IRS Revenue Ruling 70-604 and MCL 450.2541(2)(b): The Value of Expert Advice
Many individuals and corporations, including community associations, are currently preparing their tax returns. For associations with excess revenue this process most likely involves a determination of whether to exercise an election under IRS Revenue Ruling 70-604. A proper election under Revenue Ruling 70-604 can be used to reduce an association’s taxable income by deducting from taxable income any excess assessments refunded to members or carried over to the next year’s assessments. In making such an election, however, an association should be careful to rely upon advice given by professionals both in deciding whether to take the election and the manner in which the decision is made. A failure to do so could lead to potential liability for the association and its directors.
The operative portion of Revenue Ruling 70-604 states:
Excess amounts by a condominium management corporation, over and above the amounts used for the operation of condominium property, that are returned to the stock-holder owners or applied to the following year’s assessments are not taxable income to the corporation.
Revenue Ruling 70-604.
At first glance Revenue Ruling 70-604 seems relatively straightforward. If a community association collects member assessments which exceed the cost to operate the condominium for that year, it appears that Revenue Ruling 70-604 would allow that association to either: (1) return the excess assessments to its members; or (2) apply the excess assessments to the following year’s assessments to avoid treating the excess assessments as taxable income to the corporation.
Unfortunately, however, the devil is in the details and what at first appears relatively clear quickly becomes murky upon further analysis.
First, the Ruling expressly applies to a “condominium management corporation.” Even if you assume that a “condominium management corporation” is equivalent to a condominium association under Michigan law, the Ruling by its terms does not appear to benefit community associations that are not condominiums, such as homeowner associations and summer resort associations.
Second, in addition to the operative statement set forth above, Revenue Ruling 70-604 also contains several statements which appear to set forth assumptions on which the Ruling is based, further restricting application of the Ruling. These assumptions state as follows:
A condominium management corporation assesses its stockholder-owners for the purposes of managing, operating, maintaining, and replacing the common elements of the condominium property. This is the sole activity of the corporation and its by-laws do not authorize it to engage in any other activity.
A meeting is held each year by the stockholder-owners of the corporation, at which they decide what is to be done with any excess assessments not actually used for the purposes described above, i.e., they decide either to return the excess to themselves or to have the excess applied against the following year’s assessments.
Held, the excess assessments for the taxable year over and above the actual expenses paid or incurred for the purposes described above are not taxable income to the corporation, since such excess, in effect, has been returned to the stockholder-owners.
Revenue Ruling 70-604.
The Ruling appears to assume that the sole purpose of the corporation benefitting from the Ruling is “managing, operating, maintaining, and replacing the common elements of the condominium property . . .” and no other purpose. If the corporation engages in other activities, such as bylaw enforcement, the corporation’s purpose appears to exceed the allowed purpose contemplated by the Ruling. For example, the Ruling specifically states that the corporation’s bylaws “do not authorize it to engage in any other activity.” Since the Ruling was published in 1970, it is possible that the terminology and assumptions used in the Ruling are outdated and do not track the terminology used in more modern statutes. However, in the absence of a formal position on the issue, the language used in the Ruling is expected to have meaning, even though the Ruling does not indicate whether it applies (or not) to an association which engages in activities other than managing, operating, maintaining, and replacing common elements.
In addition, the Ruling also appears to require that a meeting be held each year at which the “stockholder-owners” decide what to do with any excess assessments. In Michigan, however, financial decisions such as budgeting and assessments are usually made by the board of directors, with the directors being elected by the members. The Ruling’s reference to “stockholder-owners” suggests that the Ruling requires that an election under Ruling 70-604 be made by the corporation’s members, not the board of directors. Even in situations where such an election is being made by a vote of the members, the corporation needs to schedule the vote sufficiently in advance of the preparation of its tax returns so that the tax returns can accurately reflect the vote outcome.
Finally, the last paragraph of the Ruling suggests that its rationale could potentially be applied to other types of activity, so long as the excess income was “returned” in some way to the members. The last sentence explains that the excess amount is not to be taxable to the corporation “since such excess, in effect, has been returned to the stockholder-owners.” Reading this sentence in isolation could lead to the conclusion that application of excess assessments to something other than a refund or the next year’s assessments satisfies the spirit and intent of the Ruling and could, therefore, be allowed. For example, rather than apply excess assessments against the next year’s assessments, a corporation may attempt to apply excess assessments against a capital reserve fund contribution. However, Field Service Announcement 1992-0208-1 states that excess income may not be transferred to reserves as an option of an election under Ruling 70-604 and that the only two options are a refund to stockholder-owners or to carry the excess to the following year.
The issues described above primarily deal with the terminology of the Ruling. There are additional issues that an association should be aware of in considering an election under Ruling 70-604, including tax decisions and opinions which could affect the availability of the election. For example, General Counsel Memorandum 34613 states that the Ruling was intended as a one-year only election and was not to be used indefinitely.
Against this backdrop, a board of directors may find itself in a difficult position. Under the Michigan Nonprofit Corporation Act, a director must discharge his or her duties “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” MCL 450.2541(1)(b). A director that makes an improper election (or makes the election improperly) risks breaching duties owed to the corporation. At least one district court has ruled in favor of the IRS and against an association that made an improper election under Ruling 70-604. See Mission Heights Homeowner’s Association, Inc v United States of America, 1996 US Dist LEXIS 20069; 96-2 US Tax Cas (CCH) P50,489 (SD Cal Aug 28, 1996). However, a director who fails to take advantage of Ruling 70-604 to minimize an association’s tax liability could also be targeted by association members.
The solution for a board of directors is to rely on the competent advice of third parties experienced in the area since Michigan law allows a director to rely on advice provided by experts in the relevant field. Specifically, in discharging his or her duties, a director is “entitled to rely on information, opinions, reports or statements . . . if prepared or presented by . . . [l]egal counsel, public accountants, engineers or other persons as to matters the director . . . reasonably believes are within the person’s professional or expert competence.” MCL 450.2541(2)(b).
Accordingly, a director whose community association solicits and relies upon the advice of a professional accountant in the preparation and submission of its tax returns, including as it relates to an election under Ruling 70-604 should be able to defend against any subsequent claim against that director that the election was improper, that the election was conducted improperly, or that an election was not made that should have been made while at the same time ensuring as much as possible that the election made by the association is the proper election. While this may not excuse an association that relies on bad advice, it should excuse the director from personal liability.
Matthew W. Heron is a Member of Hirzel Law, PLC where he focuses his practice on dispute avoidance, condominium law, commercial litigation, commercial real estate, land use, large contractual disputes and title litigation. He has extensive litigation and trial experience in state and federal courts involving commercial litigation issues and real estate matters. Mr. Heron concentrates his practice on drafting, revising, amending, restating and interpreting governing documents of condominium and homeowner’s associations in Michigan. He can be reached at (248) 478-1800 or [email protected]. You can also follow him on Twitter at @mwheron75.