IRC Section 501(c)(4) and Gated Associations
By: Gary A. Porter, CPA
In the Spring 1992 issue of ledger quarterly, tax attorney Beverly Verano, in an article entitled "Life after the Portland Golf Club Decision: An Analysis of Homeowner Associations as Social Welfare Organizations under IRC Section 501(c)(4)", gave us a comprehensive analysis of tax exempt associations. This article very effectively explored the pertinent authorities and rulings. Ms. Verano also indicated that she had been able to obtain 501(c)(4) status for a California association that restricted a portion of their common area facilities to members and guests only.
The purpose of this article is to further explore the possibilities of exempt status and provide additional examples of conditions which allow an association to qualify for exempt status.
There have been no significant new rulings since the above article was published, but below we again set forth the major authorities and restate their significant provisions.
Major authorities include:
• IRC Section 501(c)(4)
• IRS Regulations 1.501
• Revenue Ruling 69-280
• Revenue Ruling 72-102
• Revenue ruling 74-17
• Revenue Ruling 74-99
• Revenue Ruling 75-286
• Revenue Ruling 80-63
• Rancho Sante Fe Association v. U.S., 84-2 USTC 9536
• Flat Top Lake Association, Inc. v. U.S., 86-2 USTC 9756
Major provisions of the above are:
For 501(c)(4) organizations, a tax on unrelated business taxable income is imposed only to prevent tax exempt organizations from gaining an unfair advantage over competing organizations operating for profit. In such cases, unrelated business taxable income includes only income generated from the conduct of a trade or business and excludes taxation of investment income. Investment income (e.g., interest income on association reserves) is not included in the definition of unrelated business taxable income and is not subjected to income taxation.
Internal Revenue Code Section 501(c)(4) grants tax exempt status to organizations that are not organized for profit and are operated exclusively for the promotion of social welfare. The Regulations provide that an organization is deemed to operate 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 and is operated primarily for the purpose of bringing about civic betterments and social improvements".
Revenue Ruling 72-102 discussed a non-profit organization formed to preserve the appearance of a housing development and to maintain sidewalks, streets and common areas for use of its residents sought tax exempt status under Internal Revenue Code Section 501(c)(4). IRS distinguished a homeowners association that serves a community (constituting the promotion of social welfare) from a homeowners association formed primarily to maintain exterior walls and roofs of members' homes in a development (being for the benefit of individual members rather than the community as a whole). IRS also indicated that a neighborhood, precinct, subdivision or housing development could constitute a community and further, that an organization that administers and enforces restrictive covenants and owns and maintains properties of the type normally maintained by municipal governments is serving the "common good and general welfare of the people of the entire development" therefore, qualifying as a Section 501(c)(4) tax exempt organization.
Revenue Ruling 74-99 expanded on the criteria necessary for homeowners association to qualify for tax exempt status under Internal Revenue Code Section 501(c)(4), stating that the homeowners association must:
(1) serve a community which bears a reasonable relationship to an area ordinarily defined as governmental;
(2) not conduct activities directed to exterior maintenance of private residences; and
(3) use the common areas and facilities for the general public.
Revenue Ruling 80-63 indicated that the term "community" does not encompass a minimum number of homeowners or a minimum geographic area. Revenue Ruling 80-63 also stated that a homeowners association that serves an area that is not a community will not qualify for exemption under Section 501(c)(4) if it restricts the use of its recreational facilities to only members of the association. IRS stated that it was not possible to formulate a precise definition of the term "community", but that the finding of a community must be based upon the facts and circumstances of each case.
In Rancho Santa Fe Association v. U.S., the issues decided by the court were whether an association served a community and if so, whether the restricted access to only members and their guests of certain of its facilities would deny the association Internal Revenue Code Section 501(c)(4) tax exempt status. The court found that the development was significant in size and self contained in its orientation so as to comprise an independent community. The court went on to find that if the development and the community are one and the same, then the benefits provided by the homeowners association automatically benefit the general public within the requirements of Internal Revenue Code Section 501(c)(4). As such, it is not necessary for a homeowners association to open its facilities to the "world at large" in order to meet the requirements of Internal Revenue Code Section 501(c)(4).
