Let’s Play 20 Questions: Taxes and Audits

Let’s Play 20 Questions: Taxes and Audits

[ Blog/News ]

Let’s Play 20 Questions: Taxes and Audits

One thing is certain for community associations: An annual federal tax return. Another thing MAY be certain: an annual Certified Public Accountant (CPA) audit. If this is surprising to you, read on. If this is not surprising to you, read on anyway; as community associations are so unique in their tax treatment!

(Editor’s Note: This blog article first appeared in the March 2018 issue Community Associations Journal. It is a first in a two-part article. Part two will appear in the upcoming April issue.)

Let’s test your knowledge by playing “20 Questions”!

Question Mark in Talk Bubble Icon Green  Question Mark in Talk Bubble Icon Orange  Question Mark in Talk Bubble Icon Blue

Are associations required to file an annual federal tax return?

Answer Mark in Talk Bubble Icon GreenYES. Associations are required to file annually, even if they do not have taxable income. The return is required from the date of inception, even if assessments are not yet billed.

What type of tax return do associations file?

Answer Mark in Talk Bubble Icon GreenMost associations file a form 1120-H return, which is a special return for this industry. Some associations file a form 1120 return, which is the regular corporate return. This industry is unique in the tax law since most associations may “flip flop” back and forth each year between an 1120-H and an 1120. Some associations (such as commercial associations, and associations that don’t meet certain tests) are required to file an 1120 return. A few associations are considered a Non-Profit for tax purposes and file a form 990 tax return. This is rare and has stringent/narrow requirements.

Do associations pay tax?

Answer Mark in Talk Bubble Icon GreenYES. For the 1120-H return, they pay 30% tax on net “non-exempt function income.” Examples would be interest/investment income on all accounts, income from non-members (such as cell tower income or rental of an association owned unit), and “user fees” from members. For the 1120 return, Associations pay graduated corporate tax rates on net membership income and net non-membership income. These can be very complex issues, so it is always best to have an industry CPA advise on the best tax return choice and prepare the return for the association.

Is there a way to avoid tax?

Answer Mark in Talk Bubble Icon GreenIf the Association has interest/investment income, or income from non-members, other than the standard exemption available, it is difficult to avoid paying any tax. There are strategies to minimize tax. The association should work with their CPA on appropriate deductions that may be taken against the taxable income. If there is other taxable income, keep good accounting records of the potential direct expenses related to the production of income. Additionally, if the association qualifies for 1120 tax return filing, some tax rates are below the 30% “flat tax” for the 1120-H return. As noted above, the 1120 return is recommended in limited circumstances due to the requirements, and higher IRS audit risk.

What are some of the requirements to file an 1120 tax return?

Answer Mark in Talk Bubble Icon GreenIf the Association thinks they are planning on filing an 1120 tax return, they should consult with their CPA as this gets very complex, quickly. Generally, the association needs to follow strict accounting requirements including segregation of operating and reserve cash, and “fund accounting” is preferable. The Association should adopt and adhere to a budget that agrees with the reserve study, have minimal “transfers between funds”, document repayment plans for “due between funds” and be aware of the capital and non-capital items in the reserve study. They also need to have the association membership approve the “70-604” tax election.

What is the “70-604” tax election?

Answer Mark in Talk Bubble Icon GreenThis is a federal tax election only, and does not impact the books. As noted above, if the association files an 1120 tax return, the “net membership income” is taxable. The 70-604 allows the net membership income to be deferred from year one to year two. Since the 70-604 cannot be used two years in a row, this is only a deferral of tax. IF the association still has net membership income remaining at the end of year two, if an 1120 return is again filed, and no offsetting membership losses exist, the net membership income is taxable. Our firm recommends that each association approve the 70-604 each year at the annual meeting, regardless of the type of return filed. This is because it is not known (until the return filing) which form will be appropriate, and if an 1120 is necessary, the 70-604 may be needed. It also provides extra “IRS audit insurance”, regardless of the form filed each year. Again, this election is approved by the membership, not the board.

Is transferring monies to reserves the same as the “70-604?”

Answer Mark in Talk Bubble Icon GreenNo. Should be two separate motions.

When is the tax return due to the IRS?

Answer Mark in Talk Bubble Icon GreenThe return is due 3.5 months after the year end. For calendar year associations, this is April 15. There is an extension available, however any tax due must be paid by the tax return original due date.

What is an audit?

