A private road, owned by a community association, is in need of repair. The residents were never informed that they are responsible for the repairs and not eligible for county funding.
The Rancho Santa Fe Association Board is looking to modify its Articles of Incorporation to possibly change the Golf Club and voting membership rights for condominium owners. If they decide on the change, it would be subject to a member vote.
Cleanup from a fire caused a homeowners association to assume the shower of one homeowner had been leaking it soaked and damaged a floor. They charged the homeowner $150,000 for damage and sued him for nonpayment. The homeowner argued his case in court and won. The HOA could not prove it was the homeowners shower, especially since firefighters had doused the condos with water while putting out the fire.
A Veteran, who is disabled, is being kept from completing his therapeutic indoor pool because it was not built in a timely fashion.
A resident of a homeowners association has installed a statue on his lawn to honor current and former members of the military. The HOA wants him to remove it even though there are no prohibiting rules in their covenants.
A homeowner who lives across the street from a baseball field is finally fed up after spending over $2000 to repair windows caused by baseballs. The park is owned by the city but rented by a youth sports group.
A condominium complex was ravaged by fire. The residents are still displaced as they try to settle with State Farm to rebuild.
Most people have heard of the Mayan calendar that was created hundreds of years ago, even before the Americas were discovered by explorers. Of particular concern(once the calendars were deciphered) has been the prevailing interpretation of the Long Count calendar that some cataclysmic event would occur on December 21, 2012. Many believed this would be the end of the world.
December 21, 2012 is now behind us, and obviously the world did not end. Up until that date, however, many people were so convinced the world would end that they just refused to plan for any future beyond that date. Their attitude was, why plan for something in the future if you're not going to be here? There are others who believe that the year 2012 was simply misinterpreted, and that the end of the world is still relatively imminent.
This continued insistence that the world is going to end (soon) is nothing more than a convenient form of denial. It’s often referred to as the “2012 syndrome” since that date is so widely known, and since it was proven to be a false alarm. Those who suffer from the 2012 syndrome tend to use denial as an excuse for not taking action today. It doesn't really matter in what context this occurs. The person simply believes that there is no reason to plan because . . . (insert whatever reason you want here).
How does this concept apply to the community association world? We mostly see this in connection with reserve planning. Very few associations reach the 100% funded level, and many never even aspire to do so. We have performed reserve studies for many associations whose stated goal is to "reach 65% funded in 20 years." Some associations can get away with this by using the cash flow method of reserve funding to document that the association can get by with lower levels of reserve funding and still avoid special assessments. In one sense, there is nothing wrong with such a funding plan so long as members are fully advised to and supportive of this plan. However, it is not an "equitable" method of funding, as it means that the individuals "using up" the community components are not paying for the full use and enjoyment they are receiving - they're passing the buck to future owners.
On the other hand, too much reliance on the "percent funded" concept can also be a problem. The Association really needs to carefully conduct a cash flow analysis to make sure that enough funds will be available in "peak expenditure years." These are the years where multiple significant expenditures are scheduled to occur based on dates placed in service and estimated useful lives. As an example, if a condominium association has exterior painting, roofing, and paving projects all occurring at the same time, that would be considered a peak expenditure year. The only ways an association can accommodate the cash flow requirements for these kinds of years are to (1) build up the required cash flow in advance, (2) spread the projects out to fall on different years (although there is great danger in deferral of projects simply because they are inconvenient), and (3) borrow funds when needed and repay at a later date.
From experience I’ve learned that the "2012 crowd" is alive and well within the community association industry. These are the folks who don't want to fund reserves at all, or only at a very minimum amount. To be honest, I don't think most of these folks really believe that the world is about to end. I think they're just in denial that, for instance, the roof really needs to be replaced. After all, it has not been a problem for the last 20 years, so why should it be a problem now? Let somebody else worry about it. This kind of thinking affects association reserve funding plans by resulting in absolute minimum reserves being established and funded, and by necessary maintenance work being either deferred or funded by special assessments. This strategy might work on a relatively short-term basis, but is doomed to failure on a long-term basis.
Unfortunately, I believe the 2012 believers will always be with us. As for me, I have long been a skeptic of the 2012 theory. Think of it this way - you're creating a calendar consisting of future time periods. How far into the future do you take it? Until you run out of paper? Using a computer, you could theoretically run the calendar to any future period. However, the Mayans didn't have computers, nor did they have paper. They only had stone. I have always maintained that the Mayans simply ran out of stone, so they had no more room to continue - and after all, their calendar already looked hundreds of years into the future. Maybe they just didn't bother to get another stone.
