503.1 Condominium and Homeowners' Associations As explained in paragraph 500.1, if condominium associations, homeowners' associations, or timeshare associations do not elect to be taxed under IRC Section 528 and file Form 1120-H, they are taxed
under IRC Section 277 and must file Form 1120.
IRC Section 277 applies to certain
membership organizations formed primarily to provide services to members
that are not exempt under any other section of the Code. Although IRC Section 277 was initially
enacted to apply to social clubs, it is clear from the language of IRC Section 277 (HTL�Appendix 2F) that it is a mandatory section that applies to all nonexempt membership organizations.
503.2 Beginning in 1992, IRS private letter rulings relating to the revocation of an election under IRC Section 528 specifically state
that IRC Section 277 will apply when the IRC Section 528 election is revoked.
503.5 IRC Section 277
is not a comprehensive set of rules for taxing membership
organizations. Instead, it was added to the Internal Revenue Code to
prevent
taxable membership organizations from avoiding tax on nonmembership income by operating membership activities at a loss and using that loss to offset the nonmembership income.
Thus, IRC Section 277 focuses primarily on the activities of and deductions incurred by membership organizations. It states:
In the case of a . . . membership organization which is operated primarily to furnish services or goods to members and which is not exempt from taxation, deductions for the taxable year attributable to furnishing . . . items of value to members shall be allowed only to the extent of income derived during such year from members or transactions with members.
503.6 When taken in conjunction with IRC Section 118 (HTL�Appendix 2C),
which states �contribution to the capital of the taxpayer does not
include any . . . contribution as a customer or potential customer,� an
association is effectively confined to a very narrow and strict set of
rules. Those two sections define member activities and state that any
amounts received from members must apply either
as a capital contribution or as membership income.
Furthermore, the Committee Reports to IRC Section 118 state that it is the
expenditure of funds that determines the nature of the activity.
Thus, if an association makes a capital assessment, then expends the monies on membership activities in the same year,
the IRS would recharacterize the assessments as membership income.
503.7 Under IRC Section 277, CIRAs are taxed on their nonmembership activities just as they are taxed on their nonexempt function income under IRC Section 528. In addition, they may
also be taxed on any excess of membership income over membership expenses.
That provision differs from IRC Section 528,
under which all of an association's exempt function income is not
taxable. Unfortunately, most of the guidance for filing tax returns
under IRC Section 277 is not found in the Internal Revenue Code�the Code section itself
is less than one page long. Thus, the guidance in this chapter is based on Revenue Rulings, Private Letter Rulings, Tax Court case law
Membership and Nonmembership Income
503.8 Under IRC Section 277, CIRAs are taxed on both
net membership and net nonmembership income. Accordingly, they must segregate (a) membership and nonmembership income and (b) membership and nonmembership expenses.
503.9 Membership Income Membership income is the gross income received by a membership organization from its members in consideration
for membership activities.
In most respects, membership income is similar to exempt function income under IRC Section 528 (see paragraph 502.21)
and, thus, includes membership assessments and other amounts that are
assessed ratably to members. However, it also includes fees paid for
services by members that are considered nonexempt function income under IRC Section 528. (See Exhibit 5-9.)
Interest income paid by members if their initial membership fees are
paid in installments is classified as membership income. In addition,
interest income on delinquencies is also classified as membership
income. In contrast, interest income
on investments is classified as nonmembership income.
503.12 Nonmembership Income
Nonmembership income is defined by exception; it is gross income
exclusive of membership income. In concept, nonmembership income is
similar to unrelated business income of tax-exempt organizations. It
results primarily from two principal sources:
(a) income on investments and (b) income from commercial operations and other services provided to nonmembers.
503.16 Allocating Expenses to Investment Income The only type of nonmembership income that many CIRAs have is interest income. In that case,
a portion of indirect expenses (such as audit and accounting fees, tax preparation fees, clerical office expenses, management fees, fidelity bonds, and state income taxes) may be considered as nonmembership expenses and be used to offset interest income. In Concord Consumers Housing Cooperative v. Commissioner (HTL�Appendix 4I), the Tax Court did not dispute that some portion of certain expenses was allocable to nonmembership interest income and allowed a 5% deduction of certain expense categories even though no written documentation existed to support such deductions.
