Pulse Exclusives (119)

I'm Right and You're Not

Both sides are saying the same thing. I'm right and you're not. The issue doesn't even matter. Just watching the interactions is what makes this situation so sad. It didn't need to come to this, but each party felt the need to be right.

The association Board of Directors announced that it had decided to pursue a project. An interested homeowner with some knowledge on the subject began asking questions regarding the project based on his perception. His questions were ignored because those questions placed him at odds with the direction established by the Board of Directors. This particular homeowner is smart, clearly had some knowledge, and the questions he asked were legitimate. The board would have been far better off had they been willing to seriously listen to his questions in the months leading up to the vote. However, they did not, and worse yet, treated the homeowner disrespectfully by dismissing and ignoring his legitimate concerns. In retrospect, it is clear that the board simply could not comprehend a position that differed from their own, and they made no attempt to understand. They were locked into their position.   Had they listened they may have at least understood that there could be a legitimate alternate point of view.

As things progressed, the homeowner missed a couple of meetings and was unaware that the issue had now come up for a vote. Partially his fault, partially due to poor communications from the Board. The homeowner, realizing that, in his opinion, a bad decision was imminent, asked those questions again, in a more forceful manner, and in a public forum with far more people in attendance. He requested that further consideration be given to the matter. The homeowner was perceived by the Board as being late in asking questions on a matter they considered a done deal. But he had been asking questions for months, so his questions should not have surprised anybody.

But, the board was determined to move ahead, because they already had a plan. So again, they disrespected the homeowner by stating that discussion was closed and the vote would take place as scheduled. And the vote did take place, and the Board moved ahead with its plan because they had successfully stifled the dissent.

But this homeowner was really interested in the matter, and refused to let it drop. He now went out and performed his own research, the research that should have been done by the board. And he came up with some significantly different answers than those arrived at by the board. The homeowner knew that the board would refuse to hear any further discussion on this matter from him, particularly after they have already taken a vote and approved going ahead with the project. But, as a homeowner, this was partially his money, and his future, being decided by a board that hadn't done their job. So he took what he believed it to be the only course of action open to him, which was to publicly disclose his findings.

This disclosure finally forced the Board to address his written findings, and they had two effective options available to them; (1) they could recognize that his findings had value and were worthy of discussion, or (2) they could reject his findings outright and continue on the current path. The board decided to double down and take option number two, reject his findings and continue on the current path. If you’re counting, the Board has now effectively flipped this guy off three separate times.

It's easy to see why the board made this decision. Had they selected option number one it would have made the board look rather foolish or incompetent for failing to have discovered or considered these findings themselves. By selecting option two, they reinforce their own thought process and position and at the same time attempt to discredit the homeowner. The problem with this approach? When other homeowners read the findings, they realized that the homeowner who had done the research had really raised some significant legitimate issues, even if they did not agree completely with his findings. So now the board not only it looks foolish, but also stupid because they doubled down on a losing hand.

Human nature? Let's wait and see how this one plays out. It’s not done yet.

This series of events demonstrates two things the board did wrong. The first thing was failing to recognize that one of the problems that a board can sometimes encounter is lapsing into “groupthink,” which Wikipedia defines as “Groupthink is a psychological phenomenon that occurs within a group of people, in which the desire for harmony or conformity in the group results in an irrational or dysfunctional decision-making outcome. Group members try to minimize conflict and reach a consensus decision without critical evaluation of alternative viewpoints, by actively suppressing dissenting viewpoints, and by isolating themselves from outside influences.” That appears to pretty much describe what we saw above.

The second thing the board did wrong was to aggravate the situation by its callous treatment of one of its homeowner members. Had the board simply respectfully listened to the homeowner during the investigation phase, with an open mind, the situation could have turned out differently in a more harmonious atmosphere. Instead, we now see an entire community that is aligning themselves into one of the two camps, and a future battle brewing.

Being right isn't always the answer. Doing the right thing is the answer. Once the situation has deteriorated this far, it is difficult to get back on track, and may require different people (a different board) to resolve the situation. Suggestions anyone? Is there a way to salvage this situation?