Answer Mark in Talk Bubble Icon OrangeAn independent CPA is engaged by the association to determine if the year end financial statements are materially correct, in accordance with Generally Accepted Accounting Principles (GAAP) and that adequate financial statement disclosures have been presented. The CPA should not be connected to the association in any way. “Materiality” is a matter of CPA judgment, however it means the CPA does not look at every transaction. Examples of “disclosures” would be litigation, special assessments, contingencies, FDIC limitation exceeded, and significant events occurring after year end but before the date of the Auditors’ Report.

Is our association required to have an annual audit?

Answer Mark in Talk Bubble Icon OrangeThis depends on the body of Washington law (RCW) that governs the association, and the size of the association. Please read the noted RCW for more clarification and consult your attorney if unclear.

  • “New Act” Condominiums (Created after 7/1/90 -RCW 64.34.372) Condominiums with 50 or more audits must be audited annually. Condominiums with less than 50 units have an annual audit requirement, however, there are annual waiver provisions.
  • “Old Act” Condominiums: (Created before 7/1/90) Generally, the requirements default to the New Act Condominiums provisions, however, if the governing documents require an annual audit, then an audit is required, regardless of the number of units.
  • Homeowners Associations (RCW 64.38.045) Associations with annual assessments of $50,000 or more must be audited annually, however, there are annual waiver provisions.

Additionally, there is an audit requirement for New Act Condominiums upon the legal transition from developer control. (RCW 64.34.312)

When is an audit recommended, regardless of the requirements?

Answer Mark in Talk Bubble Icon OrangeBecause the board is charged with governance of the association, they need to think through carefully whether the waiver of an audit is advised. Some of the reasons to have an audit include:

  • The CPA may also issue a “Report of Internal Control.” This contains recommendations that protect the board and association.
  • Provides significant disclosures to current and future owners.
  • Construction defect settlements.
  • Insurance proceeds/settlements.
  • Large special assessments.
  • Large construction projects.
  • Change in management companies.

If there is suspected fraud, a separate “forensic audit” may be appropriate.

What is needed in an audit?

Answer Mark in Talk Bubble Icon OrangeThe auditor will ask for the financial records and reports for both the audit year and subsequent year. If it is a new client, the auditor will ask for the financial records of the prior year end. Additionally, the auditor will also ask for governing documents, reserve studies, tax returns, budgets, and board minutes.

How long will the audit take?

Answer Mark in Talk Bubble Icon OrangeIn our firm, IF all information is provided when requested, the process is about six to eight weeks.

Who receives the audited financial statements?

Answer Mark in Talk Bubble Icon OrangeThe Auditors’ Report is addressed to the association board and membership. Other users include future owners (in the re-sale certificate) and current or possible association lenders. (The “Report of Internal Control” is addressed to the association board and management.)

What do we do if an audit discloses an issue?

Answer Mark in Talk Bubble Icon OrangeDiscuss the audit results with your management company and CPA, if you don’t understand the issue. Then, the board should discuss their plans to rectify the issue, and document this in the board minutes.

Are there more questions?

Answer Mark in Talk Bubble Icon BluePossibly, this article has raised more questions for you, than answered. Consult your association CPA, as there are numerous exceptions/details that are beyond the scope of this article.

 

Was this really 20 questions?

Answer Mark in Talk Bubble Icon BlueNo. Apparently the CPA cannot count. End Of Article

By Catherine Kuhn, CPA

Owner, Cagianut & Company, CPA

Catherine Kuhn, CPA, manages the Bellevue office of Cagianut & Company, CPA, which is devoted exclusively to serving the financial needs of over 800 Community Associations in Washington. C&C has over 25 years of experience in serving Community Associations and currently has 18 employees. Prior to joining Cagianut & Company in 2006, Cathy was a partner in a large Bellevue CPA firm and served clients in various industries there for 20 years. Cathy teaches classes and writes articles for WSCAI. In addition to being “Mom” to 2 active teenagers, she serves as Treasurer of the Newport High School Girls Basketball Booster Club, and a financial volunteer for Bellevue Young Life.

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Thou Shalt Provide A Budget Summary

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Thou Shalt Provide A Budget Summary

It is a common refrain among those who live in or work with condominium associations that the annual budgeting process consists of two parts accounting and one part voodoo. To avoid an imbalance in the recipe, it is important that members of the Board of Directors are familiar both with the Association’s governing documents and with applicable statutes in order to effectively serve the association and its members.

 

Effective January 1, 2012 changes to Washington’s reserve study laws went into effect. The changes impacted both “new act” condominiums (those governed by RCW 64.34) as well as HOA’s (RCW 64.38) and include specific and extensive reporting requirements that have been added to the budget process for both condominiums and HOA’s. This article will focus on these reporting requirements specifically as they relate to condominiums as set forth in RCW 64.34.308(4).

