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.