Posted:
Tony,
Although I am not a CPA, I am employed by an accounting firm. I will try to explain what the auditor has told you in simpler language. However, I am not offering you any tax advice.
An uncertain position with regard to a tax benefit or deduction on a tax return is claiming a deduction for an expense (or claiming a tax benefit or tax reduction) based on a reason that is questionable or may not be allowed by the IRS. The IRS may penalize the taxpayer and/or the tax preparer for knowingly preparing a return that contains a deduction with an uncertain, or unreasonable, position. However, typically, the IRS will not apply any penalty if there is a better than one in three chance that the position will be sustained upon examination. Our firm is a little more cautious and we advise our clients to claim a questionable deduction only if there is a 50% or better chance that the deduction will be allowed.
When filing Form 1120-H, assuming your organization meets the qualifications for doing so, exempt function income is exempt from tax. Exempt function income, normally, are the regular assessments you receive from your homeowners that are typically used to meet your common expenses. An advantage of using Form 1120-H is that any exempt function income that is not used for annual expenses and is left over at the end of the year (typically the money put into reserves) is not taxed. If you were to file Form 1120 instead, that left over money (that you put into reserves) would be considered profit and would be taxed. To avoid that you would have to do some extra bookkeeping and you would have to be careful about how you account for and use that left over money (that you put into reserves). Using Form 1120-H allows you simpler bookkeeping and, for most HOAs, provides a tax advantage.
The downside of using Form 1120-H is that all non-exempt function income is taxed at a fixed rate of 30%, which is higher than the first tier rate of 15% when Form 1120 is used. However, for most HOAs this is not an issue because their non-exempt income is usually small.
Non-exempt income is all income that comes from "outside" sources. The most common non-function income is interest. Other non-exempt income could include rent payments (such as clubhouse rental) and fees that are not paid by all homeowners, such as special use fees. This income is taxed. You are allowed to take a $100 standard deduction, plus deductions related to any expenses in producing that income.
Apparently, the auditor is telling you that you have filed incomplete and/or inaccurate returns for prior years because you failed to report certain non-exempt income and pay any taxes due on it. Since I don't know all the details, such as the total of your exempt function income, the total and nature of your expenses, etc., I can't tell if you were even qualified to use Form 1120-H.
I can't tell you what to do, nor can I advise you to simply ignore the past and not file amended returns. I suggest you contact a CPA for advice. However, I can tell you this:
1. If you do owe any back taxes and file amended returns, there will likely be penalties and interest.
2. If you discover that you should have filed Form 1120 instead of Form 1120-H (either because you were not qualified to file Form 1120-H or because it is more advantageous to do so) you cannot change from one form to another without first obtaining permission from the IRS.
3. You should definitely do things correctly going forward. You might be better off having a CPA or accounting firm prepare your taxes in the future. For filing a simple Form 1120-H this shouldn't cost more than a few hundred dollars (probably $500 or less).
Again, I would consult a CPA for advice.