Understanding and Applying RCW 64.34.308(4)

For “new act” condominium associations governed by the Washington Condominium Act, RCW 64.34.308(3) requires an association’s Board of Directors to adopt a proposed budget and, then, to provide a summary of the proposed annual budget to all unit owners who must have the opportunity to reject the budget at a formal meeting of the association, if they so choose. In the past this process has been fairly straightforward and simple. Concerned that unit owners were not being sufficiently informed of the financial health and wellbeing of the condominium associations in which they lived and notified of potential exposure to increased assessments or other costs in the future, the legislature amended RCW 64.34.308(4) to include extensive reporting requirements with which all “new act” condominium associations must comply.

RCW 64.34.308(4) now requires the Board of Directors disclose the following information in the annual budget summary sent to each unit owner:

(a) The current amount of regular assessments budgeted for contribution to the reserve account, the recommended contribution rate from the reserve study, and the funding plan upon which the recommended contribution rate is based;

(b) If additional regular or special assessments are scheduled to be imposed, the date the assessments are due, the amount of the assessments per each unit per month or year, and the purpose of the assessments;

(c) Based upon the most recent reserve study and other information, whether currently projected reserve account balances will be sufficient at the end of each year to meet the association’s obligation for major maintenance, repair, or replacement of reserve components during the next thirty years;

(d) If reserve account balances are not projected to be sufficient, what additional assessments may be necessary to ensure that sufficient reserve account funds will be available each year during the next thirty years, the approximate dates assessments may be due, and the amount of the assessments per unit per month or year;

(e) The estimated amount recommended in the reserve account at the end of the current fiscal year based on the most recent reserve study, the projected reserve account cash balance at the end of the current fiscal year, and the percent funded at the date of the latest reserve study;

(f) The estimated amount recommended in the reserve account based upon the most recent reserve study at the end of each of the next five budget years, the projected reserve account cash balance in each of those years, and the projected percent funded for each of those years; and

(g) If the funding plan approved by the association is implemented, the projected reserve account cash balance in each of the next five budget years and the percent funded for each of those years.

Clearly, the job of Board members and the agents that serve them in the budgeting process has not gotten easier with these new disclosure requirements! However, the silver lining is that these additional disclosure requirements will likely provide members of the association with an important snapshot of both the current and future financial health of the association.

As another budget season rapidly approaches, it is important that you know whether these recent changes apply to your association and, if they do, that you are clear how they should be implemented. If you have questions about these changes or how to effectively and efficiently implement them, there are a host of resources available through WSCAI that stand ready to assist you! Good luck and happy budgeting.

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Tying Up Loose Ends: End of the Year Checklist for Self-Managed Communities

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Tying Up Loose Ends: End of the Year Checklist for Self-Managed Communities

As we near the end of the year, it’s time to take care of loose ends and prepare for the upcoming year. This can often prove a difficult balancing act, especially without the help of professional management. However, just because you’re a self-managed community doesn’t mean you must do without professional assistance. In fact, under the Washington Nonprofit Corporation Act, a board of directors is allowed to do just that: rely on information, opinions, reports, and statements from professionals in a given field. What follows is a basic primer on what you, as a self-managed community, need to do at year-end.

Balancing the Books — Financial Statement, Budget, Audit & Tax Return

Whether you’re a homeowners association or a condominium owners association, year-end means it’s time to balance the books and take stock financially.

Annual Financials & Budgeting

Both the Condominium Act and the HOA Act require every association to prepare, at least annually, a “financial statement.”  A financial statement consists of a balance sheet and an income-and-expense statement.  The Condominium Act provides that the statement must be prepared in accordance with generally accepted accounting principles (GAAP).  This means that all figures have to be shown on an accrual basis, which records income when earned and expenses when incurred, as opposed to a cash-basis model, where income and expenses are recorded when cash actually flows in and out.  The HOA Act does not mandate compliance with GAAP, but doing so constitutes best practices.

In addition to the financial statement, associations should prepare an annual budget that projects anticipated operating costs and reserve contributions for the coming year.  This is required by the bylaws of most associations, although it is not a statutory requirement.  However, before a new schedule of assessments may be used, there must be a budget that supports the assessment amounts.  If a budget proposed by the board of directors is not ratified by the association, the last budget that was ratified must remain in effect.

What’s an audit, and can I waive it?

