Return to Today's Anthem View The IRS Tax Audit

The IRS Tax Audit II

 

Many homeowners believe that HOAs are exempt from Federal income taxes. Not true. Like most of us, the association has to demonstrate income and expenses and has to justify any claimed deductions and offsets. What is true is that many HOAs qualify for special or preferential treatment under certain IRS rules. Either Sun City does not meet the percentage tests for income and expenditures needed to qualify to file the Homeowners Assocations tax return that was specifically designed for HOAs, Form 1120H, or there are other tax advantages to filing the standard Form 1120. Associations may choose which tax return benefits them the most. Sun City Anthem filed Form 1120.

Other homeowners are acutely aware that the association has yet to pay a dime to the IRS, thanks to those claimed deductions and offsets against income along with what looks like some interesting accounting practices. But more on that possibility later.

With the anticipated arrival of an IRS auditor on Sun City Anthem’s doorsteps to examine the 2007 tax return, it is difficult to imagine that few will be spared the humiliation that such an audit will create, especially for those who chose to tell IRS one thing on the association’s tax returns and then went ahead and ignored the law or did the opposite of what they had declared to the IRS. That about face, in the absence of any legal precedent for doing so, might be very difficult for our board officers to justify to the otherwise unsympathetic IRS auditor.  Did the association’s officers simply fail to understand how certain tax rules should be applied in their mistaken belief that they thought they knew what they were doing? Or, did they set out to deliberately mislead the IRS into believing that they knew what they were doing when they completed the association’s federal tax return?

Then again, the IRS might agree with the actions taken by successive board officers in signing off on the professionally prepared association tax returns. That’s why the association retains a professional accountant and legal counsel to provide those services. With a possible finding by the IRS auditor that no tax liability problem was created in deciding to carry forward excess income year after year, those who believed that the IRS rulings meant something different could end up with egg on their face.

The issues to be faced by the association are significant, not merely for the outcome to the association but also for the IRS since what eventually goes down now and here can have a fundamental impact on how IRS Revenue Ruling 70-604 is applied in the future. For the IRS, they will be looking to eliminate any wiggle room in the application of their forty year old revenue ruling. As with any rule making authority, the IRS will be highly motivated to restrict its application to current advisory opinions and court decisions that are consistent with that ruling. However, given known problems with its application, it’s unclear how far the IRS would be willing to go in attempting to defend that ruling in court. On the other hand, the association will be looking to modify its application by pointing out its alleged failure to take account of certain realities not foreseen when it was first published, suggesting that RR 70-604 may have more holes than Swiss cheese and is in need of further clarification.

This somewhat abstract discussion tells us little about what possible issues the IRS might be interested in looking at. The primary goal of most enforcement agencies is to obtain future compliance. They do so by a variety of methods, including, when appropriate, taking some type of enforcement action in an effort to make sure that others with similar problems also come into compliance. In their audit of the association’s tax return, the IRS will have to make a determination of the reasons for any errors or omissions found in the audit. That determination will typically go towards the issue of willfulness on the part of the preparer and responsible officials; were the errors deliberate and designed to mislead or were they made out of ignorance and a lack of knowledge. However, a lack of knowledge is no bar to seeking an enforcement remedy.

Significant areas of an audit typically include:

  1. Were income and expenses correctly allocated between member and nonmember use?
  2. Were exempt function income items properly classified?
  3. Were all claimed deductions properly supported?
  4. Were all claimed offsets against income properly taken pursuant to various revenue rulings?

On its face, none of the four areas on the tax return sends up a red flag. Said differently, the tax return has the appearance of satisfying the needs of the IRS, along with citing applicable revenue rulings to support certain claimed offsets. In other words, without an audit one could not tell whether the association had submitted an accurate return or had submitted a return with unfounded claims and was merely blowing smoke in their conclusion that there were no taxes owed for 2007.

What the auditor will likely find is that the association was indeed blowing smoke. Instead of nothing owed as a bottom line for 2007, as reported in the return, the auditor can start off with a balance due of $1,941,703 by declaring that the claimed offsets, No. 4 above, were improperly applied and may not be offset against income. So, instead of the claimed income being $6,491,235, the actual income should be $12,334,278. As a result, taxable income is a positive $5,710,892 instead of what the return had reported, which was a negative $132,151.

The above assumes that the auditor will not find any other tax related problems. To look at what the 2007 return reported on their Form 1120 compared to the likely outcome of the IRS audit on Item 4 above, scroll down to the bottom of this page.

Why would the auditor make such a determination? The simple reason is that the association lacks the kind of documentation that the IRS typically requires to support the claimed offsets. Sufficient documentation does not exist to support the claimed offsets for:

  1. Transfer to Replacement Fund                  $1,998,019
  2. Carryforward to 2008                               $3,845,024
  3. Total of the above two offsets disallowed:   $5,843,043


        This conclusion of a potential liability does not mean the association will not argue the correctness of their position on these matters. Nor does it mean that the association is obligated to accept the IRS determination. IRS determinations are subject to appeal. At this stage, however, the preponderance of the evidence known to exist would support an IRS decision to disallow the claimed offsets based on their past practice to do so in similar audits.

