Published in the ECHO Journal, January 2014
Before jumping into the discussion of homeowner association income taxes, it helps if you get a limited understanding of the tax history. Understanding the history will give you, the reader, a better insight into what the current tax laws are saying. Homeowner associations, whether formally incorporated or unincorporated, were and are subject to tax as regular corporations.
History
It was not until 1976 that Congress specifically addressed homeowner associations and in 1976 Internal Revenue Code (IRC) Section 528 was signed into law. Congress wanted to enact homeowner association tax law because one, more and more associations were being formed by real estate developers and, two, Congress believed that regular corporation laws were too complex and, potentially, unfair (not that IRC Section 528 is simple or fair) for homeowner associations. IRC Section 528 is OPTIONAL: there is nothing requiring a homeowner association to calculate its tax under Section 528. Along with the new code section 528, the IRS created a new one-page tax form 1120-H U.S. Income Tax Return for Homeowners Associations. The California Franchise Tax Board (FTB) never created a California equivalent of Form 1120-H though it adopted the language in Section 528 to give certain corporations exemption from the $800 minimum franchise tax.
Revenue Ruling 70-604
Before 1976, the IRS issued a Revenue Ruling: 70-604. A revenue ruling is an official public pronouncement by the IRS of the IRS’s application of law to a particular fact situation and carries a lot of legal weight with it. This Revenue Ruling said that a homeowner association’s membership can elect to apply excess assessments from one year to the next year and, in doing so, the excess assessments are not subject to tax. There has been endless debate about this ruling: mostly whether or not an association’s membership can annually make this election and, thereby, annually make any excess assessments exempt from federal income tax. This article will not wade into the debate. I will say, though, that I believe that the election can be safely made each year. Going back even further in time, IRC Section 277, which addressed membership organization’s expenses was enacted in 1969.
Income
So what are the similarities and differences between Form 1120 U.S. Corporation Income Tax Return and Form 1120-H. Both subject many similar kinds of income to tax however, the income base is much broader under Form 1120-H than under Form 1120. By this I mean that more kinds of income are subject to tax under Form 1120-H than under Form 1120. Generally, though, the usual income subject to tax on either Form is interest earned from banks, etc. Other kinds of taxable income include cell tower rents, Comcast easement payments, etc. You probably get the drift: income earned from a source outside of the association’s members is subject to tax. Fees charged to members for services on Form 1120 are not taxable while on Form 11120-H they are. It is also open to debate whether or not late fees, penalties and interest charged to members is taxable on Form 1120-H or not. They are not taxable on Form 1120.
Deductions
Are there any deductions available to offset taxable income? The answer is yes but they are limited to those incurred to produce the taxable income. Since the usual taxable income is interest income, any expense the association incurs to produce interest income would be an allowable deduction. While you may not think there are any expenses, the IRS has generously gone along with a Tax Court decision that permits membership organizations (which include homeowner associations) to take a percentage of management fees as a reasonable approximation of investment management time expended by management without any documentation of such. Since investment management is directly related to interest income, a percentage of the management fee is a reasonable directly-related expense to interest income. The usual only other available deduction is the cost to pay the person that prepares the income tax returns.
Form 1120 versus Form 11120-H
So aside from a broader income tax base, the other major difference between Form 1120 and Form 1120-H are the tax rates. On Form 1120 the tax rates are graduated: 15% for the first $50,000 of taxable income, 25% for the next $25,000 of income, 34% for the next $25,000 of income (we are now up to $100,000 of taxable income). On Form 1120-H the tax rate is a flat 30% (32% for time-shares). Also, on Form 1120-H, a filer gets an additional $100 standard deduction. Everything else equal, you pay less tax if you use Form 1120-H for taxable income less than $200. Otherwise you would pay less by using Form 1120 up to taxable income of about $186,000.
Tax Accounting
Unlike an individual, a homeowner association can have any year-end it wants. Your individual return is due by the 15th day of the 4th month after your “year-end”. Since as an individual your “year-end” is December 31, your tax return Form 1040 is due by April 15. A homeowner association’s corporate tax return is due by the 15th day of the 3rd month after the year end. In other words, if a homeowner association has a December 31 year-end, the tax return (either Form 1120 or Form 1120-H) is due by March 15. If it has a June 30 year-end, the tax return is due by September 15. An extension of time to file, which gives the association an additional 6 months to file a return, must be filed with the IRS on or before the regular filing date. California has an automatic extension whereby no form needs to be filed with the FTB in order to extend the California filing date. Of course, an extension is only an extension of time to file. There is no extension of time to pay and any estimated balance of tax due must be paid by the regular filing date or the association is subject to a penalty of ½% per month on such unpaid balance.
IRS Audits
I would like to conclude this article by touching on that subject no one ever wants to have happen to their association: an IRS audit of your association’s tax return. As a corporation, your association is REQUIRED to file an income tax return with the IRS. Penalties for failure to file are based on any unpaid tax so, by not filing, you may not be subject to any penalties if you did not have any taxable income. But do you want to run the risk of an IRS audit of your unfiled tax return and the IRS finding that your association did owe tax? By the way, the IRS is NOT limited by the passage of time for an unfiled tax return (the usual statute of limitations is 3 years for federal and 4 years for California). I have been involved in about 15 IRS audits in the past 3 years. In the fifteen or more years before, I had only been involved in about 3 IRS audits. The returns the IRS picked for examination were Form 1120 (this is no surprise since we most usually prepare Form 1120). The IRS made NO changes to any of these returns as filed. Of course this does not mean that our interpretation of Revenue Ruling 70-604 is correct but there can be some comfort found here as well.
William S. Erlanger, MS-Tax, is a CPA for Levy, Erlanger & Company, CPAs in San Francisco.