How Safe Are Your Reserve Funds?

By: Gary Porter

Many associations, more than half, according to CAI’s recent survey, file IRS Form 1120. We all know the reason; to take advantage of the 15% corporate tax rate versus the 30% homeowners association tax rate. But you have to give something up to gain this tax advantage. And what you give up is the safety of IRS Form 1120-H (IRC § 528). So, most people think they are retaining their safety by keeping their operating bank accounts separated from their reserve bank accounts, and that is all the safety they need. Indeed, that’s exactly what I here many CPAs saying also. But there is more to it than that (of course there is, or why would we need IRS audits anyway?). So, if keeping the bank accounts separated isn’t enough safety, what is? The only legitimate answer is “I don’t know”. And anybody who tells you he (or she) does know, must have a crystal ball, because even the IRS doesn’t know for sure. They keep making up the rules as they go along. Every time we hear of new audit activity (San Diego and Florida come to mind), we find out new things the IRS considers as important factors in accumlating reserves.

Let’s review some of the basics. On Form 1120-H, congress purposely created a safety net that allows associations to accumlate reserves without doing anything special at all. Apparently, just identifying some money as reserves is OK. There are no record keeping requirements. An even if, for some strange reason, the IRS said that this particular money didn’t quality as reserves, WHO CARES? It then becomes exempt function income and it doesn’t get taxed anyway.

But you decided you wanted to save a few bucks, so you filed Form 1120. By the way, let’s look at how much you are saving your association. According to CAI’s survey, the average association reported $ 5,582 of interest income. If we assume that you legitimately have $ 1,582 of deductions aginst your interest income, you have $ 4,000 of Taxable income. Did you notice how the taxable income came out to a nice round number? Neat trick, huh? That’s something they don’t teach you in accounting courses. Only years of brutal experience auditing homeowners associations prepares one to make such important decisions as being able to come up with the exact amount of deductions that will allow me to get to a nice round amount for taxable income. I did that only so I could make the calculation easy. So, with $ 4,000 of taxable income, you pay $ 600 federal tax on Form 1120. On Form 1120-H, you will pay $ 1,170. You are taking this enormous risk to save $ 570. Are you insane? Do you think that as a board member who saved your association $ 570 that your association members are going to thank you? Do you think they will even know? And if they know, will they care? As a board member, you have an obligation to try to get the best services for the best amount of money. (OK, we’re not going to talk about the quality ov government services, because (a) it would take too much space, and (b) “quality government service” is an oxymoron.) But the least amount is not always the best amount. You must consider the risk factor when filing Form 1120.

So, now, let’s look at Form 1120. I mean really look at. Not just as a way to save $ 570. But from a risk analysis standpoint. What does it mean when you file Form 1120? Most importantly, it menas 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 qulifying criteria and files Form 1120-H. So if you are no longer a homeowners association, what are you? A non exempt membership organization as defined in IRC § 277 (as a matter of law; you dont’ have a choice in the matter). And I’m here to tell you, those rules were not written with you in mind. So what you now have to do is contort yourself to look like the type of organization that congress had in mind when they created IRC § 277. And what they had in mind was not an organization that has an obligation to accumulate huge cashe reserve accounts to meet future needs. As you contort yourself, you 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. This is like the story of the three blind men, each touching a different part of an elephant, then trying to describe the entire elephant. You are doomed to failure unless you toch the whole elephant. Likewise, 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 contains more than 100 different rulings at eight different levels trying to capture these concepts in a coherent manner. More than 600 pages (and that’s after deleting the least important sections) of this book are devoted to 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) avoids taxation, it is taxed on Form 1120, unless you successfully get rid of it. My best , and safest suggestion, is to just pay more accounting fees to your CPA (is that sel serving?). But, if you don’t like that suggestion, there are only three options: (1) pay tax on the excess income, (2) refund it to members or roll it over to the next year under Revenue Ruling 70-604, or (3) transfer it to reserves. Hmmmm! Sounds like more risk to me. Second, there is the risk that you could expose your reserves to taxation. That’s it. Real simple. Only a couple of risks. Actually, I just combined stuff together to make it seem simple.

But hey, are these risks really that great? Why not just rely on the good old IRS audit lottery. Less than 1% of corporations (read that as associations) get audited. And if you don’t get a really sharp IRS auditor, he won’t be familiar with the tax law either, and you might just skate on by. Lot’s of people already have. However, the IRS has announced that within the next two years they expect to develop a tax audit guide for this industry. All of a sudden, the iRS agents will be smarter. And you will have a bigger problem.

Let’s closely examine each of the risks mentioned above. Excess member income. Pay tax on it? Are you kidding? Of course not! So let’s use Revenue Ruling 70-604.

Gary Porter, CPA began his accounting career with the national CPA firm Touche Ross in 1971. He is licensed by the California Board of Accountancy and the Nevada Board of Accountancy. Mr. Porter has restricted his practice to work only with Common Interest Realty Associations (CIRAs), including homeowners associations, condominium associations, property owners associations, timeshare associations, fractional associations, condo-hotels, commercial associations, and other associations.  Mr. Porter is a registered Reserve Specialist with the state of Nevada.

Gary Porter is the creator and coauthor of Practitioners Publishing Company (PPC) Guide to Homeowners Associations and other Common Interest Realty Associations, and Homeowners Association Tax Library. Mr. Porter served as Editor of CAI’s Ledger Quarterly from 1989 through 2004 and is the author of more than 200 articles. In addition, he has had articles published in The Practical Accountant, Common Ground and numerous CAI Chapter newsletters. He has been quoted or published in The Wall Street Journal, Money Magazine, Kiplinger’s Personal Finance, and many major newspapers.

Mr. Porter is a member of Community Associations Institute (CAI), American Resort Development Associations (ARDA), and California Association of Community Managers (CACM). Mr. Porter served as national president of CAI in 1998 – 1999.