The law is clear that an association’s Board of Directors is responsible for the filing of the annual federal and State income tax returns, regardless of who actually prepares them. In addition, the law imposes a fiduciary duty on directors. As a result, Board members should take an active role in understanding the tax issues involved because a substantial overpayment or underpayment of an association’s income taxes could be construed as a breach of their fiduciary duty.
This memorandum deals with the taxation of community associations, including condominiums, homeowner associations, planned unit developments and similar type entities. These entities are characterized by multiple owners that are assessed maintenance fees used to cover the expenses of maintaining common elements. The general term for these types of entities is Common Interest Realty Associations (CIRA). CIRA’s are subject to different tax laws depending on the election made by management. This memorandum will explore these tax laws and the resulting tax issues facing community associations.
The primary purpose of a community association is to govern the affairs of and pay for the common expenses of the property. It is not intended to create a profit. However, most associations tend to create a “profit” in order to cover the normal operating expenses and provide for unknown contingencies.
Non-profit organizations pay little or no income taxes. A CIRA cannot qualify as a non-profit organization under Sec. 501(c)(3) of the Internal Revenue Code because they are not an educational, scientific, religious or charitable organization. Contributions to 501(c)(3) organizations are tax deductible.
Hawaii laws allow most community associations to incorporate under the Hawaii non-profit statutes. Typically, this is done to provide further liability protection to Board members who serve without compensation. The fact that a CIRA qualifies as a non-profit organization under Hawaii statutes has no bearing when it comes to the filing of federal and State income taxes.
All CIRA’s, including condominiums, have common area expenses. Assessments are collected from unit owners to pay for the common expenses of operating the CIRA. These common expenses are shared by the members of the community associations. Logically, it makes no sense for a community association to pay income taxes on any excess of revenues over expenses (i.e. “profit”).
However, most community associations also derive revenues from other sources, i.e. interest, rental income, laundry income, vending machines, etc. The net income from these ancillary revenue sources are always subject to income taxes.
Two Types of Income Tax Returns that Can be Filed by Community Associations
Each year the Board of Directors of community associations have to make a decision to file one of the following income tax returns:
- Form 1120-H, U.S. Income Tax Return for Homeowners Associations. In order to file this return, 80% of the living area of the project must be residential in nature, i.e. owner occupant or long-term lease. Filing Form 1120-H, includes the following characteristics:
- The filing of Form 1120-H is governed by the Internal Revenue Code Sec. 528.
- Revenues and expenses are split between “exempt function” and “non-exempt function” net income.
- Exempt function net income is gross receipts (i.e. member assessments, late fees, fines from house rule violations, rental income derived from unit owners and any other revenue sources that come from the unit owners), less the operating expenses of the common areas. Net exempt function income is not subject to income taxes.
- Non-exempt function net income is gross receipts (i.e. interest, rental income from non-unit owners, laundry income, vending machine income and any other revenue source that doesn’t come from unit owners), less the applicable direct expenses and is subject to income tax.
- Net non-exempt function income is subject to a flat tax rate of 30%, less a $100 deduction.
- Net losses cannot be carried back or carried forward.
- Revenue Ruling 70-604 is not applicable to the filing of Form 1120-H because net exempt function income is never taxed. However, it should be adopted each year in the event that it may be advantageous to file Form 1120.
- Form 1120, U.S. Corporation Income Taxes. Many community associations that do not qualify to file Form 1120-H have no choice but to file the corporate income tax return.
- The filing for Form 1120 for homeowner associations is governed by the Internal Revenue Code Sec. 277.
- Revenues and expenses are split between “membership” and “non-membership” net income.
- For all practical purposes, the terms, “exempt function income,” under the homeownership rules (Form 1120-H), and “membership income,” under the corporation rules (Form 1120) are interchangeable. However, membership income also includes fees paid for services by members that would be otherwise considered nonexempt function income under the 1120-H rules.
- For all practical purposes, the terms, “non-exempt function” and “non-membership” income are interchangeable.
- If it were not for the IRS Revenue Ruling 70-604, a community would have to pay income taxes on all of its net taxable income regardless of whether they were membership or non-membership income.
- Net losses can be carried back and/or carried forward.
IRS Revenue Ruling 70-604
- Rev. Ruling 70-604 states that: A condominium management corporation assesses its stockholder-owners for the purposes of managing, operating, maintaining, and replacing the common elements of the condominium property. This is the sole activity of the corporation and its by-laws do not authorize it to engage in any other activity. A meeting is held each year by the stockholder-owners of the corporation, at which they decide what is to be done with any excess assessments not actually used for the purposes described above, i.e., they decide either to return the excess to themselves or to have the excess applied against the following year’s assessments. Held, the excess assessments for the taxable year over and above the actual expenses paid or incurred for the purposes described above are not taxable income to the corporation, since such excess, in effect, has been returned to the stockholder-owners.
