewing mailing materials and managing its mailing list to maintain member privacy, which further supported the classification of the income as royalties. The Court noted that Bellco's minimal involvement in ACH billing, which took only two hours, did not convert the income into taxable services. Consequently, the Court ruled that Affinion compensated Bellco for the use of its member lists and goodwill, not for administrative services. The findings led to the conclusion that Bellco is exempt from unrelated business income tax for its income from the Direct Lending Program, Indirect Lending Program, and royalties from the AD&D insurance for specified tax years. However, due to a lack of accurate income records, Bellco is liable for unrelated business income tax on its Credit Insurance income for 2000 and part of 2001. Plaintiff Bellco Credit Union is responsible for unrelated business income tax on its share of profits from CUILA. The Court mandates that the parties confer to determine the refund amount owed to Bellco, with a stipulation due within 60 days if an agreement is reached. If no agreement is made, Bellco must file a motion for judgment within the same timeframe, supported by affidavits and documentation for its refund request. The United States will respond within 21 days, and Bellco has 14 days to reply, after which the Court will assess the need for a further hearing. Key notes include: 1. Bellco's 2000 income from credit life and disability insurance is not itemized. 2. Certain witness testimonies, including Ms. Bedan's, lack specific page references due to non-ordering by counsel. 3. Minnesota Life reported aggregate loss ratios, not specific to Bellco, but aimed to maintain Bellco's loss ratio at or above 40%. 4. A "joint marketing agreement" was established to comply with federal privacy laws. 5. The government questions Ms. Arvizu's credibility due to her limited direct interaction with Bellco, but the Court finds her testimony credible regarding the program's structure. 6. Bellco's call center functions as its customer service center. 7. The Court aligns with the Community First Credit Union v. United States case, affirming that Credit Insurance supports thrift functions despite government arguments about pricing. 8. The government claims Bellco lacked evidence on the Indirect Lending Program's terms and loss ratios under Aimbridge, but the Court maintains that Credit Insurance is related to Bellco's thrift objective by providing asset protection and borrower benefits. 9. The call center is reiterated as Bellco's customer service department.