January 25, 2014
HOW ASSOCIATIONS ARE TAXED
By: Marc Whitfield, CPA, CFST, MBA – Tax Manager
Condo and Homeowner Associations are Nonprofit Organizations, right…WRONG! This is a common misconception we see every day. The reality is that Associations are taxable membership organizations. With this, Condo and Homeowner Associations are unique in the sense that you can choose to file your taxes using one of two forms. You may elect to file Form 1120-H or Form 1120 each tax year depending on several factors. Are you taxed under IRC 528(Form 1120-H) or IRC 277(Form 1120)? This is determined by distinguishing between exempt/nonexempt (1120-H) vs. member/nonmember (1120). What does this mean and how does it affect your Association?
If your Association meets the following 4 qualifications you can file Form 1120-H. First, The Substantial Residential Test, 85% of the Association must be held for residential use. Second, The 60% Income Test, at least 60% of gross income must consist of exempt income (excluding assessments for reserves). Third, The 90% Expenditure Test, at least 90% of expenses must be for carrying on the exempt function income. Finally fourth, The Lack of Private Benefit Test, no member of the association may profit from the net earnings of the association. If these 4 tests are met, your association may file Form 1120-H.
Now you are wondering what difference does it make? Actually, there are several differences between the two forms, such as tax rates, carryovers, taxability of certain income, and complexity of the forms. If we haven’t scared you yet, let’s dissect this more.
Associations that meet the qualifications of IRC 528 and file Form 1120-H are taxed at a flat rate of 30%. Associations that file Form 1120 under IRC 277 are taxed at graduated rates that start at 15% for the first $50,000 of taxable income and go as high as 39%. You may owe less tax by filing form 1120; however you will also have to pay state income tax. Although the tax may be slightly higher by filing Form 1120-H, the lower risk and lower tax prep fees may very well provide more of a benefit to your Association.
One distinction between the two has to do with carryovers. Under IRC 528, any excess exempt function income is not taxed. Likewise, any exempt function loss is not deductible, carried over or carried back. Under IRC 277, net member income is taxed unless the Association elects to defer the income pursuant to Revenue Rule 70-604. Depending on member votes, this allows the Association to either apply the excess to the following year or refund the excess to the members. Excess member deductions can be carried forward and used to offset future member income. Furthermore, excess nonmember loss is treated as a net operating loss and can be carried back or carried forward to offset future net nonmember income.
A second distinction between the two is the taxability of income. Under IRC 528, exempt function income is not taxable. Under IRC 277, excess member income over member expenses may be taxable. The distinction lies between the fees charged for services. Nonexempt function income includes fees for items such as laundry facilities, vending machines, room rentals, key cards, boat rentals, and restaurants charged to members and nonmembers of the Association. Whereas, the fees for the above, if charged to members are considered membership income under IRC 277.
Finally, the complexity of the two forms differs depending on how you are filing. Associations that quality and meet the criteria of IRC 528, can elect to file Form 1120-H by submitting the 1 page form to the IRS. This form has less inherent risk than the longer 1120 form and no state return is required. Otherwise, you will have to file Form 1120, which is a much more complex multi-page form that has more inherent risk associated with it as well. Plus when filing Form 1120 you must also file a state return.
With all this being said, sometimes its not a black and white decision as to which form your Association should file. Ultimately, the Board of Directors has the final choice. Be sure to consult your tax advisor in order to make better informed decisions.