Is Excess Income Taxable?

Started by JanS4 • 11 replies • 5753 views

💬 Join us to post & get advice from 50,000 HOA & Condo leaders.

⚡ Takes 30 seconds

Already a member? Log in

JanS4 (Michigan)
Posts: 14

Posted:

Our condo association keeps its books on a cash basis, has never budgeted for reserves, has never presented a balance sheet or income statement (accrual basis)at the annual meeting as required by our docs and state law, has never conducted a member vote in accordance with Rev. Ruling 70-604, and has always filed an 1120-H. The 1120-H shows total income and total expenditures (cash basis); expenditures do not include excess funds transferred to "reserves". Taxable income consists of interest income on investments.

Excess income is simply transferred into a savings or CD by the BOD. Funds in the savings and CD accounts are considered to be "reserves", but have never been designated for a specific purpose.

Do we have a tax liability because of the manner in which the transfers to "reserves" were made?

SusanW1 (Michigan)
Posts: 5,202

Posted:

Our bylaws state that a Reserve Fund is established and that 60% of membership fee is to be placed in that fund (the other 40% runs our annual expenditures).

Not-for-profits are not supposed to have large sums of "non-designated" money around. You need to get that "purposed" - - - OR return it to the Members. That's the reason it's a not-for-profit. Take in only what is needed to run the association.

JanS4 (Michigan)
Posts: 14

Posted:

Susan - thank you for your reply. Rev. Ruling 70-604 holds that any excess assessments returned to the owners by either (1) returning the excess to the owners or (2) having the excess applied against the following year's assessments are not taxable since such income has been returned to the owners.

Our association has never budgeted for reserves, provided the required financial statements at the annual meetings and conducted a vote of the owners in accordance with Rev. Ruling 70-604. The BOD simply transfers the excess to "reserves". As the excess has not been returned to the owners and the budgets did not provide for reserves, it appears to me that the excess assessments should have been considered taxable income. If so, our association could have years of unreported taxable income.

Tax returns have been prepared by someone totally unfamiliar with our condo docs, relevant state laws, and the above mentioned Rev. Ruling.

Any help would be most welcome.

GloriaM (North Carolina)
Posts: 829

Posted:

Jan:

A not-for-profit HOA can make a profit. However that profit (surplus) should be placed into the reserves/capital improvement fund. When the accountant files the 1120H he shows the funds in the reserves.

May communities have asked me can they get advertisers in their newsletter making a profit and the answer is yes, because what ever fees they collect for the newsletter offsets the cost of producing the newsletter.

JanS4 (Michigan)
Posts: 14

Posted:

Gloria thanks for your reply. My query related to excess assessments and their treatment in accordance with Rev. Ruling 70-604. Also, in looking at the 1120-H there does not appear to be a place/line where reserve balances are reported, however they may be on the 1120. Could you please clarify?

SusanW1 (Michigan)
Posts: 5,202

Posted:

What has been done with the "reserves" over the years? Has any of it been spent on repair/replacment of assets?

You say the excess has been placed into reserves, yet you say a reserve fund does not exist.

JanS4 (Michigan)
Posts: 14

Posted:

Susan - Perhaps my post is too technical as it relates to whether or not excess assessments would be considered taxable income by the IRS when our budgets are only for operating expenses. Reserves (or transfers to reserves) are not part of the budget.

As an example: Receipts from assessments $100,000 less operation expenses $60,000, equals excess assessments of $40,000. The Board transfers the excess to unbudgeted "reserves" and does not comply with Rev. Ruling 70-604. The 1120-H shows $100,000 as total exempt function income (line B) and $60,000 as total expenditures (lines C & D). Only interest from savings & CD's is shown as taxable income.

My concern is that our association has not properly reported the excess assessments ($40,000) as taxable income and, if audited by the IRS, we could be facing a bill for substantial underpayment of tax and penalties.

SusanW1 (Michigan)
Posts: 5,202

Posted:

There is no "excess" income. Your assessments are established according to need. Your board needs to make sure that all revenue is "designated" i.e. has a function for it. After your annual expenditures are figured, the reserve fund gets the rest. There is no "excess".

You DO have a reserve fund, it's just not formally established.