According to the Court in that case, the following services provided by a
management company could be allocated against interest income
� Preparing financial statements.� Making reports to the board of directors (that is, attending board meetings).� Reviewing investments.� Making requests to withdraw monies.� Reconciling interest.� Checking interest rates at various financial institutions.� Changing financial institutions or moving accounts at financial institutions.� Making requests for reimbursements from reserve funds.
503.17 In the authors' opinion, the decision in Concord Consumers Housing Cooperative
gives CIRAs some latitude in claiming minor allocations against
nonmembership interest income although there is no specific written
documentation;
however, written documentation is much superior evidence. The Court's decision provides associations and management companies with guidelines on how to calculate the portion of their expenses or fees that associations may deduct against nonmembership interest income. The authors recommend that accountants advise their CIRA clients to encourage management companies to allocate their management fees to appropriate nonmembership activities and, preferably, to invoice separately for that amount. Similarly, the portion of accountants' fees for audit, accounting, and tax services that relate to nonmembership activities also should be invoiced separately.
503.18 Allocating Expenses to Other Categories of Nonmembership Income In addition to expenditures for management, financial, and tax services, the authors believe that expenses such as
insurance, utilities, repairs and maintenance, security, and janitorial services often may be allocated to types of nonmembership income other than investment income.
Using Revenue Ruling 70-604 to Defer Tax on Net Membership Income503.22 Basic Provisions Revenue Ruling 70-604 (HTL�Appendix 6H) allows CIRAs to remove any
excess membership assessments from taxable income by effectively refunding the excess assessments to the members.
Under the revenue ruling, associations may make an annual election to
exempt or defer net membership income from taxation by, in effect,
returning the excess to its members. As stated in the revenue ruling,
associations have the following options:
� Apply the excess of membership income over membership expenses to the following year's assessments.� Refund the excess of membership income over membership expenses to the association's members
503.24 Making the Election
There is virtually no authoritative guidance about how associations
may properly make a 70-604 election although the revenue ruling has been
in effect since 1970. Frequently encountered issues about making the
election and the authors' recommendations are discussed below.
a. The 70-604 election should be made by the members.
b. The 70-604 election must be made before the tax return is filed.
c. It is not necessary to state the specific dollar amount of excess membership income in the election.
d. The 70-604 carryover of excess membership income over membership expenses that is applied to the following year's assessments should be included on Schedule M-1 (or M-3) on the association's tax return.
e. The authors do not believe that 70-604 carryovers to a subsequent year may be made indefinitely.
f. If an association has been carrying over excess membership income indefinitely from year to year, the association should take the following steps regarding unused carryover amounts from previous years in the year that the association decides to implement the one-year only carryover provision.g. If an association has been filing Form 1120 and has an excess membership income carryover to the following year, and upon a change of accountants, the association files a Form 1120-H instead of a Form 1120 for the following year, the status of the carryover may be subject to interpretation.
Authors' Recommendations503.25 Authors' Recommendations Regarding Making the Election
The authors recommend that every residential association make a
formal 70-604 election. Under the election, any excess membership income
is excluded from taxable income. Thus,
only net nonmembership income is subject to tax at regular corporate rates (for example, 15% of the first $50,000 of taxable income).
503.26 The authors have observed that many CIRAs do not make a formal election under Revenue Ruling 70-604. Instead, they �make� the election merely by filing the tax return with the appropriate calculations. In the Mission Heights Homeowners' Association case (HTL�Appendix 4P), an association filed Form 1120 but made no formal effort to document its election under Revenue Ruling 70-604. The Court ruled that the association had not made an election under Revenue Ruling 70-604, so the association's excess assessment income became taxable. Thus, in the authors' opinion, if
an association does not properly make a formal election, it does not have a valid 70-604 carryover. Absent the election, preparers may be subject to penalties for taking a position on a tax return without �substantial support.�
503.27 Applying Revenue Ruling 70-604 to Nonresidential Associations The issue of whether Revenue Ruling 70-604
applies to nonresidential associations has not been settled by the IRS.