A caller recently told me that his association had made an election under Revenue Ruling 70-604 to roll over the excess income to the subsequent year.  His issue was that the association did not then decrease the assessment for the next.  He believes the association is obligated to either decrease the assessment or refund the excess income to members.  He is an active member in his association and wants to make sure that the association is doing the right thing by its members.

I get at least a half dozen such phone calls per year.  As a CPA I received more tax questions related to Revenue Ruling 70-604 than for all other tax matters combined.  What I find as a common thread in all such calls is that the member really just wants to see his or her assessments decreased because they think they’re paying too much.  It’s frustrating for me to have to continually attempt to educate people that this is a tax issue, not an economic issue.  And, they already know what they believe, so don’t want to hear anything that doesn’t conform to their understanding of the issue.

So let me say it very bluntly.  Revenue Ruling 70-604 is a TAX election.  It has NOTHING to do with your association’s budget.

Let's discuss the basics, again, of Revenue Ruling 70-604.  That ruling allows an association that files Form 1120 to make election to either refund to the members or rollover to the subsequent year EXCESS MEMBER INCOME for the specific purpose of avoiding paying tax on that excess member income.  Please note that “excess member income” has a very specific definition under tax law, and does not necessarily correlate to “net income” for accounting purposes.  The tax definition has NOTHING to do with the accounting function or whether or not monies should be refunded or assessments decreased in the subsequent tax year.  Also, this ruling does not apply to an association that files form 1120-H.

The fact is, the Board of Directors does not have a crystal ball.  They can't know exactly how much money they're going to spend the next year.  In fact, they haven't even finished their current year, and they're putting a budget together for next year when they probably still have three months remaining in the current year.  They don’t know and are simply estimating where they’re going to end up for the current year.  Likewise, they are estimating expenditures for next year, and next year’s budget and the resulting assessment level are based on those estimated expenditure levels.

So, could the Board be wrong in their estimates?  That’s not even a question – they WILL be wrong in their estimates, the only question is how wrong – because they don’t have crystal ball.  When the Board of Directors is constructing next year’s budget, they will make an assumption regarding the amount of excess income (and remember that this is different than the tax definition of excess MEMBER income) for their current year.  That assumption could be one of three things:

1) - There will be an excess

(2 - There will be a deficit, or

(3 - Actual results will be a breakeven.  

For practical purposes, there is never a breakeven.  There will either be a surplus or a deficit.  And the board is trying to estimate what that amount will be for the current year.  Only one thing is certain, they won't get it exactly right, but hopefully they will be close.

The Board also has two other cash flow considerations as part of the budget process; working capital, and contingency expenses.  We usually recommend that an association should have the equivalent of one or two months operating expenditures on hand in the form of “working capital.”  This is money set aside just to make sure that there is always sufficient money to pay bills when they come due.  And that doesn’t consider the unknowns that attack every budget, the contingency expenses.  These are unforeseen expenditures that do pop up from time to time.  Many associations handle this by building a “contingency” expense line item into the budget.  But, if no such expenditure occurs, it means you have some excess income.

So, let’s come back to our interested member caller.  Let’s call him “Joe” for convenience.  Joe and other members have become aware that the board has made the TAX election under Revenue Ruling 70-604 and have interpreted it that excess net income exists for accounting purposes, must be rolled over to the subsequent budget year, and must result in a decrease in their assessment for next year.  Joe further indicated that assessments have gone up for three years in a row, and because an election was made, excess income must have existed in each of those three years, and that clearly the Board of Directors was doing something wrong and perhaps even something illegal.

It is not beyond the realm of possibility that assessments could go up each and every year, even while there is excess income.  Why would assessments go up?  Simply because expenditures keep increasing, every single year, due to inflation.  Everything costs more, vendors must raise their prices so they can cover their expenses.  Employees need raises so that they can cover their expenses, all the association's expenses are typically slightly higher from year to year because of inflation.  So the expectation is that assessments will go up year after year after year is reasonable.  But, while there is “excess” income?  That probably happens because of all the estimates involved in the budget process, trying to have adequate working capital, and making sure you can cover contingencies.  Also, that lack of that crystal ball.

