Having just completed another tax season, and having again dealt with the issue of educating new clients on the REAL differences between Form 1120 and Form 1120-H, it’s time to have this discussion again.
Over the years I have heard many CPAs make presentations about the advantages of Form 1120 over Form 1120-H. Virtually all of those discussions boil down to a single point – the 15% tax rate of Form 1120 versus the 30% tax rate of Form 1120-H. The position generally set forth is that it’s crazy to pay taxes at a 30% tax rate on Form 1120-H when you can just as easily pay taxes at a 15% rate on Form 1120. I am not aware of ANY tax practitioner, other than myself, who has ever included a dialogue of the risk factors of Form 1120 as part of this discussion.
While the IRS no longer publishes statistics on homeowners associations, the last year they did so it was noted that approximately two thirds of associations filed Form 1120-H. It was also reported that the average association reported $5,582 of interest income. With today’s low interest rates, that number is probably now substantially smaller. But let’s assume that those old averages are still accurate and examine the differences between the two tax forms. To make the calculations easier, we will assume that deductions allocable against interest income, composed primarily of tax preparation fees (fully deductible) and management fees (allocated at 10% deductible based on the Concord Consumers Housing Cooperative v. Commissioner case), total $1,582, leaving exactly $4,000 as taxable income. (That makes this illustration easy to follow.)
Form 1120 – The $4,000 taxable income at 15% results in a tax of $600. Assuming no problems, that’s all the tax liability. But if you apply risk factors, the answer changes dramatically. Risk Factor #1 - What if the Revenue Ruling 70-604 election is disallowed (for several possible different reasons, as discussed in a previous article – see below) and that (assumed) $10,000 of excess member income becomes taxable? The tax just increased by $1,500. Your tax savings not only just disappeared, but became multiples of the tax you would have paid on Form 1120-H. Risk Factor #2 - Worse yet, consider that the IRS audits this tax return and assesses tax on ALL your entire reserve balance because you didn’t exactly comply with the requirements to exclude reserves from taxable income. Assuming reserves of $100,000, which gets added back as additional excess member income, your taxes just increased another $20,000. You’re now so far behind the curve you can never catch up.
Form 1120-H – The $4,000 taxable income at 30% results in a tax of $1,170 because of the special $100 deduction allowed on Form 1120-H. Since excess member income is not taxed on Form 1120-H, you don’t have to worry about the Revenue Ruling 70-604 election, nor excess member income. It also doesn’t matter if you fail to exactly follow the rules on excluding reserves from taxable income on Form 1120-H, as reserves failing to meet the “capital contribution” test are reclassified as excess member income, which isn’t taxable on this Form.
Comparison – Form 1120 initially saves $570 as compared to Form 1120-H, but exposes the Association to risks (in this example) of an additional $21,500 of taxes. That’s a lot of risk to assume for a very small tax savings. Are the members going to appreciate, or even notice, a $570 savings? Maybe, but not likely, and certainly not if the Association gets tagged by IRS for the additional tax. In that instance, the members will only accuse the Board and tax preparer of making a bad decision on the tax form to file, and hold them responsible for failing to take advantage of the safety offered by Form 1120-H.
I have offered the analogy in the past that purposely filing Form 1120 when any possible risk at all exists is the same as saying that you believe insurance is an unnecessary expense and premiums should not be paid. How do you know if there is risk? Look at the following two articles to see if you’ve complied regarding Revenue Ruling 70-604 and treating reserves as capital contributions.
Making the Revenue Ruling 70-604 election
Reserves as Capital Contributions for Tax Purposes
Background - Let’s review some of the basics. On Form 1120-H, Congress purposely created a safety net that allows associations to accumulate reserves without doing anything special at all. Apparently, just identifying some money as reserves is sufficient. No specific record-keeping requirements are mandated. No election under Revenue Ruling 70-604 is required, and even if the IRS audited the tax return and took the position that the Association reserves didn’t qualify as capital contributions, it doesn’t matter – those reserves would then be reclassified as exempt function income, which is not taxable on Form 1120-H. All the tax law you need to comply with is located in a single Code (Internal Revenue Code – IRC) section; IRC § 528.
Form 1120 is a completely different matter. When you file Form 1120, it means that you are no longer a homeowners association. The term “homeowners association” is defined in IRC § 528, and applies only to an organization that meets the qualifying criteria and files Form 1120-H. So if you are no longer a homeowners association, what are you? A nonexempt membership organization is defined in IRC § 277 (as a matter of law - you don’t have a choice in the matter). Those rules were not written with your Association in mind. The Association must now contort itself to look like the type of organization that Congress had in mind when they created IRC § 277, and that is NOT an organization that has an obligation to accumulate huge cash reserve accounts to meet future needs. The Association must comply with a very large body of tax law. Unfortunately, and unlike IRC § 528, this body of law is not codified into a nice, neat set of rules. You have to look at many different categories of rulings to be able to see the whole picture. Too many people see a few key rulings and think they see the whole picture. You are doomed to failure on Form 1120 unless you are familiar with the entire body of applicable tax law. Practitioners Publishing Company’s Homeowners Association Tax Library (of which I am the co-author) contains more than 100 different rulings at eight different levels trying to capture these concepts in a coherent manner. More than 900 pages (and that’s after deleting the least important sections) of this book are devoted to Form 1120. The majority of these rulings deal with associations that file Form 1120, so only when you are familiar will all these rulings are you really prepared to consider Form 1120.
The major risks you assume with Form 1120 are quite simple. First, there is the risk that you could expose excess member income to taxation. Unlike Form 1120-H, where the excess exempt function income (a roughly similar concept and definition to excess member income) avoids taxation, it is taxed on Form 1120, unless you successfully get rid of it. There are only three options: (1) pay tax on the excess income, (2) either refund it to members or roll it over to the next year under Revenue Ruling 70-604, or (3) transfer it to reserves (subject to strict rules). Second, there is the risk that you could expose your reserves to taxation.
Commentary - Are these risks really that great? Yes! Many associations apparently just rely on the “IRS audit lottery.” Fewer than 1% of associations get audited. No professional tax preparer can advise you to consider this factor when making a decision on what tax form to file. An association may itself take that into consideration, but ethics rules prohibit the tax preparer from considering it.
I have been involved in 50 IRS audits of associations, but in only one of those instances did I actually prepare the tax return myself. I am generally retained by the tax preparer/CPA, the tax attorney, or the Association as soon as they realize that IRS has raised tax issues that had not previously been considered. Of the 50 tax audits, one was on Form 990 (an exempt association), two were on Form 1120-H, and 47 were on Form 1120. The two Form 1120-H audits resulted in no additional taxes being assessed. ALL 47 of the Form 1120 tax audits resulted in additional taxes being assessed.
I was presented with the following challenge this past tax season: informing several new clients that they had tax exposure on their prior year Form 1120 tax returns; educating them as to the risks inherent in that form; and convincing them that the minor additional tax they would pay on Form 1120-H should really be viewed as buying an insurance policy against a future tax assessment.