Through recent audit activity of nonresidential associations, the IRS
asserted, in a 1994 District Office technical advice letter, the
position that Revenue Ruling 70-604 only applies to
residential associations. However, in a June 1995 technical advice memorandum (TAM 9539001) (HTL�Appendix 10A), the National Office of the IRS ruled that Revenue Ruling 70-604 did not apply to a nonresidential association (a timeshare development)
503.28 Applying Excess Membership Income to Replacement Funds Applying excess membership income to replacement funds is
not permissible under Revenue Ruling 70-604. However, it may be possible under the provisions of IRC Section 118. The IRS has taken the position in General Counsel Memorandum (GCM) 37857 (HTL�Appendix 8H) that excess membership income may not be applied to replacement funds. The IRS's position is based on the theory that, since funds were not earmarked for capital items through the budget, the original usage of the funds was not capital in nature. The IRS also holds that an organization may not change the nature of the intent for which the money was originally to be spent. That position is consistent with its position on capital contributions
Excess Membership Deductions503.31 As explained in paragraph 503.5, IRC Section 277 (HTL�Appendix 2F) only permits membership expenses to be deducted to the
to the extent of membership income. If CIRAs have excess membership deductions, they may not be used to offset net nonmembership income. The excess deductions may not be carried back; however, they may be carried forward indefinitely to offset future net membership income.
Excess membership deductions are not treated as an operating loss.
Instead, they are a carryforward of excess deductions. [Also, see the
discussion in paragraph 503.24.]
The authors believe excess membership deductions should be shown as a
separate line item in the detail schedule for Line 26 of Form 1120.
It can be titled �IRC Section 277 excess membership deductions carryover.�
Net Nonmembership Income503.33 Regular Tax
An association's net nonmembership income is taxed at regular
corporate rates. (Excess membership income also is taxed if the
association has not made a 70-604 election. See discussion beginning in
paragraph 503.22.) Tax rates are as follows:
If Taxable Income Is The Tax IsFirst $50,000 15% of taxable income$50,001 to $75,000 $7,500 plus 25% of the amount over $50,000$75,001 to $100,000 $13,750 plus 34% of the amount over $75,000$100,001 to $335,000 $22,250 plus 39% of the amount over $100,000$335,001 to $10,000,000 $113,900 plus 34% of the amount over $335,000$10,000,001 to $15,000,000 $3,400,000 plus 35% of the amount over $10,000,000$15,000,001 to $18,333,333 $5,150,000 plus 38% of the amount over $15,000,000Over $18,333,333 35% of taxable income
503.35 Alternative Minimum Tax
The Taxpayer Relief Act of 1997 repealed the Alternative Minimum Tax
(AMT) for small corporations for tax years beginning after December 31,
1997. A small corporation is defined as
one with three-year average annual gross receipts not exceeding $5 million for its first tax year beginning after 1996 that does not have three-year average annual gross receipts exceeding $7.5 million for any later year. However, in determining their tax liability, large CIRAs that file tax returns as corporations on Form 1120 must consider the AMT.
Advantages and Disadvantages of Filing Form 1120503.40
Some accountants question why CIRAs take the time and effort to file
their tax returns on Form 1120 when Form 1120-H is designed specifically
for qualified homeowners' associations and is very simple to prepare in
comparison. The principal reason is that association income is only
subject to a
15% tax rate on the first $50,000 of taxable income versus a 30% tax rate (32% for timeshare associations) on Form 1120-H.
Advantages of Filing Form 1120
1. Taxable income is taxed at the regular corporate rates (15% on the first $50,000 of taxable income) versus the 30% (or 32%) tax rate required when filing Form 1120-H.
2. Certain tax-planning opportunities may exist.
Disadvantages of Filing Form 1120
1. The risk of compliance is much higher for Form 1120 than for Form 1120-H.
2. Form 1120 is a longer, more complex tax form to complete, and the cost of preparing Form 1120 may offset the tax benefits received. td dl { margin-top: 0px; margin-bottom: 0px; }3. Large associations are subject to the alternative minimum tax on Form 1120 (see the discussion beginning at paragraph 503.35). td dl { margin-top: 0px; margin-bottom: 0px; }4. Associations that file Form 1120 may be subject to state income taxes.