This brings us back to Joe, who is expecting either a refund or at least a decreased assessment.  What are the possibilities?

If the association should end up with a deficit at the end of the current year, that almost always means we cannot expect a decrease in assessments for next year.  

If the association should magically end up with a breakeven for the current year, we can expect an increase in assessment for the next year just to counteract inflation, so we won't have a deficit next year.  

The third possibility is that the association has a surplus for the current year.  Does that automatically mean that we will have a decrease in assessments next year?  No.  If the surplus is equal to 1% of the budget, and we're expecting a 3% inflation next year than there would still have to be a 2% increase in assessments for next year just to stay even.  And that assumes we’re right about all of our assumptions (and we won’t be).

Let's try another example.  Your monthly expenditures are $100,000.  That means to be safe, you should have between 100,000 and 200,000 cash on hand at the end of the year as working capital.  If you do not have at least that much, you should not be considering a decrease in assessments.  One way to view that is to consider this as your minimum balance.  If you do have an adequate working capital amount on hand, and are planning your expenditures on a very tight budget, then you should also have a contingency amount.  How much should the contingency be 1% 2%?  Picked a number.

Most associations are either constricted by their own governing documents or by state statutes (nonprofit laws) to not operate at a profit.  On the other hand, the Board has a fiduciary obligation statutory in some states to levy assessments sufficient to cover the association’s anticipated expenditures, including setting aside an appropriate amount for reserves.  I always marvel when I see these two restrictions because those that created the statutes or governing documents seem to think that the Board of Directors DOES have a crystal ball and will be able to manage their assessments of expenditures to arrive at exactly $0 net income at the end of the year.  This also assumes that the association is magically be able to collect all of the next month's expenses on the first day of the next year or so that they will have sufficient money to pay their bills for that month.  These are great guidelines, but interpreted as literal are totally unrealistic language.  Every time I see this type of language, I want to say to these people join the real world.  Things don't always work out as planned.

So Joe, please look at the numbers for your association and tell me what your crystal ball says.  If you were on the Board would you be willing to decrease assessment for next year?  When you're operating on net margins as thin as 1%, can you take the risk that you are 99% right in all of your assumptions and take the risk that you may have to levy a special operating assessment just to get through next year?  If you're wise man, the answer is no.

 

Employment Practices Liability Insurance

If you manage or are a board member of an HOA with employees, consider reviewing the HOA’s insurance policies to make sure you and the HOA are covered should an employee ever sue or make a claim. Many insurance policies HOAs carry do not cover employment-related claims. HOAs who employ at least 15 employees are vulnerable to discrimination claims, and an HOA need employ only 1 employee to be subject to a sexual harassment or wage and hour claim.

Employment Practices Liability Insurance (EPLI) covers these and other types of employment related claims. If an employee (or ex-employee) makes such a claim or sues, EPLI may pay for the costs of defending the HOA, manager, and/or board members. EPLI may also help pay to settle claims or lawsuits.

Of course, like HOAs and the communities they serve, every insurance policy is different. We encourage HOAs with employees to work with us, their broker and their insurance carriers to address whether EPLI should be part of the HOA’s overall insurance package.

The information contained in this HOA Tip is for informational purposes only and is not specific legal advice or a substitute for specific legal counsel. Readers should not act upon this information without seeking professional counsel.

This article discusses an IRS rule change for associations seeking formal IRS recognition of their tax-exempt status.  The goal of obtaining exemption is to minimize tax risk and to get the most financial tax benefit in future year savings.  But, refunds can be claimed too.

 

When the IRS sends out its favorable determination letters they now generally use the date the association mails in its form as the effective date of recognition.   This started beginning in 2013 with a new rule in Rev. Proc. 2013-91.  IRS says this rule will not apply when the association meets a 27 month deadline.  This policy for filing within 27 months of formation is an IRS “invention” for non-501(c)(3) tax-exempts.  Organizations like these do not have to file for IRS approval to get exempt status.  This is similar to a rule for churches.

