How your association can avoid the scrutiny of the IRS
At best, an IRS audit is a high-cost nuisance. At worst, it is a serious financial
attack upon your association. Over the past few years, several California homeowner
associations have been targets of unexpected audits by the IRS, and hit with back tax
bills as high as $800,000. Most of these audits are on hold while the national IRS office
reviews the issues. And while audits are rare, they can happen, and the record-keeping and
management of your association should be based on that assumption. The best way to avoid
an audit is to constantly prepare for one.
Do Roll Overs by the Book
Many of the audited California associations had exceptionally large reserve funds,
fattened by substantial settlements from construction defect lawsuits. They also had filed
an 1120 income tax return, as opposed to the 1120-H return. 1120-H is designed
specifically for homeowner associations, and taxes associations at a flat rate of 30
percent. 1120 is a corporate tax return that can result in lower taxes than 1120-H.
For associations that file an 1120 return, there are a few ways to treat excess
operating funds that otherwise might be taxable membership income. In Revenue Ruling
70-604, the IRS allowed an association to exclude excess membership income from taxation
by returning the excess to its members. Pursuant to this ruling, an association can make
an annual election to return the excess in one of two ways: * Refunding the excess to the
members * Applying the excess membership income to the next year's assessments
The first method is easy and poses little risk of an audit. The association simply
refunds each unit owner's share of the excess membership income. However, the second
method, the roll over of excess funds from one year to the next, is especially prone to
IRS inquiries. When the roll over method is used, the association should make sure that
the amount rolled over is absorbed in the following years.
In some cases, the association may treat part of its assessment income as a nontaxable
contribution to capital. To do so, it must meet the following criteria: * Its budgets and
financial statements delineate between operating and capital reserve activities *
Replacement fund study supports the need for capital improvements * Cash accounts for
operating and capital purposes are segregated * Tax return treatment clearly distinguishes
capital transactions from operating transactions
Documenting the association's specific action is essential. If the IRS can find no
written record of the roll over election by the association members--not just the
board--made prior to the filing of the year's tax return, they will conclude that the
election was bogus, and that the funds are fully taxable at the appropriate corporate tax
rate. Every association should adopt resolutions at its annual meeting to cover how owners
want to dispose of excess operating funds. If no excess funds exist, ignore the election
resolution.
The scenario continues into the next year as well. Let's assume these funds (properly
documented and reported in the tax return) were not used in the next year as intended.
This also can call the election into question. How do you avoid this situation? Do what
the resolution implies: refund the excess to the owners, transfer the excess into capital
reserve investment accounts, or modify the new year's budget so there is a membership loss
to absorb the roll over excess from the prior year.
Document Expense Allocations
If you report interest income on the association's tax return, assume the IRS will be
keenly interested in what expenses were allocated against it, and in other nonexempt or
nonmember income to lower the taxes due.
The main pitfall--and it applies to forms 1120 and 1120-H--is failure to create the
thorough records the IRS demands to substantiate expense allocation against various types
of income. This is especially true of many small, self-managed condominiums that lack
mechanisms to track expense categories. Consider an association with amenities that are
offered to nonmembers or guests for a fee. The IRS will ask these associations to document
the reasoning for their expense allocations (for example, hours of janitorial services).
Be Prepared
Audits are rare, but your association should always be prepared for one. Maintain
thorough records. Whether your association files an 1120 or an 1120-H return, any IRS
audit will require review of the following documents: * Copies of tax returns for the
years immediately prior and subsequent to the year under audit * Financial books including
general ledger, cash receipts, and cash disbursements * Minutes of all association
membership and board meetings, especially copies of any elections passed by the general
membership on handling of excess membership income * Copies of annual budgets * Copies of
banks/brokerage account statements holding segregated capital improvement funds (If an
association claims that part of its assessment income is a nontaxable capital
contribution, these funds should be segregated and not used for normal operating
activities. The IRS will frown upon "loans" from capital reserves to everyday
operating funds.) * Invoices and canceled checks to support expense deductions, including
payroll, arranged in categories as they appear on the return (i.e., repairs and
maintenance, utilities, supplies, etc.)
