By Steve Silberman
As a CPA, one of the most frequently asked questions I get from Board members is: Are we a not-for-profit corporation and if we are, do we have to file an income tax return?
First of all, most associations are usually incorporated as not-for-profit corporations by the developer. If this did not happen to your association, I recommend hiring an attorney to incorporate your association as a not-for-profit corporation, even though you could go to the Secretary of State's website yourself to incorporate. Once incorporated, you must remember that each year your association has to file an annual report with the Illinois Secretary of State and pay an annual fee in order to stay incorporated.
Residential condominiums, townhomes, and homeowners' associations are not-for-profit corporations that generally do not qualify for Federal income tax-exempt status. Residential associations may be taxed under Internal Revenue Code (IRC) Section 277 or may elect to be taxed under IRC Section 528. Under IRC Section 277, associations file Federal Form 1120 and under IRC Section 528, associations file Federal Form 1120-H. An association can decide annually which form it would like to file. So let's discuss which form is right for your association and the differences between each form.
FEDERAL FORM 1120-H
Federal Form 1120-H was developed so that associations would not be taxed for carrying out its main function of managing and maintaining the common elements. Commercial condominium associations cannot file Federal Form 1120-H. IRC Section 528 states that income and expenses must be allocated between exempt function activities and nonexempt function activities. Associations are only taxed on its net non-exempt function income at a Federal tax rate of 30%. (Timeshare Associations are taxed at a Federal tax rate of 32%). So what is exempt and non-exempt function income?
Exempt Function Income is:
Operating income received as assessments from owners of condominium, townhome or HOAs. They also can be assessments received from developers on unsold units or lots. These assessments must be assessed ratably to be exempt function income.
Non-exempt Function Income (or taxable income) is:
1) Income from non-association property - commercial operations and interest and dividends. 2) Income from non-members for use of association property. 3) User charges to association members for special services unless the user charge is assessed once in a twelve month period and the benefit lasts for the entire 12 month period. An example of a user charge is laundry income.
The advantages of Federal Form 1120-H are as follows:
1. Associations are not taxed on exempt function income.
2. The tax form is a one page form, with supplementary schedules, so it costs less to prepare.
3. The form has less risk than Federal Form 1120. There are four tests that have to be met to file Federal Form 1120-H, but most residential associations will qualify.
4. Fund accounting is not required since capital or reserve assessments are not taxed.
5. No election forms are required like on Federal Form 1120.
6. As long as you keep filing Federal Form 1120-H, no estimated taxes are required.
FEDERAL FORM 1120
The key advantage of Federal Form 1120 is that an association could pay tax at a lower rate than Federal Form 1120-H. Income tax rates start out at 15% on the first $50,000, however, the risk of compliance is far greater since an association must follow certain required procedures. Also, since the form is much longer and more complex it costs more to prepare than Federal Form 1120-H.
IRC Section 277 states that income for Federal Form 1120 should be allocated between membership and nonmembership income. An association can be taxed on both if there is net income, however, an association can make an annual election to defer net membership income.
Revenue Ruling 70-604 allows associations to defer net membership income for one year but if the association has net membership income in the next year then the association would have to pay tax in the next year on the deferred income. An association can also make an election under Revenue Ruling 70-604 to refund net membership income, but in my 30+ plus years of working with associations, I have never seen an association refund money. A question that I get asked about all the time is: Can our association transfer excess net membership income to reserves and then not have to pay taxes on this excess? The answer is NO if you are filing Federal Form 1120.
IRC Section 118 states that an association cannot transfer excess net membership income to reserves to avoid paying taxes since you cannot re-characterize what the assessments were for originally. In order for Revenue Ruling 70-604 to be valid, the election has to be made annually by all members (usually at the annual meeting) and it should preferably be made before the end of the year. The dollar amount does not have to be specified.
Capital contributions (reserve assessments) will be treated as non-taxable on Federal Form 1120 if certain guidelines are followed:
1. The purpose of the assessment must be capital in nature. The reserve study supports the purpose of the capital assessment. However, painting, even if it was included in your reserve study, is an operating assessment, not a capital assessment.
2. Members must have advance notice. Distributing copies of the budget to the members is considered advance notice.
3. The assessment must be accounted for as a capital contribution and held for that purpose. The books and records, along with the budget should segregate operating and reserve (capital) activities. Therefore, the association should use fund accounting.
4. Reserve (capital) assessments should be deposited into a separate account and reserve expenditures should be paid out of this separate account. An association can pay for capital expenditures out of the operating fund account as long as the reserve account reimburses the operating account in a relatively short period of time.
Now that you have a brief understanding of the two forms, you might be wondering which form should your association be using? This is a hard question to answer unless your CPA knows the facts and issues associated with your association.
Usually if your association has little interest income and no (or minimal) user fees you will file Federal Form 1120-H. As interest income grows, your association should look at filing Federal Form 1120 as an alternative. If your association has minimal interest income, but you have a net loss from your net membership (for example due to a painting project) you may want to file Federal Form 1120 since that loss gets carried forward. If your association files Federal Form 1120 because of the large amount of non-membership income, you want to make sure that you do tax planning ahead of time to minimize your net membership income.
You now should have a better understanding about the different types of Federal income tax returns and which Federal income tax return is right for your association.