Question – What does the IRS consider when it grants tax exempt status under IRC Section 501(c)(4)?
Answer - The IRS does not grant exempt status, it simply formally recognizes exempt status based upon the application submitted and any further inquiry or investigation conducted by IRS. Exempt status is NOT granted by the Internal Revenue Code (IRC) but directly from tax law enacted by congress. The basic requirements are set forth in IRC Section 501(c)(4), but are further clarified by Treasury Regulations and numerous Revenue Rulings, Court Cases, Private Letter Rulings, and Revenue Procedures. Several of the most important citations are included on this website. Without a comprehensive understanding of all of these documents and how they interact it is not possible for one to speak knowledgeably about this tax exempt status.
Unfortunately, this lack of knowledge even extends to IRS agents. The IRS training material on this code section contains only a very small section related to homeowners associations, and that section is woefully incomplete in that it addresses only the issue of "public access" which is only one of three basic methods in which an association may qualify for exempt status. Consequently, if you ask any IRS agent what it takes for an association to qualify, they will respond that you must have complete public access. That response is wrong and reflects their lack of knowledge.
Question – Can an Association "self-declare" our tax exempt status?
Answer - Yes. IRS Publication 557 "Tax Exempt Status for Your Organization" (January 2017 Edition) specifically states that an associaiton may self-declare exept status. That simply reflects that fact that IRS does not "grant" exempt status, IRS can only recognize the association's exempt status. While many uninformed people seem to be unable to accept the concept of self-declaration, consider that with out specifically calling it self-declaration, IRS has long (for many decades) allowed organizations to treat themselves as tax exempt by filing Form 990 as an exempt organization while it has a pending application.
Question – How long does it take for IRS to recognize our tax exempt status?
Answer - There is no absolute answer to this question. We have processed more than 100 applications, and had one approved within 60 days (shortest time period) while another took more than two years (longest time period). In 2018 IRS typically sends an acknowledgement letter shortly after receiving the application stating that they will take approximately 100 to 120 days to respond, depending on their review o f the complexity of the application. Normal processing time is between three and six months.
Question – I had always thought that Form 1024 is the proper application form for recognition under IRC Section 501(c)(4). I understand that Form 1023 is for charitable organizations seekeing exempt status under IRC Section 501(c)(3). Now I am informed that Form 1024-A is the form to be used for the application. What is correct?
Answer - IRS introduced Form 1024-A in January 2018, although it wasn't actually available until February 2018. If filing for recognition of exempt status under IRC Section 501(c)(4), Form 1024-A is required. If filing for recognition under IRC Section 501(c)(6) [trade organization] or 501 (c)(7) [recreational organization] then Form 1024 is still the correct form. IRS created Form 1024-A because there are more applications under IRC Section 501(c)(4) than under the other sections, so it created a specialized form, allowing a reduction in size from 19 pages to 4 pages. Unfortunately, Form 1024-A is designed for the vast majority of OTHER types of organizations that apply under 501(c)(4), not for homeowners associations. Consequently, Form 1024-A is inadequate for associations as it simply does not ask the appropriate questions nor request the appropriate documents.
Accordingly, our firm responds by attaching significant explanations and attaching a number of documents to the application that are not included in the application designed by IRS. We know from experience that this information IS required in order for IRS to perform a competent evaluation, so we provide it in advance of it being requested. This speeds up the application processing time.
Question – If association governing documents that state common areas are for use of association members and guests only, can that association still qualify for tax exempt status? If recognized for exempt status by IRS, can the IRS require that the governing documents be amended?
Answer - While the IRS will consider the governing documents as part of its evaluation process, it is the operations of the association that will determine whether or not the association qualifies for exempt status. Example, if governing documents do restrict access to certain amenities to members and guests only, but in fact members of the community that are not members of the association also have access, and access is considered a key issue in qualifying for exemption,our experience is that IRS will recognize exempt status.
If IRS has already recognized exempt status based on its evaluation of operations, it cannot require that the governing documents be amended to reflect actual operations. As stated above, IRS can only say yes or no, they cannot require changes. IRS CAN, however, before it recognizes exempt status, take the position that unless a specific change is made, it will not recognize exempt status - that is part of the yes or no process. IRS cannot take that position AFTER it has recognized exempt status. In our experience, with more than 100 exemption applications approved, we have only encountered a single instance where IRS has requested a change prior to recognizing exempt status.
Question – I read on the IRS website and have been told that a condominium association cannot qualify for our tax exempt status under IRC Section 501(c)(4). Is that true?
Answer - In general, yes, because most condominiums provide exterior maintenance of buildings, which is deemed to be a private benefit for the members, and therefore a prohibited activity. However, there are always exceptions. Example, a mobile home community legally formed as a condominium project does not provide exterior maintenance of units, therefore does not conduct a prohibited activity, so could qualify. Another example would be a condominium association where the exterior maintenance constitutes a de minimis activity when compared to the total activities of the association, so could qualify. IRS has already ruled that de minimis private benefit activity is not fatal to recognition of exempt status.