Whether selecting property management firms, attorneys, and accountants, make sure they
are familiar with IRS rules. Tax laws are defined by a continuously evolving set of IRS
rulings. Ensure that your association professionals stay abreast of ever-changing IRS
interpretations. Your property manager, for example, needs to know how to document the
allocation of various expenses so your association can properly compute its taxable income
and file the return (1120 or 1120-H) that is most advantageous. Your association should
consult at least yearly with both legal and accounting experts who make it their business
to understand community association issues.
The best way to avoid an audit is to prepare for one, and to practice careful, accurate
accounting.
IF YOUR ASSOCIATION IS AUDITED
If the IRS audits your association, you can take steps to minimize its effect:
Leave adequate time to prepare. Scrutinize the audit notice to determine its scope and
the various financial records that will be needed for the review process. Usually the IRS
will reschedule to a more convenient time if you ask them to do so. Good up front
organization will help the audit process run smoothly and may reduce professional time and
fees.
Hire an accountant to handle the audit. If there was ever a time to hire an expert,
this is it. Those who prepared the tax return are most familiar with the return under
review, and usually have prior experience with IRS audits.
Promptly get your complete records to the accountant. Even with outside help, your
association's treasurer or a board member will likely have to gather the documents
necessary for the audit. The sooner the accountant receives these documents the better.
Consider the costs of appealing IRS adjustments. Even if there are adverse adjustments
to your tax return--which the association feels are unjust--an appeal isn't always the
best way to fight it. Appeals incur professional fees. It's best to weigh your options,
and decide whether you ran preserve more of your reserve funds by simply paying these
additional levies or fighting them.
12 COMMON MISTAKES--and how to avoid them
Audits are rare, but they can happen, particularly when an association makes silly
mistakes. Avoid these 12.
David B. Price, CPA, is an accountant and business consultant in Boca Raton, Florida.
1. Failing to review. Someone, besides the tax return preparer, should review the tax
return for obvious errors and/or omissions. Avoid careless errors; check all calculations
carefully.
2. Forgetting the employer identification number. If the association does not have an
EIN, apply for one using Form SS-4, Application for Employer Identification Number. If the
association has not received its EIN by the time the tax return is due, write
"Applied for" in the space for the EIN.
3. Filing late. File on time--even if you can't pay the tax. The IRS audit manual
advises its agents to be on the alert for delinquent tax returns. An association may have
to pay late fees and may lose the right to file Form 1120-H if it doesn't file its tax
return by the due date including extensions.
4. Using the wrong tax rates. The IRS scrutinizes taxpayers' computations. Form 1120-H
is a flat tax rate of 30 percent. Form 1120 is a graduated tax rate ranging from 15 to 39
percent.
5. Filing an incomplete tax return. Attach forms, schedules, supporting statements, and
explanations. (Complete every applicable entry space on the forms. If more space is
needed, attach separate sheets, using the same size and format as the printed forms.
Transfer the totals onto the printed forms and put the association's name and EIN on each
sheet.
6. Miscalculating. It is permissible--and easier--to process your tax return if you
round off all money amounts. Round up to the next dollar all amounts that are 50 cents or
more. Round down all amounts that are between one and 49 cents.
7. Not filing all related tax forms. The association may have to file forms W-2, W-3,
1096, and/ or 1099-MISC. Every association must file Form 1099-M1SC if it pays rents,
commissions, or non-employee compensation of $600 or more to a person or partnership
during the calendar year.
8. Paying late. One way to get the IRS' attention is to not pay your taxes. If the
association owes tax when it files, do not include the payment with the tax return.
Instead, mail the payment with Form 8109 to a qualified depository. Otherwise the IRS may
assess a penalty.
9. Forgetting to sign the return. The tax return must be signed and dated by the
president or any other association officer authorized to sign. The paid preparer must
complete the required preparer information and sign the return in the space provided
(stomps and labels ore not acceptable).
10. Not listing the current address. If you use your management company's address and
you've changed companies since you last filed, check the "change of address"
box. Otherwise, the IRS will send all correspondence to your old company.
11. Not replying to IRS inquiries. Ignoring the IRS invites an audit and/or seizure of
assets.
12. Not keeping a copy. Many states require associations to retain tax returns for
several years.
