What Is a Basic Overview of Taxes?

What Is a Basic Overview of Taxes?

Your association is a non-profit corporation?  True.  Thus, as a non-profit entity, you owe no income taxes?  False!

This is a common misconception among board members, especially those first time volunteers.  If you do not understand your association’s taxes, don’t feel alone.  Community association taxes are very complex.  It is quite possible that even your personal tax preparer has little or no knowledge on this subject.  That is why it is important the Board chooses an accounting professional who knows this industry and one who will make the best choices for your association.

So on what income does an association pay tax?  This can get very complicated, as will be described in the following paragraphs, but at the very least, the association generally needs to pay tax on its interest earnings.and income from nonmembers. Nonmember income may include items such as unit rental, cell tower rental, cable incentives, amenity charges and filming fees. Per-use income from items such as clubhouse rental, parking fees and laundry is also taxable, unless it is 1) from members and the Association chooses to file Form 1120 or 2) from members who are billed annually and the Association chooses to file Form 1120-H. Associated direct costs can be deducted from taxable income. The Association needs to clearly identify those expenses. Laundry income is usually offset by an equal amount of direct expenses.

Associations have a unique tax situation found in no other area of tax law, in that they have the choice annually of determining which tax return to file. An association may file as a homeowners’ association using Form 1120-H, or may file as a regular corporation using Form 1120. This decision can change each year. The association may file Form 1120-H one year, 1120 the next year, then back to 1120-H the third year. Additionally, some larger associations may be exempt from taxation and may file Form 990. Filing Form 990 is a permanent decision. The following paragraphs will attempt to quickly explain the differences, but will not include an in-depth analysis

Form 1120-H is the form that was specifically designed for homeowners associations.  It is the easiest to prepare. has the least accounting requirements, and is the least risky with regards to IRS audits. Non-exempt function income (after direct expenses) is taxed at a rate of 30%. Non-exempt function income includes interest, non-annual per-use fees from members, and all nonmember income. There are certain qualifications in order to be able to file Form 1120-H. It is required that 60% of the income and 90% of the expenses must be exempt function. Additionally, 85% of the Association must be residential. Thus, commercial associations, associations with more than 15% commercial usage or some associations with large amounts of amenity income or services may fail the qualification requirements. They must file Form 1120.

Form 1120 is the regular corporation tax form.  It is much more difficult to prepare, and can cause even membership net income to be taxable. There are strict accounting requirements and this form carries a much higher risk of IRS audit and/or additional assessment of taxes under IRS audit. It has a much more favorable tax rate – 15% on the first $50,000 of taxable income. Another advantage is that per-use and other income from members may not be taxable. Form 1120 has much more restrictive accounting procedures – such as segregation of operating and reserve cash, fund accounting, adoption and adherence to a budget that agrees with a reserve study, minimal transfers between funds, substantiated repayment plans for amounts due between funds, and considerations of capital and non-capital categories of reserve components – that need to be considered. These requirements, as well as increased IRS audit risk, should be carefully weighed to determine whether the tax advantages outweigh the risks.

A common tax planning tool is to elect Revenue Ruling 70-604, which says that the membership may choose to have any net membership income transferred to the next year or returned to the owners. This is an important election used with Form 1120 that may provide a tax benefit to the Association. We recommend that this election be annually approved by the membership – whether Form 1120 or 1120-H is ultimately filed.

Form 990 is for larger associations that are communities among themselves.  These associations are exempt from taxation. This designation is obtained from the IRS and is difficult to get, but some associations have been successful in obtaining this tax status.

Take time to discuss your Association and its tax matters with your accountant.  Ask whether there are any tax saving tools which your association could use.  Discuss whether to file 1120 or 1120-H and whether your current accounting procedures allow you to make this choice.  Consider the Revenue Ruling 70-604 election. Evaluate per-use fees that are charged monthly. Evaluate IRS audit risk. Remember, the final tax responsibility rests with you, the board member. It is you who will have to sign the return, and you must ensure that the best interests of the association membership are being met.