Question – Can the IRS force the association to open its amenities to the public if the association is exempt?
Answer - NO! The IRS can effectively only say yes or no for recognition of exempt status. The IRS has absolutely NO authority to force the association to do anything from an operational perspective. The application for recognition of exempt status discloses operations as they presently exist, meaning with whatever access or restrictions in place at the association.
Question – Does the IRS ever revoke exempt status?
Answer - Yes, regularly. We track all revocations annually. 501(c)(4) revocations are relatively rare, but 501(c)(7) occur mre frequently, but still revocations overall still represent a small number. On average, we see no more than 20 revocations annually, but also note ruling issued denying exempt status to another 15 to 20 organizations annually. Most revocations are for organizations that were recognized more than twenty years ago. It appears that the IRS evaluation procedure was a little more lax in those days, or that the organizations having status revoked had changes in operations that later disqualified them. For 501(c)(4) organizations, the primary reason for revocation is that the organization is not providing benefit to a community (but it need not provide benefit to the general public or world-at-large). For 501(c(7) organizations we see three common reasons; (1) failure to meet the 85% of revenue test [see below], (2) failure to maintain financial records adequate to distinguish member versus nonmember revenues, and (3) failure to conduct any social activities.
Question – Is there any limitation on the amount of unrelated business income that our Association can have without affecting our tax exempt status?
Answer - IRS Publication 557 - Exempt Organizations, establishes an 85% of gross income requirement for 501(c)(7) organizations. This requirement is that the exempt organization must ". . . receive 85% or more of their gross income from their members for the sole purpose of meeting losses and expenses." This 85% rule does not apply to 501(c)(4) social welfare organizations.
Question – What exactly IS unrelated business income for a homeowners association qualifying as tax exempt under IRC Section 501(c)(4)?
Answer - Internal Revenue Code Section 512(a)(1) states ". . . unrelated business taxable income means the gross income from any unrelated trade or business regularly carried on by it [the exempt organization], less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business. . ."
Question – What is considered exempt income for a homeowners association qualifying as tax exempt under IRC Section 501(c)(4)?
Answer - Exempt income is defined to mean gross income from dues, fees, charges, or similar amounts paid by members of the organization for providing the members and guests with goods, services, and facilities in connection with the purposes constituting the basis for the tax exemption of the [social] club.
This is construed to mean that any amounts received directly from nonmembers constitute unrelated business taxable income, even if that person is a guest. If a member pays directly for the guest, then it is considered to be exempt income per the explanations above.
Question – Are there any special record keeping requirements for a homeowners association qualifying as tax exempt under IRC Section 501(c)(4)?
Answer – Yes. An exempt organization must establish an accounting system capable of tracking source of income and source of payment of that income. The system should also be able to identify those expenses directly connected to the production of income by source. Unfortunately, my experience is that, because they have had no prior requirement to do so, most new exempt organizations have not yet established accounting systems that can adequately track source of payment of fees well enough to actually know who paid it, unless the organization has a strict rule against non member payments. Consequently, the normal (and safe) approach is to consider all nonmember revenue to be unrelated business taxable income for tax purposes.
Question – How significant are the taxes on unrelated business activities?
Answer – The tax rates are the same as those that apply to regular corporations on Form 1120. However, an exempt association files Form 990-T to report its unrelated business taxable income.
Most associations, simply by the nature of their operations, will not pay any significant income tax. This is because there is usually no net taxable income resulting from the unrelated business activities after allocation of expenses.
A notable exception to this rule for many associations is newsletter advertising revenues, which normally will result in net taxable income. While most associations do not achieve a net income form the newsletter activity on an overall basis, they will end up with a net taxable income because of the special expense allocation rules applied by the IRS. As an example, an association has $100,000 of newsletter expenses, but only $80,000 of advertising revenue. But when the content of the newsletter is examined, it is determined that 25% of the pages are devoted to advertising, and 75% are devoted to community news. Applying the IRS formula, allowable deductions against the $80,000 of advertising revenue are calculated as $100,000 X 25%, or $25,000. Therefore, taxable income from this activity is $55,000 ($80,000 - $25,000).
Please contact Gary Porter for your association tax exemption services. We serve associations nationwide.
Background information on Gary Porter, CPA
Gary Porter, CPA is licensed by the California, Nevada, and Oregon Boards of Accountancy. His CPA practice is limited to Common Interest Realty Associations, including homeowners associations, condominium associations, timeshare associations, fractional ownership associations, and condo hotel associations. Mr. Porter is the co-author of the PPC (Practitioners Publishing Company) Guide to Homeowners Associations and Other Common Interest Realty Associations, and Homeowners Association Tax Library. He is also the author of more than 300 published articles on financial matters related to homeowners associations. He has been working with homeowners associations since 1976.