- The Revenue Ruling 70-604 only applies if an association files Form 1120.
- The purpose of Revenue Ruling 70-604 is to allow a homeowners association to avoid taxation on its excess membership income by either refunding it to members, or carrying over the excess to the following tax year.
- It is important to note that an association cannot make an election under Revenue Ruling 70-604 to transfer any excess net membership income to the replacements reserves as a capital contribution. The IRS position is based on the theory that, since funds were not earmarked for capital items through the budget, the original usage of the funds was not capital in nature. The IRS also holds that an organization may not change the nature of the intent for which the money was originally to be spent. In other words, a taxable event would occur if excess funds that are transferred from the operating account to the replacement reserve account.
Income Taxation of Community Associations
- Since non-exempt (Form 1120-H) and non-membership income (Form 1120) are always subject to income taxes, the issue is: Can the IRS tax net membership income even if the association adopts Revenue Ruling 70-604?
- The issues facing management on whether to file Form 1120-H or Form 1120 are complex and challenging. Generally, management should file the tax form that results in the least amount of tax liability. Sounds simple enough. However, the following discussion will point out the various issues that confront management:
- Many associations have excess net membership income each year. From a management perspective, this is a prudent and conservative course of action. Such excess funds provide a cushion against unexpected increases in budgeted expenses, minimize the need for special assessments and allow the association to earn interest that can help to defray expenses.
- The prevailing industry practice is to use the indefinite carryover of net membership income. For example, an association may have a net membership income of, say, $20,000 in the first year; $30,000 in the second year; and, $25,000 in the third year. This means that by the end of the third year, the association would have a total of $75,000 in operating reserves.
- Revenue Ruling 70-604 states, in part, that the association should “…have the excess applied to the following year’s assessments…” The IRS position is that the ruling uses the singular term “year’s” rather than the plural term “years’.” In addition, IRS General Counsel Memorandum 34613 clearly states that the carryover is a one-year only carryover. Further, Technical Advice Memorandum 9539001 indicates that Revenue Ruling 70-604 was intended to be a one-year only carryover.
- Several condominium associations on the mainland have been audited and substantial income taxes have been assessed because the association had excess net membership income each year for multiple years.
Taxation of Replacement ReservesTaxation of Replacement Reserves
Assessments for replacement reserves are never taxed even though substantial amounts may accumulate in them. This is because the IRS considers these assessments to be capital contributions.
Tax Planning for Associations with Excess Net Membership Income
- One approach is that associations that file Form 1120, with accumulated net membership income, and having adopted Revenue Ruling 70-604, should continue just as they have in the past. The chances of being audited are less than 1%. This is the prevailing industry norm.
- Another approach is to always file Form 1120-H. This means that the net exempt function income will never be taxed. However, the non-exempt function income will be taxed at a very high rate of 30%. The corporate rate starts at only 15% for the first $50,000 of net non-membership income. Some CPA’s and tax preparers take this conservative approach even though it may result in substantial tax liabilities for their client.
- A third approach is to alternate between filing Form 1120-H and Form 1120 each year. The reasoning is that any excess net membership income is automatically eliminated when filing Form 1120-H because this excess becomes exempt function income and is never taxed. However, this approach may be challenged by the IRS.
Conclusion and Recommendations
Non-exempt net income (Form 1120-H) and non-membership net income (Form 1120) will always be subject to income taxes. Thus, the decision is left to the Board to decide what type of tax return to file when dealing with the net profit from the exempt function income or the net profit from the membership income:
- Form 1120-H. Most residential type community associations will qualify to file this form. This is the most conservative and least likely to be audited. On the other hand, it will likely mean that more income taxes will be paid since the minimum rate is 30%;
- Form 1120. Associations that have a substantial vacation type rental program can only file this form. However, there are certain advantages to filing this form over the 1120-H. The income taxes may be substantially lower because of the lower corporate rates starting at 15% and current year losses may be carried back or forward.
- In order to avoid the IRS challenge that the rollover in Revenue Ruling 70-604, when used in conjunction with the filing of Form 1120, cannot exceed 1-year, we recommend that the estimated excess membership income be included as income, or treated as a deduction of expenses, on the subsequent year’s operating budget.
- The filing of Form 1120-H and Form 1120 is interchangeable from year to year.
- Revenue Ruling 70-604, must be adopted at each annual owners meeting. Although not required if filing Form 1120-H, it should still be adopted in case the association finds it more tax advantageous to file Form 1120.
Please feel free to contact us if you have any questions or comments concerning this article.
Prepared by Ronald A. Kawahara, CPA, CVA, CPM, PCAM
President, Destination Maui, Inc.
220 Imi Kala St., Suite 104
Wailuku, Maui, Hawaii 96761