Having just finished another taxation season, and achieving again managed the issue of teaching new customers regarding the GENUINE differences when considering Form 1120 and Form 1120-H, it’s time to have this discussion again.
Over the years We have heard numerous CPAs make presentations in regards to the advantages of Form 1120 over Form 1120-H. Almost all of these discussions boil down seriously to just one point – the 15per cent taxation rate of Form 1120 versus the 30per cent taxation rate of Form 1120-H. The career generally speaking set forth usually it’s crazy to cover taxes at a 30per cent taxation rate on Form 1120-H when you can in the same way quickly pay taxes at a 15per cent rate on Form 1120. I am not alert to ANY taxation practitioner, besides myself, who may have previously included a dialogue for the risk factors of Form 1120 within this discussion.
Even though the IRS no more posts data on home owners associations, the very last year they performed therefore it had been noted that around two thirds of associations recorded Form 1120-H. It was additionally stated that the typical organization reported $5,582 of interest earnings. With these days’s low interest rates, that quantity might be today considerably smaller. But let`s say that those old averages remain precise and analyze the differences between the two taxation types. To help make the calculations easier, we will assume that deductions allocable opposing interest earnings, composed mostly of taxation planning costs (completely deductible) and administration costs (allocated at 10per cent deductible based on the Concord customers Housing Cooperative v. Commissioner instance), complete $1,582, making precisely $4,000 as taxable earnings. (that produces this illustration simple to follow.)
Form 1120 – The $4,000 taxable earnings at 15per cent leads to an income tax of $600. Presuming no issues, that’s all of the taxation liability. But if you use risk factors, the solution changes significantly. Danger Factor # 1 – let’s say the Revenue Ruling 70-604 election is disallowed (for all possible different explanations, as talked about in a previous article – see below) and that (assumed) $10,000 of extra user earnings becomes taxable? The taxation just increased by $1,500. Your taxation cost savings not only just disappeared, but became multiples for the taxation you would have compensated on Form 1120-H. Danger Factor #2 – Worse yet, give consideration to that IRS audits this taxation return and assesses taxation on ALL your whole reserve stability as you did not precisely adhere to what’s needed to exclude reserves from taxable earnings. Presuming reserves of $100,000, which gets included back as extra extra user earnings, your taxes just increased another $20,000. You are today to date behind the curve it is possible to never ever get caught up.
Form 1120-H – The $4,000 taxable earnings at 30per cent leads to an income tax of $1,170 due to the unique $100 deduction permitted on Form 1120-H. Since extra user earnings isn’t taxed on Form 1120-H, you don’t need to be worried about the Revenue Ruling 70-604 election, nor extra user earnings. It does not matter if you neglect to precisely follow the principles on excluding reserves from taxable earnings on Form 1120-H, as reserves failing to meet up with the “capital contribution” test tend to be reclassified as extra user earnings, that isn’t taxable with this Form.
Comparison – Form 1120 in the beginning saves $570 than Form 1120-H, but reveals the Association to risks (inside instance) of one more $21,500 of taxes. That’s a lot of risk to assume for a rather little taxation cost savings. Are the users likely to appreciate, and sometimes even observe, a $570 cost savings? Perhaps, yet not likely, and definitely not in the event that Association gets tagged by IRS for the extra taxation. For the reason that instance, the users will simply accuse the Board and taxation preparer of making a poor choice regarding the taxation kind to register, and hold them responsible for failing to take advantage of the safety made available from Form 1120-H.
I’ve provided the example before that intentionally filing Form 1120 whenever any possible risk after all exists is equivalent to stating that you think insurance coverage is an unnecessary expense and premiums really should not be compensated.
Background – Let’s review some of the basics. On Form 1120-H, Congress intentionally developed a safety net that allows associations to amass reserves without doing something unique after all. Evidently, just pinpointing some money as reserves is sufficient. No specific record-keeping requirements tend to be mandated. No election under Revenue Ruling 70-604 is necessary, and even in the event that IRS audited the taxation return and took the position that Association reserves did not qualify as capital efforts, it doesn’t matter – those reserves would then be reclassified as exempt purpose earnings, that is maybe not taxable on Form 1120-H. Most Of The taxation legislation you will need to adhere to is located in just one Code (Internal Income Code – IRC) section; IRC § 528.
Form 1120 is an entirely different matter. Whenever you file Form 1120, this means that you are no more a homeowners organization. The definition of “homeowners organization” is defined in IRC § 528, and applies only to a business that fits the qualifying requirements and files Form 1120-H. When you are no longer a homeowners organization, exactly what are you? A nonexempt account business is defined in IRC § 277 (as a matter of legislation – you don’t have a selection inside matter). Those principles are not written with your Association at heart. The Association must today contort itself to look such as the sort of business that Congress had at heart if they developed IRC § 277, and that is NOT a business that an obligation to amass huge money reserve reports to meet future needs. The Association must adhere to a rather large human body of taxation legislation. Regrettably, and unlike IRC § 528, this human body of legislation isn’t codified into a fantastic, neat group of principles. You need to glance at a variety of categories of rulings to see the whole picture. A lot of individuals see various key rulings and think they see the whole picture. You might be condemned to failure on Form 1120 unless you are acquainted with the entire human body of appropriate taxation legislation. Professionals Publishing organization’s Homeowners Association Tax Library (of which i will be the co-author) contains significantly more than 100 different rulings at eight different levels wanting to capture these ideas in a coherent way. Significantly more than 900 pages (and that’s after deleting the smallest amount of essential areas) of this guide tend to be dedicated to Form 1120. Most these rulings cope with associations that file Form 1120, so only once you’re familiar will all those rulings will you be actually willing to give consideration to Form 1120.
The most important dangers you assume with Form 1120 are very quick. Initially, you have the risk you could expose extra user earnings to taxation. Unlike Form 1120-H, where the extra exempt purpose earnings (a roughly comparable concept and definition to extra user earnings) prevents taxation, it is taxed on Form 1120, if you don’t successfully beat it. There are only three choices: (1) pay taxation regarding the extra earnings, (2) either refund it to users or roll it over to the next year under Revenue Ruling 70-604, or (3) transfer it to reserves (at the mercy of rigid principles). Second, you have the risk you could expose your reserves to taxation.
Commentary – Are these dangers actually that great? Yes! Many associations apparently just rely on the “IRS audit lottery.” Fewer than 1per cent of associations get audited. No professional taxation preparer can advise you to take into account this factor when making a determination on which taxation kind to register. A connection may itself take that into consideration, but ethics principles prohibit the taxation preparer from considering it.
I have already been taking part in 50 IRS audits of associations, however in just one of these instances performed I really prepare the taxation return myself. I will be generally speaking retained because of the taxation preparer/CPA, the taxation attorney, or perhaps the Association the moment they understand that IRS has actually raised taxation issues that had not previously already been considered. Associated with 50 taxation audits, one had been on Form 990 (an exempt organization), two were on Form 1120-H, and 47 were on Form 1120.
Both Form 1120-H audits resulted in no additional taxes being evaluated. each 47 for the Form 1120 taxation audits resulted in extra taxes being evaluated.
I happened to be given these challenge earlier this taxation season: informing a number of new customers they had taxation visibility on their previous year Form 1120 tax statements; teaching them as to the dangers inherent in that kind; and persuading them that small extra taxation they’d pay on Form 1120-H should be seen as purchasing insurance coverage against another taxation assessment.