Differences Between IRS Forms 1120 and 1120-H
Throughout our various engagements with Community Associations, and our ongoing conversations with Board Members and management personnel, some of the most common questions pertain to income taxes. These include:
- “Do we have to file a tax return? What return do we file?”
- “We are a non-profit. Why do we owe taxes?”
- “On the representations of management letter, you want us to represent that ‘We understand that management and the Board of Directors are responsible for the Association’s choice of filing form 1120-H or Form 1120, and the consequences thereof.’ What are the consequences?”
“Do we have to file a tax return? What return do we file?”
All Community Associations must file a tax return. For the most part, all Community Associations are taxed as corporations. Which form to file depends on the type of association and a few other factors.
As a rule of thumb, Corporations must file Form 1120. Most residential Condominium Associations, Homeowners Associations, and Timeshare Associations may be taxed under Section 528 (Form 1120-H) or IRC Section 277 (Form 1120). Few Homeowners Associations qualify as tax-exempt organizations and file Form 990, Return of Organizations Exempt From Income Tax.
Form 1120-H is a tax form specifically created for qualifying Homeowners Associations. The reason behind enacting IRC Section 528 was to prevent individual homeowners from being taxed for performing functions typically managed by Community Associations, such as maintaining and managing the common property in a development. Therefore, the Community Associations themselves should not be taxed on these activities, just because the homeowners have formed an association to carry them out collectively.
However, it’s not always the case that an association would find it beneficial to file Form 1120-H instead of Form 1120. The decision on which form to file depends on various factors, including the association’s financial situation, income sources, deductions, and potential tax benefits. While Form 1120-H may offer certain tax advantages, there could be instances where Form 1120 might be more appropriate based on the association’s specific circumstances. It’s essential for the association to carefully analyze its financials and consult with tax professionals to determine the most advantageous option for its tax filing.
“What are the advantages and disadvantages of the two forms?”
As stated above, Form 1120-H is a tax form specifically created for qualifying Homeowners Associations. However, it’s not always the case that an association would find it beneficial to elect to file Form 1120-H instead of Form 1120.
Advantages of Filing Form 1120-H
- Form 1120-H is a one-page form and is easier to complete than Form 1120.
- Less risk is associated with filing Form 1120-H.
- Exempt function income is not taxable.
- Some states exempt associations that file Form 1120-H from state income taxes.
Disadvantages of Filing Form 1120-H
- Taxable income is taxed at a 30% (or 32% for timeshare associations) rate versus the flat corporate rate of 21% when filing Form 1120.
- Associations are not entitled to net operating loss deductions. The association may not claim a net operating loss generated during the year if a Form 1120-H is filed for that year, nor can the association carry the NOL forward. (However, while a net operating loss generated in a prior year when the association filed a Form 1120 may not be deducted in a year the association files a Form 1120-H, it can be carried forward and deducted in subsequent years on Form 1120 returns.)
- Associations are not entitled to write off organizational costs.
- Associations are not entitled to the deductions allowed under Part VIII of Subchapter B of the Code.
The procedures for filing Form 1120-H are as follows:
- Determine that the association is qualified to file Form 1120-H.
- Segregate exempt function income from nonexempt function income.
- Allocate expenses to nonexempt function income.
- Determine taxable income; i.e., nonexempt function income as determined in step 2 here, less expenses allocated to nonexempt function income as determined in step 3, less a federal specific deduction of $100.
- Determine the association’s tax liability.
Filing Form 1120-H for a Homeowners Association has some unique effects on the tax treatment of excess exempt function income and expenses. Under this form, any surplus of exempt function income over exempt function expenses will not be subject to taxation, which means it is not included in the association’s taxable income. However, if there is an excess of exempt function expenses over exempt function income, that amount is lost and cannot be carried over to offset future taxes.
The association’s taxable income is calculated by subtracting a specific deduction of $100 (which is preprinted on Form 1120-H) from the total income. The remaining taxable income is then taxed at a flat rate of 30% for Condominium and Homeowners Associations or 32% for Timeshare Associations.
In addition to the above, there may be other considerations that come into play when determining the association’s overall tax liability, though those additional factors were not specified in the provided text. These other considerations might involve specific deductions, credits, or any relevant tax regulations that could further impact the final tax amount owed by the association.
Overall, Form 1120-H provides a unique tax treatment for Homeowners Associations, with its flat tax rates and treatment of excess exempt function income and expenses, which can have significant implications for the association’s tax liability. However, it is essential to take into account all relevant factors and consult with tax professionals to ensure accurate and optimal tax planning for the association.
Form 1120-H has the same due dates and extension dates as corporate income tax returns. Associations may file Form 7004 to receive an automatic extension for filing the return. Note: Any estimated payments of taxes must be made by the returns initial due date.
Advantages of Filing Form 1120
- Taxable income is taxed at the flat corporate tax rate of 21% versus the 30% (or 32%) tax rate required when filing Form 1120-H.