 

To explain, since the Tax Reform Act of 19692 gave us Code Section 508, the IRS has specific power to impose a filing deadline.  But as written, it is only about “charities”, which are organizations that get tax-deductible contributions as 501(c)(3) tax-exempt groups.  This is not the form of exempt status that associations can expect to get.

Restated, the IRS does not want to give written “recognition” of retroactive exempt status when that means looking back more than 27 months.  This is a new position that seems to revoke IRS policy dating back to the year 1962.  This can be important to HOAs that want a formal IRS letter to say the HOA is tax-exempt back to the time when it started.  One reason to get that formal letter is to support a tax refund claim.

 

For HOAs the exempt status is usually based on Code § 501(c)(4) as a “social welfare organization.”  This 2013 Revenue Procedure doesn’t mean an association can’t qualify as a section 501(c)(4) organization, or prevent it being self-declared for the pre-postmark period.  It just means the IRS does not want to rule on that time period.   This new position appears, at first reading, to put tax refund claims at risk to be denied.

 

The IRS holds and delays processing most applications.  The processing time is currently running approximately 18 months to two years.  Most applications are processed on a first come, first served basis.  And the backlog is very long.  So, when the IRS letter does come in it will have an effective date at least back to when the application got mailed in.  For refund rights, this means at least the IRS should refund taxes paid during the processing time.

 

So, to get refunds for the three open years without question we want the IRS letter to have the full recognition back to the date an association was organized.  Because that may not be in the letter approving recognition, it is allowable for a qualifying association.

 

There is also the prospect the IRS may seek to collect taxes owed for the period before the application is filed.  And again, that will not be right for a qualifying association.

                                               

Note also, the potential for triggering a change in status taxable gain on appreciated assets.  It might be argued by the IRS because of how the new in 1999 Treas. Reg. § 1.337(d)-4 is phrased to deal with a change in status from taxable to tax-exempt.  Also referred to as the General Utilities doctrine repeal part of the Tax Reform Act of 1986.

 

So, to keep from triggering a taxable gain (as if this were a change in status from taxable to tax-exempt because of how Treas. Reg. § 1.337(d)-4 might apply) we want the IRS letter to have the recognition back to the date an association was organized.  There are arguments based on standing IRS precedent for allowing fully retroactive recognition with the Form 1024.  

 

The association should consider wisdom of the association filing Form 1120-H before filing the Form 1024.  

 

Consider filing amended prior returns asserting the self-declared basis.  Plus disclose the self-declared status in the first Form 990 and final Form 1120 filed after the favorable IRS letter is issued.  A Board will be well advised to be prepared with precautions in the event the IRS might assert Treas. Reg. § 1.337(d)-4 to trigger taxable gain.  Then it can have a strategic plan beyond the scope of this brief note.

                                   

Discussions with the IRS staff that wrote Rev. Proc. 2013-9 inform the view that the new “requirement” does not mean that your association will not be respected as exempt before the pre-postmark period.  It just means that they do not want to rule on that.  The IRS may respect a private letter ruling request, and perhaps shorten time for final action.  Before filing that, an association Board will be well advised to engage a tax professional with experience in the area.  A more in-depth planning to do beyond the scope of this brief article.

 

Different offices of the IRS handle the private letter ruling request.  This is not the same office based in Cincinnati that receives the exempt status recognition applications.

 

Concepts of tax law have been referred to above in a manner to speed up reading.  Doing that, however, relies on the reader to bring more background knowledge than some may feel sure about.  So, feel free to open a line of contact.  Be sure of meanings before taking action.

 

email:  This email address is being protected from spambots. You need JavaScript enabled to view it.

 

Footnotes:

1    Discussed in June 2013 issue of HOAPulse.  See at:  

http://www.hoapulse.com/index.php/component/k2/item/11934-irs-exemption-letters-will-not-automatically-be-retroactive-for-slow-filing-501cs

2    More famous for setting private foundation rules, including a minimum charitable payout requirement and a 4-percent excise tax on net investment income.

