We continually have HOA boards and management companies inquire about Revenue Ruling 70-604 (“70-604”). In this post we will provide a comprehensive examination of the ruling and look at it’s application. We will also answer the many questions that exist regarding 70-604.
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- (1) What is a Revenue Ruling 70-604?
- (2) Do you make an election under 70-604 under Form 1120-H or Form 1120?
- (3) Should an association make a 70-604 Election?
- (4) Is there a downside to making a 70-604 Election?
- (5) So how does an HOA make a 70-604 Election?
In other posts we have looked at the application of the ruling. This discussion will complement other posts we have completed that examine an overview of HOA taxation. There are many risks and complexitites so make sure you are educated.
At first pass, Revenue Ruling 70-604 may appear to be an inconsequential revenue ruling. However, for condo associations and HOAs that file form 1120 it can be a substantial planning tool.
The ruling is complex and I have seen various interpretations. Needless to say, the view taken here will be to look at the ruling and deliver impartial results. This Q&A will provide a basis for your discussions on the issue with your CPA or tax preparer. So let’s dive in:
What is a Revenue Ruling 70-604?
The purpose of 70-604 is to allow HOAs that have excess member income (assessment and fees) in a specific year to refund that excess income to the members or roll it over to the next year to avoid being taxed on any excess member income. The ruling allows an HOA to make an election that will essentially defer the excess membership income for the year to the subsequent year.
(2) Do you make an election under 70-604 under Form 1120-H or Form 1120?
Revenue ruling 70-604 only applies to HOAs that file Form 1120. It is not allowed when filing form 1120-H.
(3) Should an association make a 70-604 Election?
Most practitioners would agree that all HOAs should make a 70-604 election each and every year. Assuming the election is made, if the association has excess membership income, then making a valid election can save significant taxes for the association.
The HOA is then able to file Form 1120 and only net non-membership income would be taxed. If the election is not made, this excess membership income would be subject to taxation along with the other income of the HOA.
(3) Why should an association make a 70-604 Election?
It is just basic tax planning. An association that is concerned with limiting it’s tax liability should make the election even if they are assuming that they will file Form 1120-H.
When filing Form 1120, there are three outcomes when dealing with excess membership income:
- If no election is made, the HOA would pay tax on all net membership income. It would also pay tax on net non-membership income, which could consist of interest, dividends and capital gains. This is not the preferred outcome.
- The association can make the election to apply the excess of membership income over membership expenses to the subsequent year’s assessments.
- The association can make the election and refund excess of membership income to the members of the association. Practicably speaking, this option is difficult to manage and can conflict with the HOA bylaws and often state law.
Please note that the association is not allowed to make an election under revenue ruling 70-604 to transfer any excess member income to reserves as a capital contribution. The reason is that such an election will fail to meet the requirements of Internal Revenue Code Section 118 and interpretive rulings. This can be very important even when considering commercial condo association tax returns.
(4) Is there a downside to making a Revenue Ruling 70-604?
There is no downside to making the election. If the association chooses to file form 1120-H or the election is not applicable (no excess member income) then the election is ignored.
HERE IS WHERE I STOPPED
(7) Who makes the association’s 70-604 Election?
(8) Can the election be used indefinitely, or is it a one year election?
(9) Can excess assessment be transferred to reserves?
10) What types of associations can make an election in revenue ruling 70-604?
(5) So how does an HOA make a 70-604 Election?
First, a formal election should be made by the association. This documents the association’s intent, which is very important if ever questioned by the IRS.
Associations have always wrestled with how to properly make an election under the provision. The ruling itself just provides guidance, but does not offer any concrete requirements.
In practice, that many HOAs just file the tax return and don’t make any formal election. The argument is that the election is made by the tax preparer once accurate calculations are completed and the return is timely filed. This approach certainly comes with risk. If ever audited, there is no documentation of intent.
In the ideal situation, the election would be made by members of the association during the annual HOA meeting. Should the annual meeting occur long after the HOA’s year-end that the election is not made before the due date of the return, the HOA should make sure that the election is made in a prior year meeting so it can be effective for the respective year.
This issue has been discussed and clarified by the IRS in TAM 9539001. The IRS view appears to be that there is no need for an actual meeting. The members could actually do a mail-in vote or any other signature campaign in order to get it accomplished.
(6) When does the association make the election?
Clearly any election must be made before the tax return is filed. But practically speaking it should be made before the fiscal year is over. In some instances, it can be made even before the tax year starts.
The Revenue Ruling requires a meeting to be held annually, but the timing of the election is generally addressed. I would certainly recommend that any association should not risk losing the benefits of the election, by filing it late. I would recommend making it before the end of the tax year for which it is to apply.
HERE IS WHERE I STOPPED
(7) In order to comply with the exact wording of the ruling, the election should be made by the members, not the board of directors. I also strongly recommend that the board of directors also ratify the election by the members.