- Certain tax-planning opportunities may exist.
Disadvantages of Filing Form 1120
- The risk of compliance is much higher for Form 1120 than for Form 1120-H.
- Form 1120 is a longer, more complex tax form to complete, and the cost of preparing Form 1120 may offset the tax benefits received.
- Associations that file Form 1120 may be subject to state income taxes (if not located in a state that exempts associations that file Form 1120-H from state income taxes).
Some might wonder why Community Associations choose to file their tax returns using Form 1120 instead of opting for the simpler Form 1120-H that’s specifically designed for qualified Homeowners Associations. The primary reason for this choice is that the income of the association is subject to a lower flat tax rate of 21% on taxable income when using Form 1120, as opposed to the higher tax rates of 30% (or 32% for Timeshare Associations) applicable to Form 1120-H.
Despite the simplicity and tailored nature of Form 1120-H for Homeowners Associations, the potential tax savings with the lower tax rate on Form 1120 can be significant. This lower tax rate can help the association retain more of its earnings, which can be crucial for financial planning and future investments.
However, it’s important to note that the decision of which form to file depends on the unique circumstances of each association. While the tax rate is a critical factor, other considerations such as deductions, credits, and overall financial situation must be evaluated to determine the most advantageous choice for filing taxes. Ultimately, associations should work closely with their accountants or tax professionals to make an informed decision that aligns with their specific financial goals and obligations.
As noted above, the risks of filing Form 1120 under the provisions of IRC Section 277 are much higher than filing Form 1120-H.
Considerations when attempting to use Form 1120 include:
- Correct characterization of income and deductions.
- Ability to adequately document additions to the replacement fund as being contributions to capital rather than membership income.
- The risk of being taxed on excess membership income.
“On the representations of management letter, you want us to represent that ‘We understand that management and the Board of Directors are responsible for the Association’s choice of filing form 1120-H or Form 1120, and the consequences thereof.’ What are the consequences?”
Indeed, at first glance, the preparation of tax returns for Community Associations might appear straightforward, with the choice between Form 1120-H and Form 1120 seemingly straightforward due to the lower flat tax rate of 21% offered by Form 1120. However, in reality, the decision-making process is far more intricate and requires careful consideration of several factors.
Choosing between Form 1120-H and Form 1120 should take into account various elements, including the association’s income sources, deductible expenses, potential tax credits, exemptions, and overall financial situation. While Form 1120-H is specifically designed for Homeowners Associations and might seem simple to complete, it might not always be the most advantageous option for certain associations, especially if they have significant income or expenses that could result in a lower tax liability using Form 1120.
The role of the tax practitioner is crucial in guiding their clients through this decision-making process. Tax professionals have the expertise to analyze the association’s financials, understand their unique circumstances, and provide informed recommendations on which form to file. However, the final decision ultimately rests with the client, and it is essential for them to be well-informed and educated about the factors involved in making the best choice for their tax filing.
The complexity of the decision underscores the importance of a collaborative effort between the tax practitioner and the client, ensuring that the association can make the most informed and advantageous decision regarding their tax filing. The goal is to optimize tax outcomes while complying with relevant tax regulations and requirements.
While no approach can guarantee an audit-proof tax return, the IRS consistently considers certain factors to determine if an association has properly filed Form 1120. These questions serve as an objective means of assessing the risk involved in the filing process. The answers to these questions can help the association and tax preparer understand how well the tax return aligns with IRS regulations, which in turn can impact the chances of an audit.
Questions the IRS considers to determine if an association has properly filed Form 1120 include:
- Does the association maintain the following three separate categories of bank accounts:
- Operating accounts?
- Capital reserve accounts?
- Noncapital reserve accounts?
- Does the association have a reserve study supporting the specific capital purpose for which reserves are being set aside?
- Does the association have a budget which agrees to the reserve study?
- Does the association separately account for operating and reserve transactions in the association’s financial statements and general ledger?
- Are capital and noncapital replacement fund balances segregated on the financial statements?
- Do the members annually approve the association’s election under Revenue Ruling 70-604?
- Does the association avoid interfund borrowing between the operating bank accounts and the capital reserve bank accounts?
- If an interfund receivable is recorded instead of a permanent transfer, is there a repayment plan?
- Does the association immediately (i.e., within two weeks) transfer to the appropriate reserve bank accounts the reserve portion of dues that was initially deposited into an operating bank account?
- If reserve expenditures are paid from an operating account, is that account immediately (i.e., at least monthly) reimbursed in the exact amount of the expenditure by the reserve accounts?
There is generally no risk involved in filing Form 1120-H if the association qualifies to file that form. However, a risk exists that the association may overpay tax when filing Form 1120-H if the Community Association could have safely qualified to file Form 1120.
The filing of Form 1120 carries a high degree of inherent risk because it is so difficult for the Community Association to comply with all of the requirements upon which a proper filing of this form is based. Further, since the majority of those risk factors are under the sole control of the Community Association, there is little the tax practitioner can do to rehabilitate a bad set of circumstances.
