The Authority of the Board and the IRS Tax Audit III

The August board meeting included a Tax Planning presentation by Jack Troia and Dan Forgeron. Of keen interest to homeowners looking for some financial relief was the announcement of an assessment holiday for the fourth quarter of 2010. Instead of $1.7 million going to the association in the fourth quarter, homeowners can keep their money. While that assessment holiday decision was part of an overall plan, it’s unknown whether that plan might be modified as a result of the ongoing IRS audit. For now, however, the only thing we have to go on is the recently received mail announcement on this matter.

Ironically, and for interested CPAs, this assessment holiday may turn out to be the first legitimate offset from income permitted under IRS Ruling 70-604 in the event the IRS auditor should disallow similar past claims. As discussed below, this issue can get quite complicated.

Usually, but not when comes to IRS Revenue Ruling 70-604. Jack Troia’s tax planning presentation prominently displayed a critical statement on the application of IRS Ruling 70-604. The importance of this statement cannot be overemphasized. Unfortunately, the statement is at best misleading and at worst, blatantly false. Jack Troia and the board have been attempting to make others believe that a certain something is a fact when it’s not. What fact might that be?

But, really, does NV law empower an HOA board to act on behalf of residents? The simple answer is NO, although Jack might prefer to make that argument. It seems that Jack would like us to believe that is what the statute says, when it doesn’t. Jack has a likely reason for substituting “Residents” for the actual statutory language. What’s his purpose? Jack knows that the language in RR 70-604 in an HOA situation is intended to apply to members of the association or unit owners and not to associations or boards of directors. Since our tax returns cite 70-604 to justify the board claim of millions of dollars in offsets to reduce the association’s taxable income, what 70-604 says and what Jack Troia says about 70-604 is important. Under 70-604, unit owners are ostensibly empowered to make the annual decision on the disposition of excess funds. Knowing that, Jack would like us to believe that the board is empowered to make those annual decisions on behalf of the association’s members. However, the statute does not state that. It states something entirely different, namely that the executive board may act in all instances on behalf of the association. Here, in part, is what the statute states:

The term “association” is defined as an organized legal entity, with no mention in the statute of "residents" or unit owners. So why would Jack, who is very knowledgeable and we assume a brilliant CPA, attempt to mislead Sun City Anthem homeowners on such a critical matter? Perhaps Jack wants Sun City homeowners to believe he is doing the right thing, but sadly the meaning Jack would like to convey to homeowners is not supported or even implied by the statute he relies on in making his claim that the board can act in behalf of the residents.

Perhaps so. If what Jack wrote were true, then he might have a better chance in convincing others, like our naïve homeowners, that the board’s powers to make financial decisions preempt what some contend are outdated IRS rulings, such as 70-604. As posed by some, the unresolved issue here is whether the board or association members (unit owners) have the decision making authority to make that annual decision on the disposition of excess income. It’s true that Nevada law puts financial decision making authority in the hands of the board, while RR 70-604 puts that one annual decision making authority on the disposition of excess income in the hands of the unit owners. Are the two mutually exclusive? The board says, yes, and the IRS may agree. From a legal standpoint, Nevada law does not give the board ultimate or final authority over budgetary decisions. That authority rests with the unit owners, who have the authority to reject a proposed budget pursuant to NRS 116.31151. Practically, though, that authority is limited since any rejection must have the support of a minimum of a majority of all units’ owners. With 7,144 unit owners, authority to reject a budget in an HOA like Sun City becomes essentially meaningless.

Whether the board or the members of the association make that annual decision on excess income, that decision provides for only two outcomes. Those outcomes are that the excess income must be 1) returned to the homeowners in the current year, or 2) credited towards next year’s assessments. Under that circumstance, the issue of who decides does not appear to be that important since in either case, whether it’s the board or the members, the excess income is returned to the homeowners. Of course, in past years and currently, the board has ignored that requirement in favor of a more flexible budgeting process that has facilitated the board’s decisions to allocate funds as it sees fit. It is that process that is under scrutiny by the IRS.

But are those two propositions in conflict? I assume that we will find out sooner rather than later, perhaps at the upcoming board meeting on Thursday.

I’ll leave you with one thought on this matter. If the association wants to claim the considerable tax benefit of RR 70-604, the board can follow the will of the unit owners on the disposition of excess income through a balloting process, a process that is apparently allowed by IRS. Assuming that takes place, the excess income is returned to the homeowner one way or the other. If the board declines to follow the will of the homeowners, they are either correct in doing so or, if not, they must pay standard tax rates on the excess income.

