The IRS (notice how that spells the word “theirs”) has recently developed a new program to extract money from corporate taxpayers, which happens to include homeowners associations. This is an extension of the “Form 1099 Matching Program” successfully applied to individual taxpayers more than a decade ago. But now, corporations are the target. Not just YOUR association, but all corporations. It only feels like it’s your association, because you’re the one that received the notice from IRS. This is not really an IRS audit, but it does require your response. Two CPA firms that practice in the community association arena have reported receiving multiple notices.
Why is IRS doing this? Efficiency – the same reason that a business would use. The underlying concept is that rather than using expensive IRS Agents to verify income, the computer can do the work instead. Every time a bank issues a Form 1099 to report interest income, or a lessee issues a Form 1099 to report either rents paid or laundry room proceeds from your third-party concessionaire, that information is received (usually electronically) by the IRS. That allows them to cross check the recipient’s (YOUR Association) tax return to make sure that the income was fully reported and that the IRS has received all the tax it was due.
This Form 1099 matching program was wildly successful when it was applied to individual taxpayers. Turns out that our “voluntary” tax reporting system had a few people that “overlooked” some income. The IRS tax collections far exceeded the cost of the program. The reason it worked so well is that all individual taxpayers report on the calendar year, the same reporting period required for Form 1099. Also, individual taxpayers report income on the cash basis, so the reporting methodology also matches the Form 1099.
So, apparently, the IRS reasons that by extending this matching program to corporations, they will get the same result: more income and more taxes. IRS has just overlooked a couple of “minor” factors; (1) not all corporations operate on a calendar year basis, so in those cases the Forms 1099 will never match the tax return because of the difference in reporting periods, and (2) corporations are (generally) required to report income on the ACCRUAL basis (not cash), so the reporting methodology is also different.
Let’s look at a couple of real examples –
Example 1 – ABC Association operates on a calendar year (January 1 through December 31). Its reserve fund invests in a bank certificate of deposit (CD) for $200,000 for a one-year period, starting July 1st, which matures the following June 30. For simplicity, we’ll say that the bank is paying 1% interest, and that interest is paid only at maturity of the CD. So, on June 30 of year two, the Association receives $2,000. (That’s what we call “cash basis”.) The bank issues a Form 1099 in year two for $2,000, and files a copy with the IRS.
The Association, on the other hand, is an accrual basis taxpayer. During the financial statement audit, the CPA makes sure that interest income for the first six months of the CD term (that portion occurring in year one) is reported as accrued interest receivable (on the balance sheet) and interest income (on the income statement). (That’s what we call “accrual basis”.) The CPA then prepares the tax return based on the accrual-basis, audited financial statements. He reports the $1,000 of interest income “accrued” in year one. If this were the only “taxable” transaction, IRS is not going to have a problem with it. They don’t care if you over report income; if your association tax return contains more interest income than is reported on Form 1099, IRS just ignores it. So, in year one, you don’t have a problem with the IRS.
But in year two, the association again reports $1,000 of interest income on the accrual basis. However, the IRS now has a Form 1099 from your bank reporting $2,000 of interest income. The IRS computers don’t get a match and assume that you have under-reported interest income by $1,000, so they send you a notice – form letter “Notice CP 2030” which states:
“We have received additional information from third parties that changes the amount of your tax, deductions, and payments. As a result you owe $325 ($300 of tax, assuming you file Form 1120-H, plus $25 of interest), which you need to pay by DATE.”
What makes these notices even more fun is that you sometimes receive the notice after the due date, which makes it difficult to make a timely payment.
Sometimes the IRS will send you a notice which starts out by saying, “We noticed an error on your tax return.” As a tax preparer, that really bothers me, because in virtually every instance, the error is on the part of the IRS. Meanwhile, I have to explain to my client what really happened.
Example 2 – XYZ Association operates on a fiscal year that ends March 31. Using the same circumstances as described above, nine months of interest income is accrued in year one, and only three months in year two.
So, the IRS notice will report an even larger difference.
What should the Association do? If you feel comfortable in responding to this issue yourself, go ahead and do so, but there are dangers in this. For most associations, if you didn’t prepare the tax return, you may not have enough information to adequately respond to the notice. There is also the risk that if you get involved in a discussion with the IRS, the situation could degenerate into an expanded issue.
As an example, the IRS, in looking more closely at the tax return - since you’re now going to involve a real human being at IRS (question – do they have real human beings at IRS?) - may raise the issue of the deductions you’ve allocated against certain income sources. Do you know the tax law on this? On Form 1120-H, the test is that deductions must be “directly connected to” the production of income, while on Form 1120, a slight looser “reasonably related” test applies. Are you familiar with the Concord Consumers Housing Cooperative versus Commissioner Tax Court case, which specifies the types of deductions that can be applied against interest income? You may be short-changing yourself.
A better strategy is to contact your tax preparer and provide him or her with a copy of the IRS Notice CP 2030, copies of Forms 1099 received, and a copy of the tax return.
If you don’t have a paid tax preparer and think you need some help, check out the sponsors on this HOA Pulse site, or take a look in the business directory.
Expect to pay for this service. The tax preparer cannot control the IRS and will expend time in analyzing the issue and preparing a response.
Whatever you do, don’t ignore the notice. IRS does not just go away.
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Conversation overheard in an IRS office between two IRS Agents talking about a certain provision of the tax code:
“Just because you don’t understand it and I can’t explain it doesn’t mean we can’t enforce it.”
How exactly does that work?
