By: Linnea Juarez PCAM, CCAM
Each year the Board of Directors must take on the task of preparing and adopting an operating budget for the Association. This process involves an analysis of the reserve funding needs and requirements, operating income and expense over the current fiscal year and the association’s needs and owner’s expectations.
The result is the determination of the adequacy of the current assessment level as compared to the reserve funding requirements and operating expense projections. If the total of these two fund requirements is greater than the expected revenue sources, the board must contemplate options to cover this shortfall.
One obvious option is to raise the revenue levels usually through assessment increases. This is often necessary and desirable based on ongoing increases to operating costs. Another consideration must be the results of operations over the current operating year and prior year’s net operating results.
If the association has a positive operating fund balance, current net income which will result in a net increase to the operating fund balance and excess operating cash, then the board can and should consider using that net income to cover the increased operating and reserve requirements for the upcoming fiscal year.
An important consideration is that the net income to be applied to the budget must be backed by available operating cash. If the net income is mainly backed by accounts receivable and other non-cash assets, the net income is not a viable answer to the need for operating cash to cover increased operating expenses and reserve funding.
If the board determines that net income does exist and is backed by an accumulation of operating cash then a deficit budget should be adopted and published. This means that the revenue shown on the budget will be less than the total reserve allocations and operating expenses. The bottom line will be a net operating loss in the budget which will be covered by the carryover of net operating income from prior years.
Obviously the budget must be accompanied by a letter explaining why a deficit budget is being published and how it will be funded with excess operating cash.
After this process occurs the board’s next task is the end of their fiscal or calendar year and the preparation of the association tax returns and year-end financial statements. This involves the engagement of a CPA to perform these services for the association and to advise the board on their options regarding the filing of tax returns either under Revenue Code 277 or 528.
A short tutorial on these tax options is necessary for the board to understand the ramifications of each decision and the underlying costs and potential liabilities related to these two methods of tax filing. I am dismayed that the tax filing options are usually not even discussed with the board. They are handed a tax return and asked to sign. That appears to be the extent of their involvement in the process.
The association can file either an 1120 tax return or an 1120H. If the board chooses to file an 1120 under IRS Revenue Code 277, they must do all of the following;
1) Pay Estimated taxes in a timely fashion
2) Pay tax liability on time
3) Have the owners vote annually on the 70-604 election.
The 70-604 election is usually voted on at the annual meeting. Now, with the new election laws, this may become problematic. We have added this to our written ballot to make the process easier. This election basically asks the owners to approve the disposition of any net income which may be the result of the year’s operations. Technically there are three accepted uses for net income under this ruling which will protect the association from tax liability related to this issue.
1) Transfer the net income to Reserves.
2) Carry the net income over to the next operating year to avoid the necessity of increasing the owner’s assessments.
3) Refund the net income to the membership.
Any of these options are dependent on the availability of cash. If the board voted to transfer net income to the reserve fund, but did not have the cash available to actually move from operating to the reserves, would this create an unfunded reserve liability? That certainly would not achieve the results the board was hoping for.
The decision to use net income to cover a projected budget shortfall in the upcoming fiscal or calendar year requires the availability of cash to support the expected costs of operations. You can’t pay bills with accounts receivable.
Refunding net income to homeowners can create an even bigger nightmare. The association may end their fiscal or calendar year with a net income of $1500. If refunded to the membership, what does the association use to pay their January operating bills? These bills may be due and payable before the assessments for the month have been received. The association needs operating cash to continue normal business operations.
Rather than asking the membership to decide the best use of net income, the wording of the 70-604 should be as follows:
Resolved: that any excess of membership income over membership expenses (profit) as defined in Internal Revenue Code Section 277 for the year ended _____ shall be applied to the subsequent tax year member assessment as provided by IRS Revenue Ruling 70-604.
This allows the board to analyze the needs of the association and the best use of any excess funds. They may decide to transfer a portion of the net income to the reserve fund and maintain a portion in the operating account to offset the increases expected in operating costs.
All of these actions are based on the concept of filing an 1120 tax return and having the membership vote on the 70-604 election.
The real question is if this is the best tax option for the association?
Under tax code 277, filing an 1120, the association is taxed at 15%. If they file under tax code 528 using an 1120H, the tax rate is 30%. The real question is what is taxable?
Under tax code 277, filing an 1120, all non-assessment income is taxable. This includes interest earned on banking accounts, both operating and reserve; laundry revenue which is not offset by laundry expense; parking and other revenue not offset by specific expenses. Net income is potentially taxable unless the association has followed the steps required including the passage of the 70-604 election. Various artricles have been written regarding the taxability of net income in this circumstance and a major question is whether an association can have multi-year net operating income protected by the 70-604 election..
There is a school of thought which takes the position that net income must be “used up” in the next year by either application to the reserve fund or to the next year’s assessments to offset required assessment increases. The assumption is that the association could be liable for taxes if the IRS were to perform an audit and determine that net income has occurred over multiple years without proper application as required under the 70-604 election.
All of this uncertainty can be avoided if the association files an 1120H tax form. First the association must qualify to file under revenue code 528 and secondly they must instruct their CPA to use this option. Assuming that your association can qualify (discuss with your CPA) to file an 1120H, the next question is the tax rate imposed under this tax code. The flat rate is 30% tax on all non-assessment income excluding the $100 allowance. If we assume that in most cases non-exempt income relates to interest earned on reserves and operations, how much is taxable?
In today’s banking economy, the earnings are so minor that paying 30% of nothing is nothing. It is a great time to instruct your CPA to file 1120H on behalf of the association. This avoids the issue of voting on the 70-604 election and the question of tax liability on net income. It may also “clean up” prior questionable issues related to net income.
Many CPA’s have already switched their clients to an 1120H filing and some have always filed this way. It is important for the board to have a basic understanding of why. When interest rates rise and taxable income becomes a greater issue, the board should be ready to open a dialogue with their tax preparer.