 

Another Look at Fraud

Another Look at Fraud

In my professional career as an auditor of community associations I have been involved in the investigation of approximately 20 embezzlements (embezzlement being one form of fraud, the most common form in the community association industry) over the years.   Most frauds are not discovered by auditors, but are found based on internal reviews or tips from employees. Contrary to what many people believe, discovery of fraud is NOT the primary goal of an audit; the audit is intended to determine the (relative) accuracy of the association's financial statements.  CPAs performing audits have an obligation to consider the possibility that fraud may exist in the performance of our procedures.  

At the core  of any form of fraud are three underlying factors referred to as the "Fraud Triangle."

  • Incentive to commit fraud

  • Opportunity to carry out the fraudulent act

  • Ability to rationalize fraud

The incentive to commit fraud is normally caused by personal financial pressures that can't be relieved by ordinary, legitimate means.  Such pressures are often caused by divorce, health issues, bad investments, gambling, or addictions.

The opportunity to commit fraud exists where there are weaknesses in financial processes; internal controls over financial transactions.  

Rationalization of fraudulent activity takes place where an individual thinks they are justified in taking money because they are underpaid or under-appreciated,  or because it is for their family, or because it's just temporary and they intend to pay it back.

Exposure to fraud, or risk of fraud, differs depending on type of organizations and processes used.  

  1. Smaller, self- managed associations that depend on directors/members to process transactions have a higher degree of risk because there is usually no one reviewing the transactions.  The association is completely dependent on the honesty of the member.  Risk is reduced if an outside contractor performs some or all of the accounting function.

  2. Larger, self-managed associations that employ staff usually have the issue that no more than one or two people are involved in the accounting process, so there is little, if any, segregation of duties, which is one of the cornerstones of strong internal controls.  Use of outside lockbox and payroll services help reduce risk.

  3. Associations that employee an outside management company enjoy some level  of automatic protection against internal fraud risk.  Most management companies have a sufficient number of staff in their employ that they can achieve an adequate segregation of duties.  However, use of an outside management company exposes  the association to risk of fraud at the management company level.  Fortunately, that occurs very infrequently.

In all instances, the association should make sure that they have adequate insurance to mitigate losses.  Consult with your HOA insurance specialist, as different kinds of insurance policies may be required depending on which of the three categories above that you fall into.

Regular review of association financial statements by a knowledgeable board or finance committee member is another action that limits ability by anyone to divert funds.  Consistently late delivery of financial statements to the board or finance committee is another potential sign of problems.  Make sure that the association gets an annual audit or review of financial statements.  Even though those engagements are not specifically designed to detect fraud, discovery can occur during this process.

Weaknesses in internal financial controls cover a very wide range of activities, but there are a few generalizations that exist.  

Money can be diverted from either the billing/cash receipts cycle or the purchase/cash disbursements cycle of financial transactions.  One of the "tracks"  that perpetrators often leave are "journal entries" in the general ledger to cover up funds diverted.  Example - assessment payments received in the form of cash can be diverted, but a journal entry must be made to show the account as "paid" in the receivables listing.  Reviewing general ledger accounts for cash, assessments receivable, and accounts payable should normally not show any general journal entries, as all entries to these accounts should come from billing journals, cash receipts journals, purchase journals, or cash disbursement journals.  General journal entries in these accounts are a red flag.

Using an outside bank lockbox system is one of the best ways to reduce risk on the billings/cash receipts cycle of transactions, as it eliminates the most common methods of diverting funds.

Establishing a fake vendor, often with a name virtually identical to the name of a legitimate vendor, is one method perpetrators use to divert funds from the purchases/cash disbursements cycle.

The basic steps that an association or board member can take to protect themselves are:

  1. Never sign blank checks or checks payable to "cash"

  2. Control the blank check stock

  3. Require dual signatures on checks

  4. Demand and review monthly financial statements

  5. Review monthly bank statements and bank reconciliations

  6. Make sure you are familiar with all association vendors

  7. Segregate financial duties as much as possible amongst staff/members

  8. Use an outside collection service for delinquent assessments receivable

  9. Consider using a bank lockbox system for collecting assessments

  10. Consider using an outside payroll service

  11. Consider using a professional management company

  12. Maintain adequate D & O (Directors and Officers) and fidelity bond insurance

  13. Insist on an annual audit, which requires the auditor to document and understand your internal control system.  Such procedures are not required in a review of financial statements.

