The issue of homeowners Association taxation is a difficult one and that difficulty is never going to go away. The basic problem is that a homeowners association is the only taxable entity that gets to choose annually which tax form it wants to file; Form 1120 or Form 1120-H. New guidance issued by the IRS is rare. The new guidance that is issued is usually a clarification of existing law, regulations, and rulings. The IRS did issue a very low-level ruling in late 2009. It did not break any new ground, but is still important enough that associations should be aware of it. In addition, it is an opportunity to again review the basic ground rules with respect to homeowner association taxation.
On December 31, 2009 the IRS issued information letter number 2009-0233. An IRS information letter is considered to be the lowest level of authority released by the IRS and has no precedential authority (may not be cited as a precedent in any other proceeding). However an information letter is significant because it clarifies the IRS thinking on a particular subject, and even though this letter has no authority, it would be difficult for the IRS to later take a position that departed significantly from a position taken in an information letter.
An information letter is issued in response to a specific request by a taxpayer on interpretation of tax law. In this case the taxpayer, a homeowners association, wanted to know if it could transfer excess membership income into a “working capital reserve” and avoid taxation under the provisions of Revenue Ruling 70-604. The IRS responded that such an action was not acceptable. A working capital reserve is simply a set-aside of excess membership income to be used as working capital. In the eyes of the IRS this is still taxable income.
A little background is necessary here. In 1970 the IRS issued Revenue Ruling 70-604 related to the excess membership income of a homeowners association. In 1970 all associations were required to file Form 1120 as non-exempt membership corporations. Form 1120-H was not created and related Internal Revenue Code Section 528 was not enacted until 1976. The importance of Revenue Ruling 70-604 is that it allowed a homeowners association that had excess membership income in a given tax year to either refund it to the members or roll it over to the subsequent tax year, thereby avoiding taxation of that excess membership income. While it is clear that the IRS intent was that this be a one-year only option, the IRS has never issued any specific guidance stating so.
For most homeowners associations the only taxable income is the interest income on reserves. If the association files Form 1120-H, it pays taxes at a rate of 30% on the interest income less any related deductions. Form 1120-H was specifically designed for homeowners associations and contains certain qualifying requirements. It was created by Internal Revenue Code section 528, which also defines the term “homeowners association.” The importance of Form 1120-H is that excess membership income is not subject to taxation, because the homeowners association is considered to be a (partially) tax exempt organization. The other critical factor regarding Form 1120-H is that there is virtually no tax risk associated with this form; it is very safe to file this form. The downside of electing to file Form 1120-H is that your tax rate is 30%.
This is contrasted to homeowners associations that file Form 1120. A homeowners association that files Form 1120 is indistinguishable from any other type of organization that files Form 1120. It is simply considered to be a nonexempt membership organization. When filing this Form, in the eyes of the IRS, you are no longer considered to be a homeowners association. That is a key point that many fail to understand. The good thing about filing Form 1120 is that the corporate tax rate applied is only 15% for the first $50,000 of taxable income, which covers almost all homeowners associations. The two downsides to Form 1120 are (1) any excess membership income is considered taxable unless an election is made under Revenue Ruling 70-604, and (2) there is considerable tax risk associated with Form 1120. However many associations are willing to assume the risks associated with Form 1120 in order to get the lower tax rate.
This brief article is not intended to be a complete analysis of homeowners Association tax law. It is simply intended to alert you to the IRS’s newest ruling in review the basics of Revenue Ruling 70-604. The Revenue Ruling allows an association to make an election to either refund excess membership income to the members or to roll that excess membership income over to the following tax year.
The Ruling states that the members are to make the election. However I have had several conversations with the national office of IRS and pointed out to them the inherent conflict with state law; that only the Board of Directors has the authority to make decisions regarding disposition of association funds; members do not have that authority. The national office of IRS has acknowledged verbally (meaning no authority) that the ruling may be interpreted as stating that those who have the authority to make a decision regarding disposition of association funds may make the election under this ruling. My advice to associations is that the election under Revenue Ruling 70-604 should be a standard part of the Association’s annual meeting agenda and that the members should approve the election. In addition the board should immediately ratify the members’ action. That way the association is in compliance with state law and also avoids any conflict with the IRS.
Many times the association would like to transfer excess membership income to reserves. This is not an option under Revenue Ruling 70-604. However the association can achieve the same effect by making an election to roll excess membership income to the subsequent tax year, then make the transfer to reserves in the subsequent tax year after adequate notice to members. Advance notice to members is a requirement of capital contributions (reserves) and is normally taken care of through the budget process. If an additional transfer to reserves is going to be made the members must receive advance notification.
Revenue Ruling 70-604 is only three paragraphs long, yet it is sufficiently vague that much interpretation is required. I had the opportunity to speak with Mr. Ranson, the author of this Revenue Ruling, before he retired from the IRS several years ago. Mr. Ranson stated that he purposely left the wording somewhat vague in this ruling so that there would be some flexibility in interpretation. The unfortunate side effect of this is that there is also some dispute as to the interpretation of the ruling. The IRS is well aware of certain abuses within the homeowners association industry regarding the interpretation of this ruling and has even discussed withdrawing this ruling. Obviously that has not occurred, and the IRS officials that discussed this with me have also since retired from the IRS.
Associations are advised to always proceed with caution on homeowners Association tax issues. Consult with your CPA on this matter. I have received more questions as a tax practitioner on Revenue Ruling 70-604 than on all other tax matters combined. Consequently, I have established a website at www.revenueruling70-604.com that is intended to answer the many questions that arise regarding this important ruling. This website contains all information I was able to obtain regarding Revenue Ruling 70-604. The site is also supported by several other CPAs.