The above language certainly leaves the door open for a gated association to qualify as a community. However, IRS' presumption is that if an association has erected a security gate, it has automatically excluded the public, or "community", and therefore will not qualify for exemption. You start off waging an uphill battle, but you can still win on the issues.
Example of gated association that qualified for exemption
Our firm was recently engaged to perform the audit of an association that had been in existence for twenty-two years. As we began the audit and reviewed the prior years tax returns, we noted that the association, which was formed in 1969, had been granted exempt status under 501(c)(4) and enjoyed such status until it was revoked by IRS in February 1979. It was revoked because IRS had sent out a standard questionnaire form to which the association had responded that they had erected a security guard gate somewhere in the time period between 1969 and 1979. Based upon that information, IRS concluded that "public access" to association common areas had been denied and therefore revoked the exempt status of the association retroactive to 1977. While the association and its CPA had protested the revocation in 1979 as vigorously as they could, they were not successful, primarily because they were not in possession of all pertinent law and cases in this regard.
We disagreed with IRS' position simply because of the other pertinent facts of the association of which we were already aware as the new auditors. Based on our recommendation to the association we were engaged to prepare a new application for exemption under 501(c)(4). The key factors that were overlooked in the original revocation issue were that:
(1) The association, comprising approximately 3,000 acres and over 800 residential lots as well as certain commercial areas, was located in a very remote area. The two principle common areas of the association consisted of roads, equestrian trails and center. The equestrian center rented out stall space to anyone who wanted to rent such space, whether such individual was a member of the association or not. Therefore the general public did in fact have access to the two principle association common areas, consisting of the roads and the equestrian trails. We felt that there was, in fact, public access;
(2) We thought that due to the size and nature of operations that the "public access" definition that IRS relied on in the revocation in 1979 was incorrect. We thought that the public, as defined in Revenue Ruling 72-99, existed behind the guard gate and did not have to include "the world at large". Therefore public access existed at all times in the association.
(3) Another aspect of Revenue Ruling 74-99 further supports the exempt status. The association also covered a geographical area that was virtually identical to the geographical area covered by a community services district, a California governmental subdivision that is a special district and has powers and authorities very similar to those of a City. Per Revenue Ruling 74-99, whenever "a geographical unit bears a reasonably recognizable relationship to an area ordinarily identified as a governmental subdivision or unit or district thereof", then that association may also qualify for exemption under 501(c)(4).
We believe that we could have prevailed based on any one of the above factors, but of course utilized all three arguments in presenting the case for exemption. IRS agreed with these factors and in 1992 reinstated exempt status to the association retroactive to 1979, the date of the original revocation. The association obtained approximately $ 163,000 in refunds and will further save approximately $ 25,000 per year in federal and state tax.
Look closely at all factors and don't assume that just because you have a gated community that you will not qualify for exemption. Even where there is limited or no public access, an association may, in the appropriate circumstances, still qualify for exempt status under IRC Section 501(c)(4).
Gary Porter, CPA began his accounting career with the national CPA firm Touche Ross in 1971. He is licensed by the California Board of Accountancy and the Nevada Board of Accountancy. Mr. Porter has restricted his practice to work only with Common Interest Realty Associations (CIRAs), including homeowners associations, condominium associations, property owners associations, timeshare associations, fractional associations, condo-hotels, commercial associations, and other associations.
Gary Porter is the creator and coauthor of Practitioners Publishing Company (PPC) Guide to Homeowners Associations and other Common Interest Realty Associations, and Homeowners Association Tax Library. Mr. Porter served as Editor of CAI’s Ledger Quarterly from 1989 through 2004 and is the author of more than 300 articles. In addition, he has had articles published in The Ledger Quarterly, The Practical Accountant, Common Ground and numerous CAI Chapter newsletters. He has been quoted or published in The Wall Street Journal, Money Magazine, Kiplinger’s Personal Finance, and many major newspapers.
Mr. Porter is a member of Community Associations Institute (CAI), and served as national president of CAI in 1998 – 1999.