Federal Taxation of Community Associations
Community Associations Institute (CAI) supports rational and consistent classification of community associations under the IRS Code, including condominiums, cooperatives, and homeowners associations. CAI supports the premise that interest income earned on reserve accounts be recognized and treated as a patronage activity and not be subject to taxation.
Specifically, CAI supports these initiatives:
- Technical correction to Internal Revenue Code (IRC) Section 528 - Form 1120-H
CAI supports two minor technical corrections to IRC Section 528 that would provide full ownership associations with the same benefits presently provided to timeshare associations only. This would result in virtually all full ownership associations being able to qualify to file Form 1120-H and enjoy the protections built into IRC Section 528.
- Proper application of Subchapter T (IRC Sections 1381 – 1388) – Form 1120-C
CAI supports the application of Subchapter T for all associations—not just those designated as cooperatives. This would provide associations with the benefits of Subchapter T; the primary benefit being that interest income on reserves is considered patronage income1 and is not subject to taxation.
- Proper application by IRS of IRC Section 501(c)(4) – Form 990
CAI supports the promotion of reasonable, fair, and consistent application of tax law for associations attempting to gain tax exemption, and exempt associations involved in tax audits or tax litigation challenging exempt status. Associations filing Form 990 enjoy the benefit that interest income on reserves is not considered taxable income, and that there are virtually no tax risks associated with Form 990.
BACKGROUND
While Congress had previously passed amendments to the Tax Code that benefits timeshares, it has failed to amend the tax code to provide equivalent assistance to associations other than timeshares. Full ownership associations are, by far, a larger group as compared to timeshares. The recommended CAI position is to support two minor technical corrections to IRC Section 528 that would provide full ownership associations with the same benefits presently provided to timeshare associations only.
In 2007, Congress modified IRC Section 216 for Cooperative Housing Corporations, allowing virtually all housing cooperatives to qualify under that section. This has resulted in an approximately 90 percent reduction in the number of private letters' rulings requested on behalf of cooperatives, since cooperatives have not had to seek qualification from the IRS.
Proper application of Subchapter T (IRC Sections 1381 – 1388)
The many citations below, when considered together, support the position that homeowners associations may be subject to Subchapter T as cooperatives, and establishes that interest income from reserves is considered a patronage activity and not subject to taxation.
Subchapter T was added to the Internal Revenue Code in 1962 to recognize a special type of entity; not a for-profit organization, not an exempt nonprofit organization, but something in between; an organization formed primarily by a group of individuals or companies known as patrons to conduct business amongst themselves without profit motive. The organizations were given the label of “cooperative organizations.”
IRC Section 61 states “gross income means all income from whatever source derived” unless specifically exempted by another section of the Code. Congress recognized that no such exemption existed for cooperatives, so enacted Subchapter T that provided for organizations operating on a cooperative basis. Subchapter T exempted the “patronage” income from taxation and taxed only net “non-patronage” income.
Several tax court cases and revenue rulings have provided insight into the intent and application of Subchapter T of the Internal Revenue Code. These cases, all occurring after introduction of IRC Sections 277 and 528, clarify that associations may avail themselves of the benefits of Subchapter T.
Tax Court case Concord Consumers Housing Cooperative vs. Commissioner held that “The application of Subchapter T is not elective on the part of [Taxpayer} . . .” and “If this petitioner [taxpayer] was being operated on a cooperative basis, within the meaning of section 1381(a) (2), then the provisions of Subchapter T attach, and petitioner’s liability is to be determined under those provisions as a matter of law.” Thwaites Terrace House Owners Corporation v. Commissioner and Trump Village Section 3, Inc. v. Commissioner both concurred with this result. The courts stated that Subchapter T both precedes and preempts the more general Section 277. IRS acquiesced with Action on Decision 1995-011.
Puget Sound Plywood, Inc. v. Commissioner established the three elements of operating on a cooperative basis to be (1) subordination of capital, (2) democratic control, and (3) sharing in fruits and excesses of their cooperative endeavor. Most community associations, notwithstanding the type of association, meet these three criteria.
Cotter and Company and Subsidiaries, Appellant v. the United States, Appellee, established that any integrally intertwined activities are considered patronage activities. Thwaites Terrace, Trump Village Section 3 established that maintaining reserve accounts is an integrally intertwined activity and that related interest income is considered patronage income.
Revenue Ruling 75-371 stated that “However, a condominium management corporation may operate in such a manner as to qualify for the benefits of Subchapter T (sections 1381 through 1388) of the Code, thereby permitting the corporation to accumulate funds for reasonable business needs.”
Because so few associations presently take advantage of this position, the recommended CAI position is to educate CAI members about this tax position, which is rarely used, to promote its use. The two primary benefits to associations are elimination of tax on reserves’ interest income and a significant decrease in tax exposures that exist on Form 1120.
Proper application by IRS of IRC Section 501(c) (4)
IRS has relatively consistently adopted positions contrary to law applicable to this narrow section of tax law in the course of tax audits and the exemption application process. IRS written training materials and in-house training courses exhibit a bias against homeowners associations attempting to qualify under this Section by addressing only one of the three methods in which an association may qualify for exemption.
Treasury Regulations establish that the association must “serve a community”2 (a term that is not defined in the Code or subsequent rulings) in order to qualify as a social welfare organization under IRC Section 501(c) (4). The IRS has a single interpretation of this, which is that the association must grant unrestricted access to the public to all association owned and maintained amenities. This is the only position presented in IRS training material and training programs. That position, unfortunately, ignores other factors established in court cases and various revenue rulings where an association MAY restrict access:
- The association itself may constitute a “community.”
- The association may occupy a geographic area generally recognized as a governmental entity.
Because IRS recognizes only the unrestricted access test above in its written internal training material, IRS agents routinely inform associations that they may not qualify if they restrict access of the general public to any association facilities. IRS training materials attempt to establish a “bright line” test where none exists. This biased training material is not in accordance with law or the IRS’s own revenue rulings and has resulted in significantly raising the cost to associations of attempting to gain exempt status by forcing many of them into an expensive appeals process.
Adopted by the Board of Trustees, October 26, 1986
Amended by the Public Policy Committee, October 6, 1993
Adopted by the Board of Trustees, October 9, 1993
Amended by the Public Policy Committee, May 8, 1996
Adopted by the Board of Trustees, May 11, 1996
Amended and approved by the Government and Public Affairs Committee, July 9, 2013
Adopted by the Board of Trustees, August 15, 2013
1 Note: Definition of 'Patronage Dividend' – A dividend or distribution that a cooperative pays to its members or investors. Patronage dividends are given based on a proportion of profit made by the business. Once this amount is figured out the dividend is calculated according to how much each member has used the co-op's services. Tax rules view these profits essentially as an overcharge, which can be returned to patrons and deducted from the co-op's taxable income.
2 Note: Treasury Regulation 1.501© (4) - 1 – Describes “Social Welfare” Organizations. Appendix 5k. Describing social welfare organizations as (I) in general. An organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community.