On the Possible Origin of the Association's Tax Problems
So, you wonder how this tax mess came about. For one clue, let’s take a look at what tax advice the association was apparently getting from Hilburn & Lein, or more likely from Gary Lein, our association’s professional tax advisor and preparer. Based on what I understand from Jack Troia, either Gary Lein is correct or the IRS is correct on how IRS Revenue Ruling 70-604 should be applied to associations that are required to use Form 1120 in filing their annual tax return.
If I were taking odds on who is more likely to be correct, I would lean in favor of the IRS. But those odds may be a bit risky since the Tax Court and the Court of Appeals are replete with examples of IRS determinations being overthrown.
While the association has a lot at stake in this matter, I suspect that Hilburn & Lein (H&L) has a lot more at stake given that they provide their professional tax services to a number of like clients who presumably have acted on similar tax advice. In the unlikely event the association relied on certain tax advice that was subsequently proved wrong on appeal, how might that result affect our relationship with Hilburn & Lein? In that event, where does liability fall if the client was relying on such advice?
What kind of advice has Hilburn & Lein provided?
Hopefully, Hilburn & Lein has been providing the association with tax advice that is correct, in which case the association will owe nothing to the IRS. But that hope appears to be fraught with uncertainty given their published tax advice on applying 70-604.
While we do not know the scope of professional tax advice offered by H&L, we can garner an important clue by reading from H&L’s website on how they view the application of 70-604. Under the section Income Tax Considerations for associations filing a Form 1120 tax return, we can see H&L's published tax advice on page two.
Among the steps listed that must be taken by a Form 1120 tax filer, such as SCACAI, is the following relating specifically on how to apply 70-604:
6. Using Revenue Ruling 70-604, associations may exclude from taxable income excess membership income by recharacterizing as follows:
a. Apply the excess of membership income over membership expenses to the following year's assessments, or
b. Apply the excess of membership income over membership expenses to the capital reserves of the association, or
c. Refund the excess of membership income over membership expenses to the association's members.
What’s especially interesting about this advice is that while there is abundant documented support for following steps (a) and (c), there does not appear to be the same documented support for following the advice in (b), namely apply excess income to capital reserves under 70-604. Said differently, 6(b) is not an available alternative or option under 70-604. If the IRS is to be believed, a Form 1120 tax filer may not do anything other than (a) or (c), either refund the excess income or credit that excess income to next year’s assessments. Sun City Anthem may not do (b) and forget about (a) or (c) as H&L's advice would seem to suggest that possibility as an alternative.
The key to this issue is whether an association can recharacterize excess income which would otherwise be taxable at years end as contributions to capital reserves of the association. H&L appears to believe that is possible. But may such amounts be recharacterized? According to the Summary to the case quoted and cited below, the answer is, no.
"The condominium association had excess membership income, filed Form 1120, made appropriate election under Rev. Rul. 70-604, but did not either refund the excess or carry it over to the subsequent tax year. Instead, the association transferred the excess to reserves. IRS reversed this on audit and treated the excess as taxable income (since excess member income is taxable on Form 1120 unless an election is made and income is either refunded or carried over to the subsequent tax year). The IRS concluded that since the monies had been assessed as operating funds, they could not be subsequently recharacterized as capital contributions." (emphasis added.)
Admittedly, we are not privy to the advice that was offered by H&L insofar as 70-604 is concerned. As previously written, both (a) and (c) are mentioned in the language of 70-604 as alternative conditions that must be met in order for the association to take advantage of 70-604. If the association does not wish to do (a) or (c), fine. However, the cost of not doing either (a) or (c) is that the excess income is taxable. That is what the IRS concluded in their 2011 audit of the association’s 2007 tax return.
While the association may wish to make all kinds of expenditures with those millions in carryforward monies, the association has only two options available if they do not wish to pay taxes on that amount.
From an internal IRS memo providing advice on a case where the association then under audit neither refunded excess assessments nor applied them to the next year’s membership expenses, the IRS national office concluded as follows (see footnote):
“It is our view that Rev. Rul. 70-604 is an . . . . exception to the general rule of I.R.C. §61 which would otherwise require any excessive assessment to be fully taxable in the year collected. As such, the revenue ruling should be strictly construed.”
“Any amounts collected from the membership in excess of allocable expenses are includible in income of the association unless . . . . the excess is to be applied to the next year’s [membership] expenses. If a decision is made to apply the excess to the next year’s assessments and that in fact does not occur, the excess is taxable because the amount has not, in effect, been returned to the members, which is the underlying theory of the revenue ruling. We do not read the ruling as providing authority to continually carry over that excess amount beyond the next year.”
“The requirement in Rev. Rul. 70-604 that the excess assessments must be applied to next year’s expenses is not met if the members’ assessments in the subsequent year have not been reduced to reflect the availability of the prior year’s excess assessments.”
"Where the amount in question was collected from the members as association dues in the first instance and never earmarked for any specific capital expenditure, an inference is justifiably drawn that the amount was not a nontaxable assessment for a capital expenditure purpose or for placement in a capital surplus account in the absence of any prior understanding that the excess dues would be placed in a capital reserve account."
As to how the association will address this matter and the audit’s results in their appeal, we will just have to wait and see. Regardless of the outcome of the appeal, one can anticipate that the outcome will be revealing.
For an excellent article on these tax matters, see HOA tax expert Gary A. Porter’s REVENUE RULING 70-604: THE LATEST WORD here. In this article, Mr. Porter provides concise and easily understood information on virtually all of the tax related questions that might arise in an HOA that files Form 1120.
Ronald Johnson, 13 March 2011