TAX EXEMPT ASSOCIATIONS – THE COMPLETE GUIDE
By Gary A. Porter, CPA
Most discussions of homeowner association taxation are a tired recitation of the differences between IRS Forms 1120 and 1120-H. However, a number of associations do have other options, as they will qualify for tax exempt status. A more comprehensive comparison of the tax filing options for associations is shown below.
1) Form 1120-H applies to homeowners association electing to be taxed under this method. These associations pay tax on interest income and non exempt function income. Exempt function income is not taxed. This is a very safe filing method, virtually risk free, as this tax law was created specifically for homeowners associations.
2) Form 1120 applies to homeowners associations that do not elect, or do not qualify, to file Form 1120-H. These associations are not recognized as homeowners associations by the IRS, but are categorized as “non exempt membership organizations.” These association pay tax on interest income and any other net non member income. They are also potentially taxable on net membership income. This is an extremely risky tax filing method, as the tax law was not created with homeowners associations in mind.
3) Associations filing Form 990 under IRC Section 501(c)(7) must qualify as recreational organizations and must apply for exempt status and be approved by the commissioner. These associations pay tax on interest income and any net unrelated business income, which is primarily derived from non member sources. This is a virtually risk free tax filing method, once you meet the qualifying criteria.
4) Associations filing Form 990 under IRC Section 501(c)(4) must qualify as social welfare organizations and must apply for exempt status and be approved by the commissioner. These associations do not pay tax on interest income, but do pay tax on any net unrelated business income, which is derived business activities unrelated to the association’s core exempt activities. This is a virtually risk free tax filing method, once you meet the qualifying criteria.
This discussion focuses primarily on large scale associations, as they are the type of association that most likely to qualify for and benefit from the tax exempt statues.
The large scale homeowners’ association is different from smaller associations in its tax characteristics, just as in more obvious factors. I define a large scale association as any association of more than 500 units or lots, and/or a budget in excess of $1,000,000. Most large scale associations are property owners’ associations or planned developments, rather than condominium associations.
So what is that sets these larger associations aside from their smaller counterparts? Primarily, it is the range of activities provided by the association. Most of the large scale associations provide recreational activities that are not available in smaller associations. These can include golf courses, tennis clubs, equestrian facilities, marinas and boating facilities, etc. These activities create tax problems for associations because of the way the tax law was written in 1976. Specifically, the qualifying tests to file Form 1120-H include a 90% test. This test states that 90% of the association’s expenditures must be for the care, maintenance, and management of the common areas of the association. Associations with extensive recreational activities generally cannot meet this test. Congress, in 1976, apparently looked at the associations that existed and concluded that most were smaller associations maintaining only common areas, rather than large scale associations also responsible for maintaining recreational facilities and operations. In fact, in 1976, it is estimated that less than 30,000 associations existed. Now that number is estimated to be well in excess of 260,000.
The smaller association generally has two tax filing options available to it; either Form 1120-H, or Form 1120. This is a familiar discussion that all of us heard too many times. Based on a recent survey, approximately 85% of all associations in the United States qualify to file Form 1120-H, but almost all smaller associations will qualify. Fewer large scale associations will qualify.
These two options are not always available to larger associations. Often, the recreational activities will prevent these associations from qualifying to file Form 1120-H. That means that Form 1120 is the only option
available to these associations. And for large scale associations with $3,000,000 or more in reserves, this can result in higher taxes than would be paid on Form 1120-H, so these associations suffer a penalty. In addition, these associations cannot avoid the inherent risk associated with Form 1120 on taxation of reserve balances.
However, large scale associations often have two additional options available to them that are not available to the smaller associations. These two options are qualifying for exemption under 501(c)(7) of the Code, or 501(c)(4) of the Code. Let’s explore each of these alternatives.
IRC Section 501(c)(7) organizations are recreational organizations. The sole functions of this organization must be recreational activities. Unfortunately, this excludes a large majority of homeowners association that would like to file as a 501(c)(7) organization. Revenue Ruling 75-494 clarifies this issue by stating that, if an organization maintained private roads that provided access to residences, rather than just access to recreational facilities, then that organization was involved in activities other than recreational activities and could not qualify as a 501(c)(7) recreational organization. In addition, even if the roads are publicly owned, the simple factor of having architectural control involves the organization in activities other than recreational activities and precludes them from the use of IRC Section 501(c)(7).
So why would the association want to qualify under 501(c)(7) anyway? Very simply, you avoid all the inherent risk associated with Form 1120 when you are a qualified 501(c)(7) organization. As a recreational organization, you would pay taxes only on your interest income, or net income from nonmember activities. The taxes you pay on this form are generally the same amounts you would pay on Form 1120, but you would do so without any tax risk whatsoever. That is what makes this filing option so attractive.
Several of our associations are qualified 501(c)(7) organizations, and we are quite familiar with the activities that allow an association to qualify under this section of the Code.
Let’s look at the IRC Section 501(c)(4) option. This Code Section applies to social welfare organizations. At this point, everyone should be asking, “what is a social welfare organization and, what does that have to do with homeowners associations?” A social welfare organization is any organization which provides a public benefit. Revenue Ruling 75-286 held that an organization as small as a block association that was created for beautification of city streets only one block long can qualify as a 501(c)(4) organization.
