Reserve funds and the IRS

Lately there have been a number of messages regarding reserve funds

1) what the IRS requirements are,
2) whether they should be maintained separate from the operating fund, etc., etc.

I recently came across an ariticle dealing with IRS audits of a number of CA HOAs that occurred a number of years ago. All these HOAs had filed taxes using form 1120 - the tax form for corporations. The initial audit findings stated the HOAs were not following proper procedures because:

1) reserve funds were not segregated from operating cash,
2) noncapital reserve items (specifically painting and contingency) were incorrectly included as reserve items for tax purposes
3) IRS Rev. Ruling 70-604, which allows an assn to transfer excess opeating income to the following year's budget, was not being correctly elected by the members, and
4) reserve assessments needed to be special assessments, not part of the regular monthly assessment.

To avoid an audit, HOAs should:

1) segragate noncapital type reserve items into a separate cash account
2) members should vote on rev. ruling 70-604 if they want to transfer excess operating income to the following year
3) make certain the reserve portion of the assessment is distinct on the budget and is considered to be a "contribution of capital" on the tax return.

Now, remember all of this ONLY applies if the HOA chooses to file on a form 1120 (corporation). None of this applies if the HOA elects to file on a form 1120H (specific to HOAs), meaning they fall under section 528 of the Internal Revenue Code.

Some HOAs choose to file the 1120 because the tax is only 15% instead of 30% if using the 1120H. That determination is best left to the HOA's accountant. He will know all the Rev. rulings, tax codes, etc.

I hope this information will put an end to all the speculation, misleading information and misconceptions.

Perhaps Brian will include this info in his Legal FAQ.

Dave,

Here's the article. As you can see, it goes back to 1991 but was just posted on an HOA website last month.

Audit Update IRS Delays Collection of Settlements From San Diego Associations
Vol. 3, no. 1
Ledger Quarterly, Summer 1991

Gayle L. Cagianut, CPA

In March of 1993, the IRS surprised several San Diego homeowner associations with audits claiming they owed thousands of dollars in back taxes. The audits were directed to associations that filed Form 1120 (corporation tax return). Initial audit findings disclosed that the IRS believed these associations were not following proper procedures because: 1. Reserve cash activity was not segregated from operating cash. 2. Noncapital reserve items (specifically painting and contingency) were incorrectly included as reserve items for tax purposes. 3. IRS Revenue Ruling 70-604, which allows an association to transfer excess operating income to the following year's budget, was not being correctly elected by the members. 4. Reserve assessments needed to be special assessments, not part of the regular monthly assessment. The IRS San Diego audit manager recently announced that because of the national publicity generated from the audits, the IRS will not collect settlements from them. Instead, the IRS will conduct a formal study of the matter and issue a position statement or revenue ruling. Many accounting professionals believe that associations will prevail in most of the cases. They also assert that associations may continue to file Form 1120 and reap the benefit of a 15 percent tax rate (in some cases), as opposed to the 30 percent Form 1120-H tax rate. However, to avoid an audit associations should: [] Segregate reserve cash and operating cash and its activity. [] Segregate noncapital type reserve items into a separate cash account. [] Have the members elect 70-604 if this revenue ruling is being used. [] Make sure that the reserve portion of the assessment is distinct on the budget and is considered to be a "contribution of capital" on the tax return.

Gayle L. Cagianut is a CPA with Cagianut & Grunewald, CPAs of Oak View, California.