Reserves as Capital Contributions
By: Gary A. Porter, CPA
The tax rules for reserve contributions by a homeowners association are far more complex than most people realize. Many associations filing Form 1120 are at risk in an IRS audit situation because that will have failed to comply with one or more of the seven parameters established in tax law. This article identifies each of the seven parameters with which you must comply, tells you where the authority for that parameter is established, and shows you the common sense manner in which the association can fully comply with the tax law.
Most discussions about homeowner association income taxes begin and end with the single issue of filing Form 1120 or Form 1120-H. This is usually discussed simply from the perspective as the difference in tax rates. But, Form 1120 carries significantly higher tax risk. The largest risk, and the focus of this article, is the issue of reserves being considered as capital contributions for tax purposes. This an important issue because capital contributions are automatically excluded from income. It has no significant impact if filing Form 1120-H, as Exempt Function Income (EFI) is not taxed on that Form. It is a critical issue on Form 1120, as any amounts received from members that cannot be classified as capital contributions may create excess member income under IRC Section 277 that is subject to taxation.
The Internal Revenue Code (IRC) is law passed by Congress. Regulations are the Internal Revenue Service (IRS) interpretation of that law. Revenue Rulings are specific situations described by the IRS that clarify how certain tax rules are to be applied. Judicial decisions by various courts provide the final say in how certain tax law is interpreted. There are actually numerous other levels of authoritative rulings, but these are the primary guiding authorities. It is important to understand this framework to see why something as simple as a reserve contribution can actually be very complex.
The basic structure of the Internal Revenue Code is that all receipts are considered income under IRC Section 61, unless exempted from income by another section of the Code. IRC Section 118, “Contributions to the Capital of a Corporation,” exempts capital contributions from income. IRC Section 118 has been interpreted by numerous subsequent rulings. The balance of this article examines each of the criteria raised by those various rulings.
While IRC Section 118 establishes the broad principle that capital contributions are not included in taxable income, the detailed parameters established by subsequent rulings are:
The PURPOSE of the assessment must be capital in nature (IRC Section 263, Revenue Rulings 74-563, 75-370, and 75-375, Court cases Chicago Board of Trade and Maryland Country Club)
ADVANCE NOTICE must be given to members as to the intent of the purpose of the capital contribution (Court cases Gibbons and Maryland Country Club, Revenue Rulings 75-370 and 75-371, GCM [General Counsel Memorandum] 35929)
Money contributed must be ACCOUNTED FOR as a capital contribution (IRC Section 118, Court case Chicago Board of Trade, GCM 35929)
Money must be HELD FOR THAT PURPOSE and no other purpose (Court cases Chicago Board of Trade and Maryland Country Club)
Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association (Revenue Rulings 75-370 and 75-371)
Money must be actually EXPENDED FOR THE INTENDED PURPOSE (Court Case United Grocers)
Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder (Court case Chicago Board of Trade , GCM 35929)
My many years of experience as a tax preparer in the homeowner association industry have provided numerous examples to me that virtually no associations are aware of these critically important rules, and few tax preparers believe they are important. I have been retained as a consultant on dozens of homeowner association IRS audits, more than any other tax practitioner in the country. In all but a few cases, Form 1120 was involved. I did not prepare ANY of the tax returns being audited by the IRS; I was retained at the recommendation of the CPA firm or tax attorney as their expert consultant. The issue of capital contributions existed in 100% of these IRS audits.
Associations that do not adhere to each of the parameters set forth above MAY not lose their reserves as capital contributions in an IRS audit, but each instance where the association fails to adhere significantly increases the risk that your reserve additions will not qualify as capital contributions.
How associations can qualify under each of the parameters set forth above.
1) The PURPOSE of the assessment is described in IRC Section 263 as “Any amount paid out for new buildings or for permanent improvements or benefits made to increase the value . . . “ and “Any amount expended in restoring property . . . “ That pretty much describes the majority of reserve funds expended by associations. But, it also includes additions to or replacements of personal property. It DOES NOT include monies expended or set aside for painting or contingencies.
The purpose for which funds are being accumulated in reserves is generally set forth in the reserve study. Is a reserve study absolutely required to establish the capital purpose? No, it could be more informal, such as being described in the budget. However, the reserve study is better, and this is an instance where it is better to comply than to have to fight this issue in an IRS audit.
Other critical mistakes associations make are (a) not formally adopting their reserve study, (b) having a reserve study that contains multiple proposed funding plans with no indication of which plan was adopted, (c) having a reserve study that does not agree with the amounts adopted in the association’s annual budget as reserve contributions.
2) ADVANCE NOTICE is usually given to members as part of the annual budget, with accompanying information that discloses the reason for the “Capital” reserve assessments. It is critical to note that if painting or contingency are part of the reserve budget and the amounts are not disclosed it jeopardizes the entire capital contribution, because painting and contingency are not capital in nature.
3) Money contributed must be ACCOUNTED FOR as a capital contribution in the association’s financial statements. While this is routinely done in professionally managed associations, too many small, self-managed associations fail to take this critical step. As long as reserve monies are held in a separate bank account and there is a clear record of reserve contributions and expenditures, the association should be able to overcome this accounting deficiency in an IRS audit situation.
4) Money must be HELD FOR THAT PURPOSE and no other purpose. This means that once you set aside monies in reserve accounts, you should NEVER invade those reserve accounts for operating purposes. California statutes permit associations to borrow from reserve under certain circumstances. While permitted under California law, federal tax law does allow such use of funds.
5) Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association. The IRS interpretation of this is that (as an example) roofing and paving funds, considered capital in nature, cannot be held in the same bank account as painting monies. Why? Painting is considered non-capital in nature. Combining painting or contingency reserves with your capital reserves jeopardizes the entire capital contribution. This is probably the most critical item in your reserve planning. If you do not have these separate bank accounts, you should probably not be filing Form 1120, as your tax risk is too high. This issue has been raised on virtually every IRS audit on Form 1120 on which I have consulted.
What this means is that most associations must maintain three different bank accounts – one for operating funds, one for capital reserve items, and one for noncapital reserve items. Few associations take this seriously enough to actually maintain the separate bank accounts. This deficiency could potentially be overcome in an IRS audit if you have adequate accounting, but there is no guarantee. This is one of those situations where, although it is a pain to comply, it is still easy to comply, and why have to fight the IRS over an issue that is so easy to comply with.
6) Money must be actually EXPENDED FOR THE INTENDED PURPOSE. This does not mean that if you assessed money for roofing that that exact amount must be expended for roofing. It means that if you assess reserve monies for a capital purpose, it must be spent for a capital purpose. Reserve bank accounts commingle various capital components (roofing, paving, fencing, etc.). That dollar in the account does not know that it is a roofing dollar or a paving dollar. That dollar does not know what kind of dollar it is, other than it is a capital dollar. That is the only important criteria.
7) Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder. This is effectively an automatic process with which the association normally need take no action. The reason is that, as defined in other sections of the Code, a member’s “capital account” is presumed to reflect an increase in value for monies added to reserves.
What all of this means is that the association must be very careful in its handling of reserves IF IT IS FILING FORM 1120. If you’re filing Form 1120-H, you can effectively ignore all of the above and still have a safe tax return.
If the association fails to comply with the above parameters established in tax law, THERE IS NOTHING THAT THE TAX PREPARER CAN DO TO MITIGATE YOUR TAX RISK. The tax preparer’s responsibility is limited to properly presenting reserve activity in Schedules M-1 and M-2 of the association’s Form 1120 tax return. Any errors at this level can generally be overcome during an IRS audit.