I've been asked many times to perform what is referred to as a forensic investigation where fraud is known or suspected.  It is possible to do, but be advised that such an investigation can, and usually does, cost many times more than a traditional financial statement audit.  The reason is that the normal  concept of "materiality" that is part of audit or review engagements does not exist in a forensic  investigation.  Instead, the investigator  must look at much lower levels of transactions than would be considered in a financial statement audit.

In addition, while a financial statement audit is relative predictable and can often be bid on a fixed fee basis, a forensic investigation is usually an hourly billing engagement, because you never know what you will encounter.  As an example, I was once engaged to perform an investigation that was discovered by the business owner.   He showed me what he discovered, but asked me to investigate further and determine the total losses.  We discovered five additional schemes used by the employee to divert funds, and the amount was quite large.

In summary, the best way to deal with fraud is to avoid it completely.  You do this by designing strong accounting controls where there are always checks and balances rather than reliance on a single individual, and review financial statements frequently using year to year and budget to actual comparisons to look for anomalies.  And, last but not least, request an annual audit or review of the association's financial statements.

 

Important New Book - Update on Reserve Standards

Reserve Studies – The Complete Guide was published in October 2015.  This book is the definitive guide on the topic of reserve studies.  More than 400 pages explaining the conceptual principles, and dozens of exhibits that show you exactly how the calculations are made.  If you prepare or use a reserve study, this guide is a “must have.”

The Generally Accepted Reserve Study Standards issued April 16, 2015 by the International Capital Budgeting Institute (ICBI) have been making waves in the community association industry.  Due to normal work pressures, I, as president of ICBI, only had time to send out about a dozen emails to select individuals regarding the new standards.  However, the professional standards page of the ICBI website had more than 650 “hits” as people visited the site to see the new standards within the first few days.  Turns out those few emails were forwarded around to lots of people.

Stay tuned for more news as these new reserve study standards are more fully distributed within the industry.  These standards resolve the biggest complaints about reserve studies by requiring a uniformity in format and consistency of calculations.

Reproduced below is the table of contents of Reserve Studies – The Complete Guide. 

To order, click here.

TOC image

To order, click here.

 

 

 

 

The International Capital Budgeting Institute (ICBI) announced the adoption of new professional reserve study standards effective April 16, 2015.  These standards, known as Generally Accepted Reserve Study Principles and Generally Accepted Reserve Study Standards, represent the culmination of a year-long effort by ICBI to provide standards for reliable, consistent reserve studies for the community association and timeshare industries.  These standards represent the biggest change in the reserve study process in twenty years and will result in better reliability and consistency of reporting in reserves.  

ICBI formed a team of 16 industry professionals from six countries for this process.  The ICBI standards committee included a broad spectrum of industry professionals that were able to provide a perspective reflecting all stakeholders in the industry.  These are truly global standards and are already being applied in several countries.

The primary differences of the new ICBI standards as compared to previously existing standards are best summarized in four broad categories:

1) A more comprehensive definition of components – The standards expand and clarify the definition of components to reflect the true maintenance responsibility of the association.  This results in greater consistency and reliability in reserve studies.

2) A more definitive description of service levels – ICBI provides for three service levels; independent study, reserve management plan (collaborating with the association), and consulting.     

                  

3) A requirement for consistent calculations – ICBI standards establish requirements for consistent calculation methods and software capable of making accurate calculations.  Standards also require consistent terminology definitions.      

                               

4) A consistent and uniform approach to reporting on reserve studies – ICBI standards require specific, consistent reporting formats on a summary basis, generally with a report of no more than 20 pages.  Supplemental schedules providing the detail are generally separated from the basic report.

The result to the public is a reliability and uniformity that benefits all users of reserve studies.

There are articles providing a more complete description of these standards in the Linkedin groups “Condo and HOA Finances” and “Condo and HOA Reserve Studies.”  Another financial related group is “Condo and HOA Taxes.”  All are open groups, but you have to be a member of Condo and HOA Finances before you can join the other two.