So what type of an association can qualify here? Most associations do not qualify for Federal Tax Exemption under 501(c)(4). For instance, all condominium associations are automatically excluded because there is maintenance of personal residences as part of the primary function of the condominium association, which is a prohibited transaction under 501(c)(4). In addition, those associations that are formed as cooperative housing corporations are also required to apply the mandatory requirements of Subchapter T as the code and may not qualify under 501(c)(4).
What this leaves as potentially qualifying associations are planned developments, whether residential or even commercial or industrial in nature. As long as they do not provide exterior maintenance of privately owned structures, such as residences or commercial buildings, the associations may qualify under 501(c)(4). Gated communities usually do not qualify for tax exemption, although we have successfully obtained exempt status for approximately a half dozen gated associations. There are 3-ways for qualifying for tax exemption under IRC Section 501(c)(4):
- The association grants public access to all of the association amenities without significant restriction. An example of this type of an association will be one that maintains extensive slopes and fences and monument signs and parks as the common areas in a single family residence association and does not have security that patrols to keep outsiders from using such facilities. A variation of this is that there may be some restrictions such as limited access to pool and tennis court areas. So long as they are not substantial, significant restrictions, the association will still qualify.
- The association covers the same geographic territory as a governmental unit. An example of this would be an association that has approximately the same geographical boundaries as a City or California Community Services District. In such case, even if the association is gated, it may still qualify for tax exemption under IRC Section 501(c)(4).
- The association itself qualifies as a community. By definition, this generally must be a very large or very remote association in that it has such a large population that it would in and of itself qualify as a community even if there are restrictions on access. This is very rare and is not usually encountered in urban areas.
So why would an association want to gain 501(c)(4) status? This is the best one of all, because, when an association gains exemption under 501(c)(4), it pays no taxes. Not even on its interest income, because the organization is deemed to exist for public benefit.
What is “public benefit,” and what does it take to qualify in this Section? The most significant case in recent years governing this area of tax law is the Rancho Santa Fe vs. Commissioner case. In this case, a community qualified as a 501(c)(4) organization, apparently for two reasons; (1) it constituted a community in and of itself, and (2) it had sufficient public access.
If you are a gated community, what kind of public access does it take? Unfortunately, that must be decided on a facts and circumstances case. Each association is unique, and each will be uniquely considered for determination of whether or not they grant sufficient public access. The law governing this area is spread out between several Code Sections, Regulations, Revenue Rulings, Private Letter Rulings, and Court cases. It is not embodied in a single location. The individual preparing the tax exemption application on IRS Form 1024 must be intimately familiar with all of the significant rulings dealing with this area of tax law. General Counsel memorandum 35570 and Private Letter Ruling 8028010 both allowed “limited non public access” that was “incidental” to the primary exempt purpose of the organization.
More than knowing the law, you must be able to write the application in such a manner as to properly present the facts. This must be done in an appropriate manner that both clearly and accurately states the issues, and benefits the association. An example of this is balancing the issue of access with restrictive signs.
Several of our association clients that are not gated have public streets serving the association, but also have restrictive signs placed on the green belts and parks. These signs state that the green belts and parks are restricted for the private use of the members of the association only. This is a critical “access” factor for the association. The association’s hope is that the signs keep nonmembers from using association common areas. But, most of these associations do not have adequate security to keep outsiders from using these “open” common areas. Properly written, you can present what is an apparent restriction as an unenforceable restriction. If you carefully construct the arguments discussing the restrictive signs, and other mitigating factors, this factor will not kill an exemption application. Further, Revenue Ruling 80-63 also clearly states that some restricted access within an association will not be fatal to its ability to qualify under 501(c)(4). We often use this example in writing about the restrictions to swimming pools and spas. Generally, these must be behind locked gates as a matter of local law. Consequently, we cite health and safety codes as the reason that these are not accessible to the general public, and further disclose what is often a low proportionate maintenance cost compared to total operating costs. If the reserve allocation to the restricted areas compared to the overall common areas of the association is small, it will prove that they are not significant in amount.
If your large scale association doesn’t look like either of the above described entities, does that mean that you are completely precluded from ever availing yourself of the benefits of these two Code Sections? Not necessarily. But, at this point, you must do more work. You may also begin to wonder if the amount of trouble and bureaucracy you are creating is worth it. But there are further steps you can take.
For instance, we have advised associations to spin off recreational activities and recreational common areas into a separate 501(c)(7) organization in which all of the members will automatically participate. Sometimes, that will allow the remainder of the association to qualify under Code Section 501(c)(4). More often, moving the recreational activities out will allow the remainder of the association to qualify under IRC Section 528 to file Form 1120-H. This is because it will no longer be violating the 90% expenditure test, as the recreational activities which cause this violation had been moved out to a separate entity. This may not save much in taxes, but eliminates the risks associated with Form 1120.
