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Is Credit Union Tax Exemption an Unfair Advantage?

tax increase 2South Dakota has no individual or corporate income taxes. I’m quick to point this out to those unfortunate enough not to live in our fair state. Most recently I was reminded of this advantage when I calculated that a California client would pay 23.8% in federal capital gains taxes and another 13% in state capital gains tax, a total of 36.8%.

Unfortunately, my claim of South Dakota having no corporate income taxes is somewhat incorrect. If you choose to be in certain types of businesses, you do have to cough up a percentage of your net income to the state. Cleverly, we just don’t call these income taxes.

The first of these taxes is an “energy minerals severance tax” of 4.5%, imposed on the extraction (mining or drilling) of resources such as oil, coal, and uranium.

We also tax banks at the rate of 6%. This is called a “franchise tax,” and it only applies to banks.

Why are banks singled out? The official explanation is the bank franchise tax was a replacement in 1939 for what was termed to be a tax on money and credits. My guess is that it was an unspoken punishment on banks who were seen by some as the villains of the Great Depression. It started at 3% of net income. The legislature has increased it three times, most recently in 1979 to the current rate of 6%.

Not only do banks compete with one another for their share of deposits and loans, they also compete with credit unions. Unlike banks, credit unions don’t pay the South Dakota franchise tax.

Not only do credit unions not pay the South Dakota franchise tax, they also don’t pay any federal corporate income taxes, which are the highest in the world. A profitable South Dakota bank will pay over 40% of its income in state franchise and federal income taxes. A non-profit South Dakota credit union pays zero, nothing, nada. Clearly, this puts South Dakota banks at a competitive disadvantage.

Why such a discrepancy? In the beginning, credit unions served specific groups of people with limited means. The tax exemption was more of a charitable exemption, as credit unions were not for profit and didn’t offer the range of services that banks did. That has changed significantly. Today credit unions are open to broader groups of consumers. They offer a wide range of financial services and products, including commercial loans and investments, that compete directly with banks. In some towns the local credit union is larger than any commercial bank.

Not surprisingly, for many years the banking community has pushed for the end of the credit union tax exemption. President Obama’s 2014 budget estimated eliminating the exemption would raise an additional $2.2 billion.

Still, consumers love credit unions, where they often can earn a little more on savings accounts and CD’s and borrow at lower rates than at banks. If the tax exemption on credit unions is eliminated, most certainly customers will see lower earnings on deposits and higher rates on loans.

This is precisely the point the banks make: the tax exemption is nothing more than a government subsidy of their competitors. That was never the intent of the original legislation.

While the banks call for the elimination of the exemption, another option would be to eliminate the corporate income taxes on banks. South Dakota could lead the way by either eliminating the franchise tax on banks or implementing one on credit unions. As the differences between for-profit banks and nonprofit credit unions disappear, it makes sense for them to compete on a more level playing field.

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  1. Rick Kahler: Tax exemption favors credit unions over banks | Kahler … | Income Tax Guide - November 20, 2013

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