 

 

 

 

Review Governing Documents Before Entering Into a Contract

Whenever an association is renewing or entering into a new contract, there are many issues to consider.  With so much focus on finding the right company at a good price, it is easy to overlook the requirements that may exist in the declaration and bylaws.

 Some governing documents require that certain contracts be approved by the members or by a specific percentage of the board (such as 2/3 or 75%).  Other times, documents place limits on the length of term for a contract.  For example, an association’s bylaws may limit contracts to no more than one-year terms.  Such a requirement could impact many possible contracts, such as landscape contracts, management contracts, or security contracts.

 Governing documents may also require that contracts contain specific terms allowing for termination of the contract.  For example, the governing documents may require that the contract contain a provision stating that the contract can be terminated with 30 days’ notice.

 Finally, some governing documents contain specific requirements on who must sign the contract (such as the President and the Secretary).

 Associations should be mindful of these types of requirements and limitations in their governing documents so that, once the association finally finds the right company at the right price, the contract does not get challenged or invalidated over a technicality.  If your association has questions about contracts, please contact Lynn Krupnik at 480-922-9292.

Theinformation contained in thisHomeownersAssociationTip isfor informational purposesonly and isnot specific legaladviceor a substitutefor specificlegalcounsel.Readersshouldnot actupon thisinformation withoutseeking professionalcounsel.

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© Ekmark& Ekmark,L.L.C.2012.

 

Revenue Ruling 70-604 Carryovers

The recent articles on Revenue Ruling 70-604 generated a number of questions from readers. One of the questions related to how carryovers under Revenue Ruling 70-604 interact with member losses (excessive member expenses over member revenues) calculated under Code Section 277.

The Internal Revenue Service issued Revenue Ruling 2003-73 to explain this issue, providing four examples that illustrate the calculations. Simply stated, an association choosing to file Form 1120 can have only three possible outcomes as it relates to that member income:

  1. 1)The Association could have an excess of member income over member expenses, which generally is either refunded or rolled over to the following year under the provisions of Revenue Ruling 70-604. If the excess member income is not refunded or carried over to the subsequent year, it’s considered gross income under Code Section 61 and is added to taxable nonmember income.
  2. 2)It could have an excess of member deductions over member income under Code Section 277, which by law is required to be rolled over to the subsequent year. It may not be carried back, nor may it be used to offset nonmember income.
  3. 3)It could have exactly $0 net member income, though that outcome is virtually impossible.

The following table is reproduced from Revenue Ruling 2003 – 73.

 

Member Income

Nonmember Income

Taxable Income

Year 1

 

 

 

Income/(Loss) before loss carryover

(2,000)

4,000

 

Minus loss carried forward

0

0

 

Income/(loss)

(2,000)

4,000

4,000

Loss carryover

(2,000)

 

 

 

 

 

 

Year 2

 

 

 

Income/(Loss) before loss carryover

1,500

3,500

 

Minus loss carried forward

(2,000)

0

 

Income/(loss)

(500)

3,500

3,500

Loss carryover

(500)

 

 

 

 

 

 

Year 3

 

 

 

Income/(Loss) before loss carryover

2,250

3,000

 

Minus loss carried forward

(500)

0

 

Income/(loss)

1,750

3,000

4,750

Loss carryover

(0)

 

 

 

 

 

 

Year 4

 

 

 

Income/(Loss) before loss carryover

1,000

(1,500)

 

Minus loss carried forward

0

0

 

Income/(loss)

1,000

(1,500)

(500)

Loss carryover (IRC Section 172 loss)

(0)

(500)

 

 

Note that in Year 1, the member loss cannot be upset against the nonmember income, resulting in the full $4000 of nonmember income being reported as taxable.

In Year 2, the same situation exists in that after applying the member loss carryover from Year 1, there is still a net member loss in Year 2. That cannot be offset against nonmember income, so the $3,500 nonmember income stands alone as being taxable.

 

In Year 3, a different situation occurs. There is a net member income which is not fully offset by the member loss carryover from Year 2, thus resulting in a net member income in Year 3. This calculation assumes that no election has been made under Revenue Ruling 70-604, so net member income is added to nonmember income and the combined amount is taxable income. Had the Association made an appropriate election under Revenue Ruling 70-604 in Year 3, the net member income of $1,750 would have been either refunded or carried over to the subsequent year and would not be taxable in Year 3.