Planning, or How to do it Wrong
We have seen associations make major mistakes in the planning and development stage, or in the consolidation stage. In the planning and development stage, developers have a unique opportunity in large scale associations to form the associations in a manner that provides long term financial benefits. We are advising one developer, who had planned to create five associations within a master development using strictly geographic boundaries as the determining factor, to reconsider the structure of the corporate profiles. The developer’s previous plan would have created six fully taxable associations, with none qualifying to file any form except Form 1120, as a nonexempt membership organization, the highest risk form of tax entity. By restructuring the organization (before it was set in concrete) we were able to create one 501(c)(7) recreational organization, one 501(c)(4) master association, and five associations that all qualified to file Form 1120-H. None of the associations has any tax risk, and the tax savings to the master association will amount to millions of dollars during the next few decades.
One of the most outstanding mistakes we have seen was a Master Association that consolidated its 12 sub-associations into the master association leaving a single legal entity. I don’t know the motivation behind this consolidation, but I’m sure that there were valid reasons for it. However, of the 1,850 residential units that were consolidated into this master association, there were only some 300 condominium units. 1,550 were single family homes in what had been several separate property owners’ associations. By combining the 300 condominium units in with the 1,550 single family homes, the association eliminated any possibility to qualify as 501(c)(4) organization. If they had consulted with us instead, we would have advised them to keep the condominium units out as a single sub association within the master association. This sub association would be subject to all of the same rules, and would pay the same dues to the master association. By keeping them separate, the remaining 1,550 homes would have qualified as a 501(c)(4) organization, because there was wide-open access to this particular association. We calculated the tax savings at something just more than $100,000 per year that could have been achieved had the association been aware of the tax ramifications of their actions. I first discovered this association only six months after this 2-year consolidation process had been concluded. When I informed the general manager of the mistake that had been made, he turned pale, and said he never wanted to hear me discuss this issue again. The manager had been employed there only a short time, and was not a part of the decision-making process. However, he recognized that this was an issue that could tear the community apart, as well as potentially causing a malpractice suit against the association’s law firm that structured the deal.
Revocation of Exempt Status
If your association ever held exempt status under 501(c)(4) and later had that status revoked, don’t necessarily accept this as the final word. In several instances we have been successful in regaining 501(c)(4) exempt status for the association by proving that the IRS made an incorrect determination when they revoked exempt status. On one of these associations, we achieved this even after two CPA firms and a tax attorney had failed to regain the exempt status. While we believe these people fought gallantly, they simply weren’t experienced enough in this area of tax law. We have prepared dozens of exemption applications for associations. We have already experienced and tested many of the issues that other tax preparer’s have never even thought about. If your association is paying any significant income tax and thinks there is a possibility that you may qualify based upon the discussion set forth above, please contact us for an evaluation.
The Internal Revenue Service (IRS), through Treasury Regulation No. 1.337(d)-4, has established significant restrictions on who may apply for exempt status. This regulation imposes what we have termed a “transfer tax” on associations that go from taxable to tax exempt. The regulation compares the total market value of all assets at the date of conversion from taxable to tax exempt to the taxpayer’s basis in those assets (and in the case of the community association the tax basis is generally zero for fixed assets), and the difference is subject to taxation. If the amounts are large, the maximum tax rate is 39%. This limitation is imposed for all associations who are filing for exemption at a date more than three years after the date of incorporation. However, Gary Porter, working with a tax attorney in a private letter ruling process, has discovered a way around this restriction imposed by the IRS. Knowing how to avoid the negative impact of this Regulation is critical to the Association. This eliminates significant tax exposure. Most tax preparers do not know how to do this. No association should proceed with the exemption application process unless they have assurance that the tax preparer knows how to avoid the negative tax consequences of Treasury Regulation 1.337(d) 4.
How to do it Right
If you have concerns in this area, have an experienced, competent professional carefully review your options. We at Gary Porter CPA have prepared dozens of exemption applications, and have obtained tax refunds exceeding four million dollars for our clients. In addition, those same clients have saved more than $15,000,000 in taxes on a cumlative basis since we obtained exempt status for them.
Gary Porter, CPA began his accounting career with the international CPA firm Touche Ross & Co. in 1971. He is licensed by the California Board of Accountancy and the Nevada Board of Accountancy. Mr. Porter has restricted his practice to work only with Common Interest Realty Associations (CIRAs), including homeowners associations, condominium associations, property owners associations, timeshare associations, fractional associations, condo-hotels, commercial associations, and other associations.
Gary Porter is the creator and coauthor of Practitioners Publishing Company (PPC) Guide to Homeowners Associations and other Common Interest Realty Associations, and Homeowners Association Tax Library. Mr. Porter served as Editor of CAI’s Ledger Quarterly from 1989 through 2004 and is the author of more than 300 articles. In addition, he has had articles published in The Ledger Quarterly, The Practical Accountant, Common Ground and numerous CAI Chapter newsletters. He has been quoted or published in The Wall Street Journal, Money Magazine, Kiplinger’s Personal Finance, and many major newspapers.
Mr. Porter is a member of Community Associations Institute (CAI), and served as national president of CAI in 1998 – 1999.