Association Tax Services, LLC

It’s that time of year again -tax time. Sometimes we CPAs wonder if associations never think of taxes at all for 364 days per year, and then only think of them that one day per year when they realize, “Whoa! It's time to file taxes.”

Every year about this time, many associations reach out to ask us to prepare their income tax returns. Many times, the contact is from a new treasurer of an Association who, upon accepting the job, discovered that the prior treasurer had prepared tax returns for the Association, but has no interest in assuming that responsibility. Other times, it is because an individual or board read something online or heard something from another person that makes them think that there may be more to this Association tax return issue than previously thought.

For whatever the reason, we get the call. With virtually every contact we get, the first question asked is, “Should the Association be filing Form 1120 or Form 1120-H?” While that's always a good question, the answer is actually, “It depends.” The answer varies depending upon the unique situation for each Association.

For the majority of associations, interest income is the only taxable income that the Association must report. Given the current economic situation offering the lowest historical interest rates of the last century, the decision of which tax form to file becomes a little easier. Form 1120-H is currently the best choice for many associations.

Let's review the basics of association tax forms again quickly.                 

Form 1120-H was designed specifically for homeowners associations and can only be used by residential homeowners associations that meet certain qualifying tests. The primary qualifying tests are:

1. 1)60% of revenues must be from member dues and assessments. This is referred to as exempt function income.
2. 2)90% of expenditures must be for the management, maintenance, care, and improvement of Association common areas. These are known as example function expenditures.
3. 3)85% of the project must qualify as residential. For condominium associations, this means 85% of the square footage of the project. For planned developments, it means 85% of the lots. For both, common areas ancillary to residential use are counted as residential.

There are additional tests that apply for determining residential use, but those additional tests apply to a very small subset of associations, generally condominium associations located in resort areas where there are short-term rental programs in place that may disqualify a project from meeting the residential test.

Form 1120-H is a very safe form for the Association to file, as it has virtually no tax risk if the Association meets the qualifications to use this form. One of the biggest benefits of Form 1120-H is that any exempt function net income is automatically excluded from taxable income. That means only the net non-exempt income( normally interest income less any related deductions) is included in taxable income.

People tend to consider the biggest negative factor on Form 1120-H to be that taxable income is subject to a flat tax rate of 30%.

Form 1120 was NOT designed specifically for homeowners associations. It is the tax form used by all taxable corporations that do not qualify for, or are not required to file, another tax form. An analogy we’ve used many times in the past is that using Form 1120 for an association is the equivalent of trying to shove a square peg (your Association) into a round hole (Form 1120). It's not a good fit. You have to jump through a lot of hoops in order to do this safely. In essence, jumping through those hoops is trying to “shave the corners” off your square peg so that it will fit into the round hole. There are ways to do this safely, but it generally requires advance planning. In other words, it's not a decision that should be made after year-end.

Key:

118 = Code Section 118

277 = Code Section 277

263 = Code Section 263

70-604 = Revenue Ruling 70-604

These are the primary technical rules that apply in trying to make Form 1120 “safe.” Such rules should be applied only by experienced individuals.

Too many people don't look at the technical issues that can arise with Form 1120, and look only to the one single item that matters to them: the tax rate is only 15% for the first $50,000 of taxable income. Since most associations don't have $50,000 of taxable income, their tax rate is 15%, which makes Form 1120 about twice as attractive as Form 1120-H with its 30% tax rate.

Many people are either not aware of or ignore the many technical issues that exist with Form 1120, so they do not appreciate the tax risk associated with this tax form. Please take a look at the Form 1120 checklist on our website to appreciate all the technical requirements that your Association would need to meet in order to safely file this tax form.

IRS no longer publishes statistics regarding how many homeowners associations file Form 1120-H versus those that file Form 1120. However, in the last year that such statistics were published, it was noted that approximately 75% of homeowners associations filed Form 1120-H, and only 25% filed Form 1120. Informal surveys taken by the Community Associations Institute’s (CAI) accountants’ committee (in which we have participated for many years) show the statistics to be almost exactly reversed – for associations represented by accountants who are very active in CAI, approximately 75% file Form 1120 versus only 25% filing Form 1120-H. The implication is that the accountants who participate actively in CAI are more likely to have the appropriate level of knowledge to guide their Association clients to safely file Form 1120.

Still, Form 1120 carries considerably more inherent tax risk than Form 1120-H. At Association Tax Services, LLC, our tax manager, Gary Porter CPA, has consulted with or represented associations in more than 50 IRS tax audits. In all but one of these cases, Mr. Porter was not the CPA who prepared the tax return. Rather, he was called in to consult either by the Association or preparer of the tax return, or by the tax attorney representing the Association in the IRS audit. Mr. Porter’s expertise is well-known, having authored dozens of articles written on various aspects of homeowners association taxation. As he has stated, of 50 Association IRS audits, one was performed on a Form 990, two were on a Form 1120-H, and the rest were on a Form 1120. Even more important is the fact that, of the associations that filed Form 1120 and were audited, the audit resulted in a negative tax consequence 100% of the time, meaning the Association paid more tax. In virtually every one of those cases, had the Association filed Form 1120-H, they would have paid less tax once the results of the IRS audits were completed.

At Association Tax Services, we continually recommend Form 1120-H for most of our Association clients because it eliminates tax risk. We do not universally recommend Form 1120-H, as there are certain circumstances where Form 1120 is clearly more appropriate. However, the bottom line for most associations is that there has never been a better time to file Form 1120-H than right now. The reason is because interest rates are so low that there is generally little difference between the tax you would pay on Form 1120 and the tax you would pay on Form 1120-H. Therefore, our recommendation is to go with the safer form, Form 1120-H.