We keep thinking that the issue of filing Association tax returns is so well-settled and well-documented by numerous articles on the subject that we shouldn't have to address it again. But apparently we were wrong. The answer is YES, Associations do have to file income tax returns. Failing to file tax returns caused the Association in this article major problems.
Why are we looking at this again? We were recently contacted by an Association that had not filed tax returns for a five-year period. The newly appointed treasurer wondered why. He asked the prior treasurer, who told him that since the Association did not have any taxable interest income in excess of $100, he had been advised that there was no need to file income tax returns. Bad advice.
This small, 15-unit condominium project located in California is a volunteer-run Association. They felt that because of their small size, professional management services were too expensive. Apparently they felt the same way about tax and legal services, as they did not consult with outside professionals for either of these services. Clearly this was a case of penny wise and pound foolish. The added fact that this is a California association just makes the problem worse.
An association is always required to file a federal tax return, even if they have no taxable income at all. Federal tax rules (for most associations) are that the Association can either elect to file Form 1120-H (assuming they meet the qualification requirements), or Form 1120 if they do not elect to file Form 1120-H. We routinely advise associations to file Form 1120-H to avoid the tax risks inherent in Form 1120.
Because Form 1120-H is a simple, one-page form, many associations just have the treasurer prepare it. The simplicity of the form was intentional when Congress created the tax law, so that associations could easily comply. The lack of professional advice, however, means that many associations could be making poor decisions in selecting which tax form to file. There are times when Form 1120 is clearly advantageous, and tax risk can be minimized.
The federal tax issues related to five years of delinquent tax returns are fairly straightforward. One simply needs to prepare and file the delinquent returns. The problem is that Form 1120-H can only be elected on a timely-filed return. Since the tax returns in this case are all delinquent, the Association is technically required to instead file Form 1120. Form 1120 is a much more complex form, and also exposes the Association to taxation of excess member assessment, which would not have been taxable on Form 1120-H.
The treasurer had visited the local IRS office and explained the situation. He was provided with Forms 1120-H for all five years. His question to uswas which form to file. In this circumstance (which we encounter several times annually), most associations will file the Form 1120-H, even though technically they are not allowed to do so, since they did not make a timely election. It is interesting to note that we have never seen IRS reject the Forms 1120-H, even when it was brought to their attention that the forms were not timely filed. In a rare example of common sense, IRS has apparently realized that simply getting the tax returns filed and up-to-date is most important, and that there is likely no tax going uncollected by allowing Form 1120-H rather than insisting on Form 1120.
For our California association, the federal taxes were the easy part. It was California that caused the problems. This Association had applied for and was granted California tax exemption as a homeowners’ association in the early years of its existence. That means that the Association was required to file two tax forms annually for California: Form 199 to comply with the exempt organization rules, and Form 100 to report taxable activities.
The Association's failure to file tax returns for five years caused two things to happen. First, their exempt status was revoked. Second, their Association's corporate status was suspended.
The revocation of exempt status meant that the Association was now subject to the California minimum corporate tax of $800 annually. (For those of you counting, five years amounts to $4,000 in taxes, plus penalties and interest). Overcoming this issue required re-filing for exemption by preparing a new exemption application and submitting all the delinquent tax returns for the five-year period. it was fairly easy to resolve, but expensive.
The biggest issue was the suspension of corporate status. That meant that legally, in the eyes of the state of California, the corporation no longer existed. That became a huge problem because the Association had entered into a contract for roofing and was having difficulty with the contractor. That's when the Association finally consulted with a lawyer and discovered the suspension. The attorney had advised the Association that they must immediately resolve the suspension issue in order to legally conduct business as a corporation. Otherwise, the individual owners may have exposure to risk, as they no longer had the protection of the corporation.
We also inquired and discovered that the Association had failed to file its biannual officers’ statement with the Secretary of State, and had been assessed a $250 penalty.
Resolving the corporate suspension required filing all delinquent tax returns, paying the $4,000 in minimum tax (which would later be refunded after the new exemption application was approved), filing the officer statements, and filing a Certificate of Revivor with the Secretary of State to be reinstated.
Because of the contractual and legal issues, the attorney advised immediate resolution. It can take several months for the exemption application to be approved by the California Franchise Tax Board (FTB) (California's equivalent of the IRS), so the only way to quickly resolve the issue was to move forward as a for-profit corporation and pay the $800 per year minimum tax, plus related penalties and interest. We prepared the delinquent tax returns for the five years, and had the Association file the federal returns and Form 100 for California. We also prepared the Certificate of Revivor, and had the Association file that form and pay all delinquent taxes, penalties, and interest.
We then immediately prepared the exemption application, and had the Association submit that application along with Form 199 for all five delinquent years, as well as a request for refund of minimum taxes paid. The California FTB refunded only four of the five years of minimum tax, as the fifth year was considered to be beyond the statute of limitations. Penalties and interest were NOT refunded.
Bottom line, this was a very expensive lesson for a very small Association. They would have not only saved money but also avoided risk had they sought competent professional advice on a timely basis.
