April 19, 2024

Top Lawyer

Think Phenomenal Law

How Do You Explain Revenue Ruling 70-604 To Your Homeowners’ Association Members?

I receive more questions on Revenue Ruling 70-604 than on all other tax issues combined. One of the questions that continually arises is, “How do we inform and educate our members that they can vote on this important ruling?”

I recommend putting some descriptive wording on the ballot so that the members have a basic understanding of the Revenue Ruling. An example of such wording follows.

Revenue Ruling 70-604 is a tax ruling only. The purpose of this ruling is to allow a homeowners’ association to avoid taxation on any excess member income (as defined in the Internal Revenue Code) that may inadvertently arise in a given tax year. The ruling states that the members of the Association meet to make the election. The ruling applies to any excess member income. The ruling allows two options only; refund the excess member income to the members or apply the excess to the following year’s assessments.

The Board of Directors has determined that it is impractical to attempt to refund the excess member income because of the administrative issues involved and the fact that the excess member income may be needed as working capital to pay for continuing Association operating expenses. Therefore the Board of Directors requests that you approve an election under Revenue Ruling 70-604 to apply any excess member income to the following year’s assessments. This does not mean that the assessments for next year will be reduced, as the budget has already been prepared and approved. Since expenses typically rise year-to-year, it is probable that any excess member income will be absorbed by an increase in expenditures.

Your failure to approve this election may mean that the Association will be subject to additional federal income taxes for the current year, which will cause a rise in assessments for all members.

My advice to the Association and the governing board is that the ballot be drafted with only a single option, which is to apply the excess member income for the following year’s assessments, and that a yes or no vote be what is presented to the members.

The wording above explains why the Board of Directors is presented only a single option. To be silent on this issue and explain both options would force members to make a decision which could result in a majority of members voting to refund any excess member income. This creates a difficult situation for the board, as that excess in income may represent working capital that is necessary to operate on a continuing basis. Without adequate working capital, the board would be forced to either borrow funds on an expensive short-term basis or to make a special assessment of members for working capital.

For the hundreds of associations with whom I have discussed this issue in the past, you will probably recall that I have stated that, in my opinion, on which I have received verbal concurrence from the national office of IRS, Revenue Ruling 70-604 as drafted, requiring approval of the members, is generally in conflict with the governing documents of most associations and with state law. To the best of my knowledge, statutes in all states vest the authority to make financial decisions regarding the disbursement of Association funds in the hands of the elected board of directors. The general membership normally does not have authority to make such a determination. Therefore state law is generally in conflict with Revenue Ruling 70-604.

So how do you resolve this apparent conflict? In my opinion it is relatively simple, although it requires little work. First of all, go ahead and have the membership approve the election at the annual meeting, or in any other meeting or format in which a valid membership vote occurs. Second, have the Board of Directors meet and ratify the election approved by the membership. By handling the Revenue Ruling 70-604 approval process in this manner, you first, meet the requirements of the IRS and second, meet the requirements of state law.

Can you skip the member approval and simply have the Board of Directors make the election? In my opinion, yes you can. However, to do so is to invite a challenge by the IRS. And that is a battle that you don’t need to fight. It is so simple to get the member approval to make the election that it is best to simply get member approval and avoid a potential fight with the IRS.