3 Tax Traps for Associations and Managers to Avoid

Community associations haven’t historically been in the cross-hairs for IRS auditors, but they can face unexpected tax bills. Here are three tax-related areas where associations sometimes slip up and suffer potentially costly consequences as a result.

1. Understanding that even nonprofit associations are taxable.

It’s not unusual for boards to believe that, because their association was formed as a nonprofit, they don’t even have to worry about taxes.

“All my clients think they’re nontaxable, like a church or a charity, but associations are taxable,” says Brad Sokol, managing director of the Miami, Fla., accounting firm Sokol & Sokol and a CPA who specializes in the condominium and homeowner association industry. “That’s the call I get the most — ‘Why are we paying taxes? We’re nonprofit!’

“That’s a state designation, though, and it holds no weight with the IRS. It has nothing to do with their taxation.”

Sokol says associations need to determine their nonexempt function income. “Exempt function income is dues, fees, assessments, fines for violations, and interest paid by members,” he says. “Those aren’t subject to tax.”

But nonexempt function income — basically, everything else — is taxable. “That would be interest from banks, payments for nonassessment items, and income from work performed outside the normal course of business,” Sokol says. It includes everything from vending and laundry income to money paid to use an association’s grounds for a photo shoot or film location.

Sokol says nonexempt function income is taxed at a flat rate of 30 percent for residential associations: “The income can be offset, though, with expenses related to that income.

“So, for example, although the income associated with laundry is subject to tax, you can net the related expenses against that income. If you have $5,000 in laundry income for a year and $4,000 in laundry-related expenses, $1,000 is taxable. You can estimate and allocate expenses like utilities, and you also can allocate indirect expenses like management fees and insurance as long as you do so on a reasonable basis.”

Most associations file IRS Form 1120-H, U.S. Income Tax Return for Homeowners Associations, which allows them to exclude exempt function income from their gross income. Associations with significant nonexempt function income might want to consider filing Form 1120, U.S. Corporate Income Tax Return, though.

“The corporate tax rates are lower than 30 percent, but there are loopholes to jump through,” Sokol says. “For example, the association must make an election each year to either apply the excess membership income remaining at the end of the year to the budget next year or refund it to members. Associations should consult their accountants.”

2. Properly classifying workers.

“The misclassification of employees as independent contractors happens all the time,” says Jamie Dokovna, a shareholder in the Florida law firm Becker & Poliakoff who practices employment law and works in the community association arena. “I see it with landscaping and maintenance, bookkeepers, really all kinds of staff.”

“Sometimes it’s because the board members just don’t know better; sometimes they do, but it’s just the cheaper route.” It may not prove cheaper in the end, though. If the IRS or state tax agency finds misclassification, an employer can end up on the hook for unpaid payroll taxes, employee benefits, fines, penalties, and interest.

And it’s not just associations that misclassify — management firms can make the same mistake.

“Employers will say ‘well, I don’t tell the person what to do,’” Dokovna says. “But you have to look at the totality of the circumstances. If the person is there five days a week, is economically dependent on you, doesn’t really have their own business, and you’re providing the tools — that’s probably an employee.”

She suggests associations and management firms conduct internal audits to determine whether they’ve misclassified workers. “If they have, they should fix it, and fix it fast. It’s so much better to stop the bleeding and move forward. Put measures in place to make sure it doesn’t happen again, such as bringing landscapers on as employees from day one.”

3. Paying sales taxes.

Finally, Sokol says, associations should be mindful of their sales tax obligations. This can be confusing because some states exempt associations from sales tax — but that exemption generally applies to purchases associations make, not sales tax on goods or services they sell.

“Sales tax is a big red alarm for some associations,” Sokol says. “Some parking fee income and rental income from things like storage lockers may be subject to state sales tax.”

Sokol advises associations with such income to talk to their CPAs. And, if an association receives any notice from a taxing authority, he says they should consult their CPA before replying.