I believe that the kind of "income" you need to be concerned about is interest earned from investments,etc. - not assessments.

Pass a motion to establish the Reserve Fund, formally. Get a Reserve Fund study done.

MaryA1 (Arizona)
Posts: 7,043

Posted:

Jan,

Even though the budget does not show a "reserve" account and the assn may not have an "established" reserve if they are transferring the excess monies into an account "earmarked" reserves that should be sufficient. However, since a vote of the members is not being conducted, IMO, they may assessed penalties should the IRS ever conduct an audit. Contrary to Susan's suggestion to return the excess monies to the members, IMO, this is not allowed for an HOA operating under Internal Revenue Code 528 and filing an 1120-H.

I would push for the BOD to have a professional reserve study conducted and subsequently set up a procedure to have monies deposited into a reserve account on a regular basis -- not just excess monies deposited at year-end. Also, in future years when a "profit" is realized, the members should be asked to vote on having the excess monies placed into the reserve account. Also, when preparing the yearly budget, care should be exercised to try and prevent a net profit at year end. The budget should never show a profit or a loss -- all monies expected to be earned should be expensed out.

SusanW1 (Michigan)
Posts: 5,202

Posted:

Like I said before, your bylaws could be amended to establish this Reserve Fund - and all "excess" (monies left over after all expenditures are paid) could be automatically forwarded to this account. This Reserve Fund should be funded in the annual budget, anyway.

GloriaM (North Carolina)
Posts: 829

Posted:

Jan:

The excess $40,000.00 should be transferred to a reserve account. Even though it is a surplus of funds the money once used will be used for the HOA capital expenditures. Therefore the funds are not a profit and will go right back into the HOA. The only thing that is a profit is the interest made on the funds and that could be taxed and should be reported.

DeeB (Arizona)
Posts: 18

Posted:

Jan,

Your assumptions are correct. In the event of an IRS audit your HOA could be subject to Penalties and interest on unpaid taxes of excess funds. Your annual budget should include operating and reserve needs. An IRS agent will ask to see this budget. If your budget and accounting records do not show that part of the assessments received were for reserves and that those reserve receipts were deposited into a separate account on a timely basis upon receipt of those monies, then the IRS has been known to claim any excess funds as excess operating funds and yes these are taxable, if: 1) They are not returned to the HOA members at a pro rata share or 2) the HOA members (not the Board members) have not voted, per Rev. Ruling 70-604, to apply the excess operating funds to the following years operating budget, (not the reserves). This is a yearly election that the HOA members must make, to avoid taxation of this excess. Your next years budget should then also show that you have reduced assessements for that year according to the excess of the prior year that you are applying. You do not have to wait to the end of the year to make this election. Simply have them vote that IF there is an excess that the excess will be applied to the following years operating budget and make sure that the outcome of the vote is clearly documented. The IRS has been known to dissallow non-taxable status to excess funds of those HOA's who have simply transferred the excess operating funds to a reservce account at the end of the year. It can be done, but the budget needs to be amended and published showing the intent of this money to be allocated to the reserves AND this money should be deposited immediately into a separate account designated for the reserves. Your P & L should clearly show assessments received for operating and assessments received for reserves. If you transfer money from operating funds to reserve funds or vice versa this needs to be clearly documented with an amended budget and shown on your financials.

To avoid taxation of operating funds and those designated as reserves, the following steps should be considered:
1) Get a reserve study done.
2) Include the reserves in your annual budget,
3) Determine what percent of assessments received on a monthly or quarterly basis is actually for the reserves.
4) Make sure your bookkeeper is tracking the operating and reserve receipts and expenses separately.
5) Make sure the reserve funds are deposited into an account held separately from the operating funds.
6) Make sure any transfer of operating funds to reserve funds or vice versa are clearly documented and that the amended budget and financials show this transfer.
6) Make sure your HOA members are making the annual 70-604 election and that it is well documented.

🎯 You've read this entire discussion

Join the conversation with 50,000 HOA & Condo Leaders:

✓ Ask follow-up questions
✓ Share your experience
✓ Get expert advice
✓ Access 350,000 discussions

Create Free Account →

⚡ Takes 30 seconds

Already a member? Log in here