Risk-based discussion of Form 1120 Vs Form 1120-H

Having just completed yet another tax season and once again addressed the issue of educating new clients about the REAL differences between Form 1120 and Form 1120-H, it is time to start this discussion again.

Over the years, I have heard many CPAs present about the benefits of Form 1120 over Form 1120-H. Virtually all of these discussions boil down to a single point – the tax rate of 15% of Form 1120 versus the 30% tax rate of Form 1120-H. The position generally described is that it is crazy to pay tax at a 30% tax rate on Form 1120-H when you can just as easily pay tax at a 15% rate on Form 1120. I do not know any taxpayer, other than myself, who has ever included a dialogue on the risk factors in Form 1120 as part of this discussion.

While the IRS no longer publishes statistics on homeowners’ associations, the last year they did, it was noted that approximately two-thirds of the associations filed Form 1120-H. It was also reported that the average association reported $ 5,582 of interest income. With today’s low interest rates, the number is probably now much smaller. But let’s assume that the old averages are still accurate and examine the differences between the two tax forms. To make the calculations easier, we assume that deductions that can be distributed on interest income, which primarily consists of tax preparation fees (fully deductible) and administrative fees (divided into 10% deductible based on Concord Consumers Housing Cooperative against the commissioner’s case), totaling $ 1,582 and leaving exactly $ 4,000 as taxable income. (This makes this illustration easy to follow.)

Form 1120 – The taxable income of $ 4000 at 15% results in a tax of $ 600. Provided there are no problems, it is all taxable. But if you apply risk factors, the answer changes dramatically. Risk Factor # 1 – What if the choice of revenue regulating 70-604 is rejected (for several different reasons, as discussed in a previous article – see below), and (assuming) $ 10,000 excess member income becomes taxable? The tax just went up by $ 1,500. Your tax savings not only disappeared, but multiplied by the tax you would have paid on Form 1120-H. Risk Factor # 2 – Worse still, consider the IRS reviewing this tax return and assessing tax on ALL of your reserve balance because you did not exactly comply with the requirements to exclude reserves from your taxable income. Assuming reserves of $ 100,000, which are added as an extra excess member income, your taxes just increased another $ 20,000. You are now so far behind the curve that you can never catch up.

Form 1120-H – The $ 4000 taxable income at 30% results in a $ 1,170 tax due on the special $ 100 deduction allowed on Form 1120-H. Since excess member income is not taxed on Form 1120-H, you do not have to worry about choosing revenue that governs 70-604 or excess member income. It also does not matter if you do not exactly follow the rules to exclude reserves from taxable income on Form 1120-H, as reserves that do not meet the “capital contribution” test are classified as excess member income that is not taxable in this form.

Comparison – Form 1120 initially saves $ 570 compared to Form 1120-H, but exposes the Association to the risks (in this example) of an additional $ 21,500 in taxes. It is very risky to assume a very small tax saving. Will members appreciate or even notice a $ 570 savings? Maybe, but not likely, and certainly not if the association gets tagged by the IRS for the extra tax. In this case, members accuse only the board of directors and the tax preparer of making a bad decision about the tax form to be filed and holding them accountable for not taking advantage of the security offered by Form 1120-H.

I have previously offered the analogy that intentionally filing Form 1120, when any potential risk exists, is the same as saying that you believe insurance is an unnecessary expense and that premiums should not be paid.

background – Let’s go through some of the basics. on Form 1120-H, Congress has purposefully created a safety net that allows associations to accumulate reserves without doing anything special at all. Apparently, just identifying some money as reserves is sufficient. No specific registration requirements are required. No election under Revenue Adjustment 70-604 is required, and although the IRS revised the tax return and held that the association reserve does not qualify as a capital contribution, it does not matter – these reserves will then be classified as exempt functional income, which is not taxable on Form 1120 -H. All the tax law you must comply with is contained in a single Internal Revenue Code (IRC); IRC § 528.

Form 1120 is a whole other matter. Filing Form 1120 means you are no longer a homeowners association. The term “homeowners association” is defined in section 528 of the IRC and applies only to an organization that meets the qualifying criteria and files Form 1120-H. So if you are no longer a homeowners association then what are you? A non-exempt member organization is defined in IRC § 277 (as a matter of law – you do not have a choice in the matter). These rules were not written with your association in mind. The association must now distort itself to resemble the type of organization that Congress had in mind when they created Section 277 IRC, and it is NOT an organization that has an obligation to accumulate huge cash reserve accounts to meet future needs. The association must comply with a very large number of tax laws. Unfortunately, and contrary to section 528 of the IRC, this legal system is not codified into a neat, neat set of rules. You need to look at many different categories of decisions to see the whole picture. Too many people see a few key decisions and think they see the whole picture. You are doomed to fail on Form 1120 unless you are familiar with the entire body of applicable tax law. Practitioners Publishing Company’s Homeowners Association Tax Library (of which I am a co-author) contains more than 100 different decisions on eight different levels trying to capture these concepts in a coherent way. More than 900 pages (and that is after deleting the least important sections) in this book are devoted to Form 1120. The majority of these decisions are about associations filing Form 1120, so only when you are familiar is All of these decisions really prepared to consider Form 1120.

The biggest risks that you take on Form 1120 are quite simple. first, there is a risk that you may defer excess member income from taxation. Unlike Form 1120-H, where the excess exempt functional income (a substantially similar concept and definition as excess member income) avoids taxation, it is taxed on Form 1120 unless you successfully get rid of it. There are only three options: (1) pay tax on the excess income, (2) either repay it to members or roll it over to the next year under Revenue Adjustment 70-604, or (3) transfer it to reserves (subject to strict rules). Other, there is the risk that you may defer your reserves for tax purposes.

Comment – Are these risks really that big? Yes! Many associations apparently just rely on the “IRS audit lottery.” Fewer than 1% of associations are audited. No professional tax preparer can advise you to consider this factor when deciding which tax form to file. An association may take this into account, but ethical rules prohibit the taxpayer from considering it.

I have been involved in 50 IRS audits of associations, but in only one of those cases did I actually prepare the tax return. I am generally restrained by the tax preparer / CPA, the tax attorney or the association as soon as they realize that the IRS has raised tax issues that had not been considered before. Of the 50 tax audits, one was on Form 990 (an exempt association), two were on Form 1120-H and 47 were on Form 1120.

The two Form 1120-H audits resulted in no additional taxes being assessed. ALL 47 of the tax audits from Form 1120 resulted in additional taxes being assessed.

I was presented with the following challenge during the past tax season: to inform several new clients that they had tax exposure on their previous year, Form 1120, tax returns; educate them on the risks inherent in this form and convince them that the small additional tax they would pay on Form 1120-H should really be considered buying an insurance policy against a future tax charge.