 

In Year 4, there is the unusual situation of a net member income of $1,000 and a net nonmember loss of $1,500. This is similar to Year 3 in that member income and nonmember income are both considered taxable and are combined. Please note, however, that member losses may not be offset against nonmember income.

 

In a subsequent article, we will address additional questions that were raised relating to Revenue Ruling 70-604.

 

The 2012 Syndrome and Reserve Funding

Most people have heard of the Mayan calendar that was created hundreds of years ago, even before the Americas were discovered by explorers. Of particular concern(once the calendars were deciphered) has been the prevailing interpretation of the Long Count calendar that some cataclysmic event would occur on December 21, 2012. Many believed this would be the end of the world.

December 21, 2012 is now behind us, and obviously the world did not end. Up until that date, however, many people were so convinced the world would end that they just refused to plan for any future beyond that date. Their attitude was, why plan for something in the future if you're not going to be here? There are others who believe that the year 2012 was simply misinterpreted, and that the end of the world is still relatively imminent.

This continued insistence that the world is going to end (soon) is nothing more than a convenient form of denial. It’s often referred to as the “2012 syndrome” since that date is so widely known, and since it was proven to be a false alarm. Those who suffer from the 2012 syndrome tend to use denial as an excuse for not taking action today. It doesn't really matter in what context this occurs. The person simply believes that there is no reason to plan because . . . (insert whatever reason you want here).

How does this concept apply to the community association world? We mostly see this in connection with reserve planning. Very few associations reach the 100% funded level, and many never even aspire to do so. We have performed reserve studies for many associations whose stated goal is to "reach 65% funded in 20 years." Some associations can get away with this by using the cash flow method of reserve funding to document that the association can get by with lower levels of reserve funding and still avoid special assessments. In one sense, there is nothing wrong with such a funding plan so long as members are fully advised to and supportive of this plan. However, it is not an "equitable" method of funding, as it means that the individuals "using up" the community components are not paying for the full use and enjoyment they are receiving - they're passing the buck to future owners.

On the other hand, too much reliance on the "percent funded" concept can also be a problem. The Association really needs to carefully conduct a cash flow analysis to make sure that enough funds will be available in "peak expenditure years." These are the years where multiple significant expenditures are scheduled to occur based on dates placed in service and estimated useful lives. As an example, if a condominium association has exterior painting, roofing, and paving projects all occurring at the same time, that would be considered a peak expenditure year. The only ways an association can accommodate the cash flow requirements for these kinds of years are to (1) build up the required cash flow in advance, (2) spread the projects out to fall on different years (although there is great danger in deferral of projects simply because they are inconvenient), and (3) borrow funds when needed and repay at a later date.

From experience I’ve learned that the "2012 crowd" is alive and well within the community association industry. These are the folks who don't want to fund reserves at all, or only at a very minimum amount. To be honest, I don't think most of these folks really believe that the world is about to end. I think they're just in denial that, for instance, the roof really needs to be replaced. After all, it has not been a problem for the last 20 years, so why should it be a problem now? Let somebody else worry about it. This kind of thinking affects association reserve funding plans by resulting in absolute minimum reserves being established and funded, and by necessary maintenance work being either deferred or funded by special assessments. This strategy might work on a relatively short-term basis, but is doomed to failure on a long-term basis.

Unfortunately, I believe the 2012 believers will always be with us. As for me, I have long been a skeptic of the 2012 theory. Think of it this way - you're creating a calendar consisting of future time periods. How far into the future do you take it? Until you run out of paper? Using a computer, you could theoretically run the calendar to any future period. However, the Mayans didn't have computers, nor did they have paper. They only had stone. I have always maintained that the Mayans simply ran out of stone, so they had no more room to continue - and after all, their calendar already looked hundreds of years into the future. Maybe they just didn't bother to get another stone.

Moral of the story? Don't be a denier. Carefully consider your association's future funding requirements and start setting aside an appropriate amount of money to fund those future expenditures.

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