Where did the association go wrong? That’s not clear. What is clear is that the association’s claim to offset certain transactions from income does not conform to the IRS rulings the association relied upon. For example, take that almost $2 million transaction labeled “Transfer to Replacement Fund.” This transaction was ostensibly made pursuant to IRS Rev. Rul. 75-371 and similar rulings. First of all, there is no such fund as the “Replacement Fund,” unless the reference is to the general reserve fund. Historically, recurring transfers to the reserve fund are not allowed under RR 75-371. But the problems with relying on RR 75-371 are even greater. In order for RR 75-371 to apply, only certain transfers are allowable and deductable from income as a capital contribution. Those transfers must meet certain conditions. They are:

  1. The money for the capital project must arise from a special assessment;
  2. The money must be earmarked in advance for a specific capital purpose; and
  3. The money raised for that specific purpose must be placed in a separate bank account, not comingled with other funds.

To my knowledge, the association failed to meet these three conditions. As a result, the claimed offset for the transfer of nearly $2 million to the reserve fund is not allowed.

What about that “Carryforward” amount of $3.8 million? Was that claimed offset proper under RR 70-604, as alleged by the association. No way if our understanding of the written word means anything.

Setting aside the potential contested issue of who decides, either the board for the unit owners or the unit owners themselves, there is the central issue of the options available under RR 70-604. There are only two options available. However, it is evident that the board decided to ignore both options in favor of decisions to 1) carry forward the excess income amounts year after year; 2) spend the money on capital improvements or for operating expenses; and 3) transfers to the reserve fund. However, those decisions have placed the association in serious financial jeopardy since they are contrary to the ONLY two options available under RR 70-604. As previously reported, those options are to:

  1. Return the surplus amount to the unit owners; or
  2. Credit the surplus amount as an offset to unit owner assessments in the following year.

Since the board did not elect to follow either of those available options, their claimed tax offset for that $3.8 million reserve fund transfer will be disallowed. There is no other way to view the matter.

Whether that 2009 fourth quarter assessment holiday waiving $1.7 million in member dues qualifies under RR 70-604 is questionable since the purpose of that holiday had nothing to do with the distribution of excess income, but instead was based on the reported failure of the Liberty Center to open that year as originally planned. The board acknowledged that funds previously budgeted that year to operate Liberty Center were not needed.

In the end, successive boards wanted to retain the flexibility to make these financial decisions themselves. The path they chose, however, resulted in an ever increasing accumulation of surplus funds in excess of member income. Those decisions forced the boards to engage in a sort of hide and seek game with the IRS, literally deceiving the IRS into believing something of significance that was not true. That something was alleged compliance with numerous IRS revenue rulings. Successive boards were put in the uncomfortable position of having to submit tax returns that at best were not properly supported by the board’s actions and at worse deceptive and false.

As a final note is the observation that numbers in a spreadsheet or on a tax return can be arranged in such a manner so as to produce a desired result. Say, hypothetically, you are interested in achieving a zero outcome on your tax return for the amount owned. While everyone might prefer that as an outcome, that prospect is highly unlikely and is virtually impossible to achieve year in and year out. For example, a negative outcome is reached in the following for income, expenses and taxable income: 5 – 6 = -1. With a negative result for taxable income, the amount owed is zero. As anyone who has completed a tax return knows, the final outcome is a function of what went into the income and deductions categories.

In the case of the association, they might have the convenience of making certain financial decisions after the end of the tax year, such as the amount to transfer to the reserve fund for the preceding year’s tax return, as well as the convenience of filing their return later in the year. The 2007 tax return was filed in September 2008. By that time critical financial information was know not only for 2008 but was also projected for the following year, 2009.

That convenience may have permitted the board to adjust the amount of their 2007 transfers to the reserve fund with the potential of achieving a given outcome on their tax returns. However, without additional information concerning such transfers, it’s difficult to understand how discretionary transfer decisions by the board were arrived at.

It has always been a mystery to me, and possibly to others as well, why any given amount was being transferred to the reserve fund. Historically, we were told and the board has reported that 10% of member assessments were automatically allocated to the reserve fund. In 2007, member assessments totaled about $7 million, based on their tax return. Ten percent of that amount equals $700,000. Add to that figure another $100,000+ for Interest and Developer Contributions that year and there remains a balance of roughly $1 million in so called discretionary transfers.

Exactly when all of those transfers occurred is not clear. According to the November 2007 Budget presentation for FY 2008 on the status of the Reserve Fund, a total of $1.628 million in 2007 transfers was accounted for. That leaves $370,000 unaccounted for based on a reported $1.998 million transferred that year to the reserve fund.

Then again, perhaps it was likely that the board was lucky and just happened year after year to come up with a serendipitous outcome that managed to produce a zero amount as the amount owed on their tax returns independent of the amounts alleged were proper offsets in compliance with IRS rulings. But knowing what we know about the application of IRS rulings, that luck and the zero amounts owed were as false as the returns themselves.

 

Ron Johnson, 11 August 2010, amended.

Note: Some corrections and minor amendments were made to the body of the text on 14 August.

 

 

 

Below is a comparison of certain amounts reported by the association on Form 1120 to the corresponding amounts that the IRS auditor will likely adjust, based on IRS past practice and only for claimed offsets pursuant to IRS revenue rulings 70-604, 75-371, etc., and apart from any other adjustments the auditor may make.

Form
1120
Sun City Anthem Community Association
2007
               
Line
  Actual Tax 
 
 Likely IRS 
         
  Return Figures 
 
 Audit Outcome 
11
Total income
   
 $      6,491,235
 
 $     12,334,278
       
27
Total deductions
   
 $      6,623,386
 
 $       6,623,386
       
28
Taxable income (Subtr. line 27 from 11)
 $      (132,151)
 
 $       5,710,892
 
[Tax rate]
   
34%
31
Total tax
     
 $                      -  
 
 $       1,941,703