Tax-planning Opportunities503.43 Alternating Form 1120-H and Form 1120 One of the most significant tax planning tools a CIRA has is alternating the use of
Form 1120 and Form 1120-H to take advantage of the inherent differences in the tax rate structure of the two forms and timing differences
Specific strategies might include the following:
� A CIRA might file Form 1120-H in its initial years before its reserves have accumulated significant balances. Since interest income on reserve balances will be low, the tax due on Form 1120-H should not be materially larger than that owed on Form 1120. During those early years, the association should attempt to build its operating surplus since exempt function income is not taxable on Form 1120-H. � In later years, when material cash balances have created larger tax liabilities for interest income, the association could switch to Form 1120 to benefit from that form's lower tax rates. At the same time, the association could change its budgeting strategy to reduce operating dues and increase reserve dues while keeping the overall dues amount the same, resulting in IRC Section 277 (HTL�Appendix 2F) excess membership deductions. The operating surplus that was accumulated untaxed in earlier years could be drawn down and Form 1120 filed with little or no risk of excess membership income.� The timing of painting expenditures, which are deductible when incurred or paid (not assessed), may be used to an association's advantage. It may want to file Form 1120-H when initially accumulating painting reserves to avoid a tax liability on those funds. However, Form 1120 should be filed in the year the painting funds are expended. Since painting is considered to be a membership deduction, a large membership loss should be created to be carried forward to future years as an IRC Section 277 loss carryover.
503.44 Use of the Revenue Ruling 70-604 Election to Reduce Taxes Revenue Ruling 70-604 (HTL�Appendix 6H)
is perhaps the most powerful tax planning tool that exists for
associations filing Form 1120. However, the authors recommend a
conservative approach in using the revenue ruling because it is so vague
on key issues. Specific strategies that may be considered relating to
the use of Revenue Ruling 70-604 include the following:
� An association may find during the year that it is projected to end the year with excess membership income. It may want to avoid having to use Revenue Ruling 70-604 by revising its budget to eliminate that excess membership income. The revised budget should be distributed to members to provide them adequate notice of the reallocation of their dues.� Associations generally make an election under Revenue Ruling 70-604 whenever excess membership income exists at year end. Since the IRS requires that any excess from Year 1 be utilized in Year 2, the association should create a membership (or operating) loss in Year 2. The Year 2 budget may be revised to create the necessary loss by a reallocation between the operating and reserve budgets. Consequently, the operating surplus created in Year 1 will be drawn down by the operating loss in Year 2.
503.51 Form 1120-H
If the tax practitioner ensures that the CIRA meets the criteria to
qualify as a homeowners' association, there exists little other risk in
filing Form 1120-H. However, should a Form 1120-H be filed in error, the
association may find itself required to make a mandatory change to Form
1120, which exposes the association to greater risk. To qualify as a
homeowners' association, and thus to utilize Form 1120-H, the
association must meet the following requirements.
� Lack of Private Benefit Test. Most associations will automatically meet the lack of benefit test. Thus, that risk is considered to be low. (See the discussion a paragraph 502.19.)� Substantially Residential Test. It is generally clear for most associations whether they meet the substantially residential test which requires that 85% of the lots or square footage must be used for residential purposes. The greatest risk in meeting the substantially residential test is for resort-type associations where there is a high degree of short-term rental use of condominium units. (See the discussion beginning at paragraph 502.6.)� The 60% Income Test. The 60% income test often presents qualification problems for associations that submeter utilities, provide valet or maid services, or provide extensive recreational amenities and services. (See discussion at paragraph 502.11.)� The 90% Expenditure Test. This test is the most difficult qualification for associations to achieve. Generally, any association that fails the 60% income test will also fail the 90% expenditure test. For example, associations that provide even a simple laundry room facility to their members may discover that their costs related to support of the laundry room facility will exceed 10% of total expenditures, causing the association to fail the 90% expenditure test. (See the discussion beginning at paragraph 502.12.)
Amending a Form 1120 to Change to Form 1120-H503.60 As discussed beginning in paragraph 501.41, a CIRA may determine, subsequent to filing a Form 1120, that it should have filed Form 1120-H instead. For example,
the CIRA may have used an impermissible accounting method, received inadequate tax advice, or have significant tax exposure because it did not procedurally comply with the requirements of IRC Section 118 on contributions to capital or Revenue Ruling 70-604 on carryovers of excess membership income. Unless amending Form 1120 within 12 months from the original due date of the return under the provisions of Treasury Regulation 301.9100-3, amending a Form 1120 to change to Form 1120-H involves requesting an extension of time to make an election under IRC Section 528. Since an election under IRC Section 528 may be made only on a timely filed return, it is not possible to simply file an amended return replacing the Form 1120 with Form 1120-H. To assist in the amendment process, the IRS has provided administrative relief in the form of Treasury Regulations Sections 301.9100-1-301.9100-3 (HTL�Appendix 5Y).