Audits, which are conducted by certified public accountants (CPAs), verify the accuracy and fairness of an association’s financial activity and reports.  Condominiums with 50 or more units are required to have their financial statements audited annually by a CPA.  Condominiums with fewer than 50 units can waive the annual audit if 60% of the units (not including units owned by the declarant) vote to waive.  Homeowner associations with annual assessments of $50,000 or more are required to have an annual audit, unless waived by a 67% vote at a meeting at which a quorum is present.  Waiver must be done one year at a time: multi-year waivers are not allowed under the statute.

Taxes, Taxes, Taxes

An association must file a federal tax return each year, even though it is a nonprofit corporation or association.  The return is due March 15, unless an extension is requested.  One of two IRS forms is used.  Form 1120 is considered the “Corporate Method,” and graduated tax rates begin at 15%.  Form 1120H is the “Exempt Method” and uses a flat tax rate of 30%.  If the association has no taxable income, the tax rate may be irrelevant.  Form 1120 can save you money if there is taxable income to report, but it is more complex to fill out and requires advance planning.  Form 1120H is easier to complete but the following four criteria must be satisfied: (1) 85% of the units must be for residential use; (2) at least 60% of gross income must be tax exempt income; (3) 90% of expenses must be to acquire, build, manage, maintain, and care for property; and (4) residual income must not be used for members’ benefit.

Given the complexities of tax laws, consult with a tax professional to ensure compliance with federal requirements and the most favorable tax treatment for your association.

Preserving Your Investment – Reserve Study and Maintenance Plan

Next on the list are those items which keep your buildings and improvements in good repair over the long term: reserve studies and inspections.

Confused about Reserve Studies?

Under a law passed in 2008, all Washington condominium associations (including old-Act condos) must conduct a reserve study and update it annually.  Non-condo homeowner associations are not subject to this requirement.  A full reserve study includes a physical assessment of all building components and improvements that are expected to require replacement, and a financial analysis.

The purpose of annual updates is to ensure that reserve funding is on track and, if not, to adjust the funding schedule. This means comparing actual wear of components to anticipated wear, adjusting estimates of remaining service life as needed, and checking actual funding and investment returns against expected revenues and investment returns. The update must include an onsite inspection every third year; interim-year updates do not require onsite inspections.  Annual updates are not required for associations with ten or fewer units.

Inspect and Repair Every Year

Annual inspections and regular maintenance and repair are key to the long-term well being of any association.  The reserve study may include physical inspection of buildings and improvements, but inspection is not the same as maintenance.  As board members, it is your responsibility to make sure that regular maintenance and repairs are carried out to preserve the condition of the buildings and improvements.  Since board members change year, having a maintenance plan that specifies the schedule for maintenance of each component helps provide continuity as members rotate off the board – particularly in self-managed associations.  Most reserve study analysts can also prepare maintenance plans.

Legal Housekeeping – License Renewal

The reserve study and annual inspections help preserve the physical well-being of your buildings, but ensuring the legal life of your association is important as well.  Nonprofit corporations must register annually with the Secretary of State.  An Annual Report must be filed with the Secretary of State.  This can be done online and includes verifying the names and addresses of all officers and directors, the principal place of business, your corporation activities, a signature from an authorized board member, and paying a fee. (See http://www.sos.wa.gov/corps/).  Failure to renew your registration will trigger an administrative dissolution of the corporation.  The corporate license can be reinstated for three years after dissolution, but there is an extra fee for reinstatement.  A corporation must be in good standing with the Secretary of State to maintain any court action – such as a collection action – so annual renewal is important.

Fostering a Sense of Community – the Annual Meeting

The above items are needed to keep your association in good order, but remember what creates a sense of community: the people.  While the law (and probably your bylaws) requires every condominium and homeowner association to have an annual meeting, the annual meeting is also a great opportunity to strengthen your community.  Adding a social element to the meeting, by having food and beverages, brings people in and creates a positive atmosphere for participation.  If alcoholic beverages are involved, it is prudent to complete the annual meeting business before opening the bar!  Putting photos from the annual meeting on the association website reinforces the sense of community and fun.

Conclusion

Managing your own association can be a daunting task.  Knowing the things you have to do at year-end to satisfy legal requirements is critical.  By getting started early in the fall on financial matters, annual inspections and reserve study updates, and license renewal, you will keep your association on track and be ready for a productive and fun annual meeting.

By Tony Rafel

Managing Partner, Rafel Law Group PLLC

Tony Rafel is the Managing Partner of Rafel Law Group PLLC, a law firm that represents community associations
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