Why this double effort? The IRS lives only by its own rules, and their ruling states that “. . . A meeting is held each year by the stockholder-owners of the corporation, at which they decide . . .” Therefore, the IRS position is that the members must make the election. This, however, conflicts with state law in most jurisdictions, which states that ONLY the elected board of directors has authority to make such financial decisions. The best bet for the association is to have members make the election, then have the board ratify it, and you’re covered both ways.
Given contradictory state law, the only logical way to interpret the ruling is to interpret the term “stockholder-owners” as “those persons with the legal authority to make the decision.” The IRS National Office has informally agreed with this interpretation, but this is non authoritative and cannot be relied upon.
Recent IRS audit activity on homeowners associations has indicated that IRS agents are requiring that the election be made by the members, and not by the Board of Directors. In the absence of clarification on this matter, I recommend that the wording of Revenue Ruling 70-604 be literally interpreted and that the election be in the form of a resolution adopted by the membership.
(8) Many CPAs contend that an association can make and use the revenue ruling 70-604 election every year. Some CPAs even remove the excess member income from one tax year, but never add it back to the next tax year to which the carryover was made.
The IRS has repeatedly indicated that revenue ruling 70-604 was intended to be a one year carryover only, and could not be used indefinitely year after year, as such a scheme would represent a permanent deferral of income. The ruling was meant as a one year deferral only, a “timing difference’ in tax parlance.
The ruling uses the words “. . . have the excess applied to the following year’s assessments” to describe the carryover. “Year’s” is used in the singular, not the plural “years’.” General Counsel Memorandum (GCM) 34613 likewise uses the singular form in two different places in that analysis of the ruling.
It is clear that the IRS considers revenue ruling 70-604 to be a single year election only, that was never intended to defer excess revenues forward indefinitely.
FSA (Field Service Announcement) 1992-0208-1 ruled directly on this issue, noting that “. . . the subsequent year’s shortfall must be at least equal . . .” to the carryover assessment for the requirements of revenue ruling 70-604 to have been met.
(9) An association can NOT make an election under revenue ruling 70-604 to transfer any excess member income to reserves as a capital contribution. FSA (Field Service Announcement) 1992-0208-1 ruled directly on this issue, noting that a transfer of excess revenues to reserves does not meet the two criteria specified in the ruling; refund to members or carryover to the next tax year. The principal reason for this is that such an election will fail to meet the requirements of Internal Revenue Code IRC Section 118 various interpretive rulings and cases of that Code section.
The biggest hurdle here is that IRC Section 118 requires advance notice to the members of the capital nature of their assessment before it will qualify as a contribution to capital under IRC Section 118. There are also other requirements to qualify as capital contributions. This subject is so extensive that it requires a completely separate discussion, which is located at www.garyportercpa.com.
(10) TAM 9539001 is the only guidance, other than the ruling itself, regarding the types of associations that may make an election under revenue ruling 70-604.
Revenue ruling 70-604 states “A condominium management corporation assesses its stockholder-owners for the purposes of managing, operating, maintaining, and replacing the common elements of the condominium property. This is the sole activity of the corporation and its bylaws do not authorize it to engage in any other activity.” The key words to note here are “condominium management corporation” and “managing, operating, maintaining, and replacing the common elements . . . is the sole activity . . .”
TAM 9539001, in denying the revenue ruling 70-604 election to a timeshare association, stated “. . . The association does not have as its sole activity the management and maintenance of the common areas of the property; the purposes, nature, and scope of the time-share association’s activities are materially distinguishable from those of a regular condominium association . . .”
One conclusion that can be drawn from the above is that any association with extensive activities other than maintenance of the common areas will not qualify to make an election under revenue ruling 70-604.
A question that still remains is whether or not the TYPE of association is also a “make or break” qualifier under the revenue ruling. Revenue ruling 70-604 specifically identified the subject association as a “condominium management corporation”. From the wording of the ruling, it is assumed that the subject association is a “residential” association, particularly since commercial associations were virtually unknown in 1970. Does this mean that a residential property owners association will not qualify, since it is not a condominium management corporation? Does this mean that a commercial condominium association will qualify, although since it is not residential in nature, it still is a “condominium management corporation? I would argue that both should qualify. However, we will need to wait for additional guidance to find out the official answer.
The above analysis attempts to demonstrate that, like so many other areas of Community Association taxation, what would seem like a simple issue, the filing of a Revenue Ruling 70-604 Election, is actually a very complex consideration. Unfortunately, associations and tax preparers have to make decisions and answer questions based on the best information and support available to us at the time. When an IRS audit occurs years later, we will be second-guessed by the IRS agent. Further, the person doing the second guessing, the IRS agent, will surely have the benefit of hindsight, and may have the benefit of subsequent IRS rulings and/or tax court cases that clarify these issues. Community Association taxation is an emerging and evolving area and there are still many questions that must be answered by the issuance of further rulings by the IRS or tax court decisions.
I recommend that an Association should be making and documenting a formal 70-604 election. The election form located on this site is one means of accomplishing this. As discussed above, however, the election form can by no means be considered foolproof. Only the passage of time and the further development of this area of tax law will indicate whether or not this is an adequate election. However, it is certainly better for an association to have made this election and documented it in the association minutes, than not to have any documentation at all.