Is Revenue Ruling 70-604 Still Alive?
By: Gary A. Porter, CPA
Originally published January 1993 in CAI's The Ledger Quarterly
IRS Revenue Ruling 70-604 continues to cause enormous problems for associations and CPA practitioners throughout the United States. This is due to the very ambiguous wording in the ruling itself. Without a very careful reading, the ruling could be interpreted in a very liberal manner, and unfortunately, this appears to be the manner in which too many tax preparers have interpreted it. Gary Porter’s article “Revenue Ruling 70-604 – The Complete Guide” was the first comprehensive article written on the subject, but many readers felt that the conclusions reached were too restrictive. The passage of time, and a conversation with the new Special Industry Group Liaison at IRS, have shown us that the article was "right on".
New developments at IRS now show us that IRS is in fact taking an even more restrictive view of Rev. Rul. 70-604 than any of us ever thought possible. What is the net result of this? We can expect that IRS will continue on its attack on associations that use Revenue Ruling 70-604, and will disallow the "rollover" treatment that the ruling provides. Does this mean that Revenue Ruling 70-604 is dead? NO! However, it does mean that it should be used as little as possible, and with extreme caution in the future. It is certainly not the universal cure-all that many CPA practitioners have previously believed.
The disallowances by IRS noted above are not because Revenue Ruling 70-604 is no longer a viable alternative, but rather because associations and tax practitioners have abused the ruling. They have failed to adhere to the language of the ruling, failed in their documentation of the rollover, and failed to consider the subsequent year "recovery" of the amounts rolled over. Taken together, these failures mean that, effectively, no election under Revenue Ruling 70-604 was ever made. Another major failure is the failure to consider the provisions of Revenue Rulings 75-370 and 75-371 in determining net membership income. Again, many associations are discovering during the IRS audit that they had a net membership income they didn't know existed. Let's look again at what makes a proper election under Revenue Ruling 70-604:
* Election made by the members, not the board of directors
* Election documented in writing
* Election made prior to the filing of the tax return
* Consideration in the subsequent year of the amount "rolled over"
* "Absorption" of the rollover in the subsequent year.
Omission of any of these factors destroys your election. Having the association approve the election at their annual meeting before year end (or after year end but before the tax return is filed) and documenting this either in the annual meeting minutes, or preferably as a separate resolution, will meet the requirement of the first three points above. The CPA must also document the actual amount of the rollover in schedule M-1 of the tax return. Failure to do so means that no one can replicate the calculations and confirm the fact that a rollover really occurred. The final, and most crucial consideration in the eyes of IRS, is that the amount rolled over must be "absorbed" in the subsequent year. IRS does not interpret 70-604 to be a perpetual rollover scheme. Indeed, the language of the ruling is "...have the excess applied to the following year's assessments." Note that year's is singular, not plural.
This means that if an association rolls over $ 50,000 from year 2001 to 2002, the association must generate a $ 50,000 membership loss in 2002, or it will be taxed on any excess carryover from 2001. This is not how most people are interpreting 70-604. It is however, how IRS is interpreting it. Unfortunately, the people within IRS who are making this interpretation are the same people that will (1) write any future Revenue Rulings for this industry, (2) write any Private Letter Rulings for this industry, or (3) be relied upon as the industry technical experts for IRS in any Tax Court petitions. This means we really have no choice but to accept this interpretation.
The new IRS Liaison for this Special Industry Group has made a further interpretation of 70-604 that also adds a new twist. It is not too hard to understand if you relate it to the rollover provisions of IRC sections 1031 or 1034. IRS theory is that if the above example association elected to rollover $50,000 from 2001 to 2002 and fails to absorb the $50,000 in 2002, then any unabsorbed portion will be taxed in 2001, not 2002. This will require an amended return to be filed for 2001. How can this be? The theory is that since the association failed to absorb the carryover in 2002, the election to carryover is invalidated. This is similar to the treatment under IRC Sections 1031 or 1034. You don't automatically avoid taxation only by completing the first part of the transaction, you also have to complete the second part of the transaction. If you don't complete the second part of the transaction, it is as if the "rollover" or "election" was never made, hence the need to amend the initial year's tax return.
Too many tax preparers are now discovering that they failed to comply with the technical requirements of Revenue Ruling 70-604 and are now having their association clients audited by IRS. They are discovering that while they thought they were safe, the associations are being subjected to taxation on their net membership income. In many cases, the resulting tax is far greater than if a form 1120-H had been filed to begin with. The only way out for the tax preparer in such a case is to plead ignorance, and attempt to utilize the provisions of Revenue Ruling 83-74 to amend the returns to an 1120-H.
So is there any way to avoid the above situation? YES! There are several planning techniques that can be used to avoid the situations described above:
• File 1120-H and avoid the entire issue of excess net membership income, although for most associations you will pay double the tax by doing so, but with less risk.
• If an association appears to have a large excess net membership income, allocate the excess to capital reserves before year end under the provisions of IRS Section 118, thus avoiding Rev. Rul. 70-604 altogether.
• If an association has a large carryover from year one to year two, have the association modify its budget for year two to purposely create a membership loss. This will assure that the carryover is fully absorbed in year two. You don't have to have the association modify its assessment structure to do this; simply allocate more money into the "capital" components of its replacement (reserve) fund.
• See if the association can qualify for exemption under 501(c)(4) to avoid taxation of its net membership income.
Other tax planning techniques exist which are not discussed here, as we intended to focus on the major planning areas only.
I have set forth the concept above that the practitioner and the association should consider exemption under 501(c)(4), which applies to social welfare organizations. Most associations will not qualify for exemption under this section. Many associations felt that there was no need for them to consider tax exempt status, as they could exist as a non-exempt membership organizations subject to IRC Section 277 and Revenue Ruling 70-604 would protect them from taxation on their net membership income. Now that we are discovering that this is not true, 501(c)(4) should be reconsidered by many associations.
What is the advantage of Code Section 501(c)(4)? Two things; first, interest income is not subject to taxation, and second, net membership income avoids taxation. The association would still be subject to the same tax on any unrelated business income less any related deductions. However, it may continue to operate with net operating profits from membership activities forever and still not be subject to any tax on that net income.
As always, the above points out the need for proper long-term tax planning by a qualified professional.
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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 200 articles. In addition, he has had articles published in 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), American Resort Development Associations (ARDA), and California Association of Community Managers (CACM). Mr. Porter served as national president of CAI in 1998 – 1999.