If the Community Association fulfills the necessary criteria to be taxed as a Homeowners Association, then filing Form 1120-H involves minimal additional risk. This form is designed specifically for qualifying Homeowners Associations and offers a straightforward tax reporting process.
However, if the association mistakenly files Form 1120-H and later discovers that it doesn’t meet the requirements to qualify as a Homeowners Association, it may be compelled to make a mandatory change to Form 1120. This switch exposes the association to higher risk as Form 1120 is more complex and carries a greater potential for compliance issues and associated risks.
To qualify as a Homeowners Association and take advantage of Form 1120-H, the association typically needs to meet the following requirements:
- Lack of Private Benefit Test. Most associations will automatically meet the lack of benefit test. Thus, that risk is considered to be low.
- Substantially Residential Test. It is generally clear for most associations whether they meet the substantially residential test which requires that 85% of the lots or square footage must be used for residential purposes. The greatest risk in meeting the substantially residential test is for resort-type associations where there is a high degree of short-term rental use of condominium units.
- The 60% Income Test. The 60% income test often presents qualification problems for associations that submeter utilities, provide valet or maid services, or provide extensive recreational amenities and services.
- The 90% Expenditure Test. This test is the most difficult qualification for associations to achieve. Generally, any association that fails the 60% income test will also fail the 90% expenditure test. For example, associations that provide even a simple laundry room facility to their members may discover that their costs related to support of the laundry room facility will exceed 10% of total expenditures, causing the association to fail the 90% expenditure test.
When filing Form 1120 for a Community Association, there are several significant issues that need to be carefully considered:
- Revenue Ruling 70-604 issues: The election under Revenue Ruling 70-604 must be approved by both the association’s members and the board of directors. Proper calculations of exempt function income and capital reserve expenditures are critical to determine any excess income carryover.
- IRC Section 118 issues: Associations should avoid commingling operating and capital funds, and reserve accounts for painting and other noncapital items should be kept separate from capital reserve accounts. The reserve study and budget must identify specific capital purposes and be in agreement with each other to qualify for IRC Section 118 treatment.
- Sufficient documentation is required on the tax Form 1120 to clearly delineate member and nonmember transactions, operating and capital transactions, and any carryovers from the prior year.
- Failure to properly account for capital transactions can lead to the IRS asserting an improper tax accounting method under IRC Section 481(a). This could result in substantial tax liabilities and penalties for the association.
Overall, preparing Form 1120 for a Community Association involves addressing these complex issues. Professional tax preparers need to ensure accurate documentation, adherence to IRS rulings and regulations, and proper accounting methods to minimize risks and potential audit challenges.
Failure to address these concerns can have significant financial implications for the association.
Our good friend Gary Porter of Porter & Lasiewicz CPAs, who is a leading voice in the Community Association accounting industry, gives a great example of the risks of the differences of filing Form 1120 and 1120-H. Assume exactly $4,000 as taxable income. (That makes this illustration easy to follow.)
The $4,000 taxable income at 21% results in a tax of $840. Assuming no problems, that’s all the tax liability. But if you apply risk factors, the answer changes dramatically. Risk Factor #1 – What if the Revenue Ruling 70-604 election is disallowed (for several possible different reasons, as discussed in a previous article – see below) and that (assumed) $10,000 of excess member income becomes taxable? The tax just increased by $2,100. Your tax savings not only just disappeared, but became multiples of the tax you would have paid on Form 1120-H. Risk Factor #2 – Worse yet, consider that the IRS audits this tax return and assesses tax on ALL your entire reserve balance because you didn’t exactly comply with the requirements to exclude reserves from taxable income. Assuming reserves of $100,000, which gets added back as additional excess member income, your taxes just increased another $20,000. You’re now so far behind the curve you can never catch up.
The $4,000 taxable income at 30% results in a tax of $1,170 because of the special $100 deduction allowed on Form 1120-H. Since excess member income is not taxed on Form 1120-H, you don’t have to worry about the Revenue Ruling 70-604 election, nor excess member income. It also doesn’t matter if you fail to exactly follow the rules on excluding reserves from taxable income on Form 1120-H, as reserves failing to meet the “capital contribution” test are reclassified as excess member income, which isn’t taxable on this Form.
Form 1120 initially saves $340 as compared to Form 1120-H, but exposes the Association to risks (in this example) of an additional $21,500 of taxes. That’s a lot of risk to assume for a very small tax savings. Are the members going to appreciate, or even notice, a $340 savings? Maybe, but not likely, and certainly not if the Association gets tagged by IRS for the additional tax. In that instance, the members will only accuse the Board and tax preparer of making a bad decision on the tax form to file, and hold them responsible for failing to take advantage of the safety offered by Form 1120-H.
In conclusion, there is a lot to consider when deciding which of these forms is best for your specific situation. We hope you find this information helpful. Should you have any questions or would like help with your filing, please reach out to us!
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