Moral of the story? Don't be a denier. Carefully consider your association's future funding requirements and start setting aside an appropriate amount of money to fund those future expenditures.
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.
I was working in our Association office one day when I overheard my office manager's half of a telephone conversation. I was surprised at what I was hearing, because I thought the misunderstanding was a thing of the past these days.
The caller was a new owner in a rural, sprawling, single-family home community. He was calling because he had just received a notice of delinquency for nonpayment of Association assessments. The issue? This new owner did not have a clue that he was a member of the Association. Ironically, this happened to be in California, where disclosures to buyers have been mandated for decades. How did this happen? When asked by the office manager, the new owner explained that he had purchased this property directly from the previous owner without the benefit of a professional real estate agent or an escrow company. The previous owner had simply executed a deed to the new owner in exchange for money - a classic private transaction. Neither the seller nor buyer had had any knowledge of the disclosure requirements mandated by law.
Had either a professional real estate agent or an escrow company been utilized as part of this transaction, both buyer and seller would have been informed of the disclosure requirements, and there would have been no surprise to the new owner. As it was, the new owner was not just surprised, he was downright angry. The only target remaining in sight was the Association office, as the seller was long gone. So the new owner decided he needed to visit the Association office.
The new owner came into the Association office to "get to the bottom" of this situation. He was apparently convinced that he was going to find a way to get out of paying these assessments. I suspect this gentleman was just used to getting his own way. The office manager provided him with all the documents he should have received in a disclosure statement, including the CC&Rs, rules and regulations, Member's Handbook, and Association budget. The new owner looked these documents over while in the office and asked for an explanation of their content . The office manager patiently and politely explained that the CC&Rs (Covenants, Conditions, and Restrictions) were recorded documents, and indicated that if the gentleman would examine his recorded deed, he would see that it made reference to these recorded CC&Rs. These CC&Rs are a part of his property and may not be separated from the property acquired.
The rules and regulations explained the operating rules established by the Association. The Member’s Handbook explained the amenities provided by the Association. Once the new owner realized what amenities existed and quickly looked at the budget, he demanded that his assessment be reduced, since he had not been aware of, nor would he be using, any of the Association amenities. Again, the office manager patiently explained that the assessment was not a buffet where owners could pick and choose what amenities they wanted to use or pay for. All members shared the cost of the amenities, whether or not they used those amenities.
The new owner then challenged the "exorbitant" amount of "General and Administrative" costs in the budget, stating that the cost was simply too high. (This is really good feedback coming from someone who never even knew he was a member of the Association and had had the budget for all of 15 minutes). Again, the office manager explained the basis for the costs and assured the new owner that the Board of Directors, who were also dues-paying members, did everything within their power to keep assessments as low as possible. Perhaps if the new owner would like to attend a board meeting and discuss this with the Board of Directors, he would get some answers? He would be allowed five minutes to make a statement. The owner declined, stating that he didn't have time to waste with this Association.
Interestingly, the man's comments caused me to look at the budget numbers again from a different perspective. The budget was essentially laid out by department, and He was right: the total for general and administrative expenses was a large amount. I asked our outside accountant about this, and wondered if there was possibly any different way to present the information that could be more informative and less confusing.
Our accountant explained that he had previously tried to introduce the concept of ABM (Activity-Based Management) to a group of Association managers as an alternate manner of presenting financial information, but that there had been little interest in the topic. He also explained that in the nonprofit organization world, their practice of presenting a required "Statement of Functional Expenses" was a similar concept.
He described how a manager's salary, shown by department, ends up in the “General and Administrative” section. However, upon analyzing how the manager actually spends his time, one realizes that his salary should instead get spread around to Maintenance, Recreational Amenities, Security, Member Services, and Governance. Except for the Governance portion, none of that manager's salary remains in the General and Administrative section. If all expenses were examined in the same manner, one would see a completely different picture of how the Association spent its money. The accountant also explained that, with planning and the correct software, it would be possible to present the same information in both the traditional departmental format as well as the activity-based management format.
Maybe that's something to consider.
Thanks to Gary Porter, CPA for insight on activity-based management.