Since this money thing we’ve been talking about is “excess” income, some might argue that such income is actually in excess of the needs of the community to function, that is, the funds are not really needed for operational or reserve needs. Those pondering this issue would be correct. The board is thereby left unencumbered but ONLY to manage the community’s needs, presumably as the State intended. The issue of the board having the decision-making authority in financial matters could be interpreted as having only LIMITED authority. For example, NRS 116.3102 tells us what powers the association has; see the footnote at the bottom of this article. In 1(b) of that section, it states that the association may “adopt and amend budgets for revenues, expenditures and reserves and collect assessments for common expenses from the units’ owners.”

What’s important here is that such efforts must be “for” some purpose. What is that purpose? According to the statute, that purpose is defined as being for “common expenses.” And the funds for that purpose shall come from “the units’ owners.” With this in mind, what we need now is an example to illustrate the nature of the problem faced by the board and our homeowners.

For what authority the board has under Nevada law regarding "surplus funds," see the new highlighted section below.

Hypothetically, say the association’s level of assessments is $800/yr. However, in order to meet the association’s needs “for common expenses,” those needs can be met for only $600/yr. This goes on year after year. In other words, the association is collecting and accumulating more money than they actually need to meet the common expenses. With about 7,000 members, the association is collecting $1.4 million each year that they do not need to operate the company, that is, 7,000 members x $200/yr. That money keeps building up over time.

Now, taking a look at 116.3102, the association is empowered only to collect those assessments that are needed to meet the common expenses of the community, nothing more. However, our homeowners should note that the association is NOT empowered to collect assessments that are NOT needed, although that is what’s been going on for almost seven years here in Sun City.

The board may think that having a readily available piggybank growing fatter year after year to fund this, or that or to sock it way for another day, is a desirable objective. However, a strict constructionist of the statute could easily conclude that the board actually lacked any statutory authority to do what they have been doing, namely assessing homeowners far beyond the community’s need to fund its “common expenses.” If the board is not funding "common expenses" as the statute requires but is doing something else with the excess income, by what authority is the board acting?

Does Nevada law address the issue of surplus funds? That's an interesting question. With the board anxious to convince homeowners that decision-making authority regarding budgets rests with the board, what exactly is the board's authority when it comes to surplus funds? Can the association roll those funds over year after year, bank those funds, allocated those funds for capital projects or sock those funds away in the reserve fund? According to Nevada law, the answer is NO. Apparently, the board is relying on advice that tells them otherwise.

Board members might be interested in knowing and perhaps surprised to learn that Nevada law actually addresses the surplus funds issue. Virtually paralleling the IRS ruling, NRS tells the board what they are required to do with surplus funds. Such funds "must be paid to the units' owners . . . . or credited to them to reduce their future assessments for common expenses." By the way, when is the board required to do that? According to NRS 116.3114, this should happen "after payment of or provision for common expenses . . . ." Since that is a yearly event, one would expect that to happen yearly. Here is what the entirety of that section states:

While Nevada law on the disposition of surplus funds looks clear enough, it apparently was not clear enough to the association's decision makers. Do good intentions trump the law, or were those decisions more about retaining control of the process while portraying to the membership a false picture of another good job in their efforts to "hold down assessments?" When assessments, like in our example above, are 30% more than what's actually needed to fund operations, it's not too difficult for the board's officers to portray "good news" about the proposed level assessments remaining unchanged at the association's annual budget meeting.

What does the Treasurer’s signature on a Sun City Anthem association tax return mean when the following statement, reproduced below, appears on that tax return?

Did we actually cast a vote to specifically empower the treasurer to make this election on our behalf. I do not recall that ever happening but assuming that we did as alleged, does that mean our excess membership income was carried over to the following year's assessments. I do not recall that happening either. If so, what do you think our treasurer had in mind when signing that tax return while stating that membership income will be carried over to the "following year's assessments?"

Will that same statement also appear on the 2009 tax return that was presumably filed by extension due on or before September 15, 2010? Or, are they waiting for further advice?

Ron Johnson, 19 September 2010, Rev 21 Sept., along with a new section added on "Does Nevada law address the issue of surplus funds?"

NRS 116.3102 Powers of unit-owners’ association; limitations.
1. Except as otherwise provided in this section, and subject to the provisions of the declaration, the association may do any or all of the following:.
(b) Adopt and amend budgets for revenues, expenditures and reserves and collect assessments for common expenses from the units’ owners.