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Show me the money!
Reconciling surplus operating funds should be a relatively straightforward task every year, but many associations aren't quite sure what to do. It would be ill-advised to assume that any and all surpluses should be rolled forward to cover next year's operating expenses OR simply transferred to your replacement reserve. Likewise, an association's cash position may require an injection if deficits are ignored.
Common interest communities are non-profit member organizations are required by law in many states to review reconciliation annually. Spending down a surplus during the fiscal year (FY) in which it is accrued helps avoid the need to reconcile and makes decisions about material savings easier.
Most folks you ask will recommend keeping between 1 and 3 months of operating expenses available in your operating account at all times. That operating cushion allows you to make small to moderate capital improvements and weather periods of owner assessment delinquency without facing a cash flow crisis. Does your community have an operating fund policy in place? That examples guides to an 8% minimum and 15% maximum cash surplus (total) in relation to the annual budget.
Surplus funds are considered Retained Earnings (RE) in accounting parlance. ASC 606 is a revenue recognition standard that applies to common interest communities that have accrual accounting. Learn more here and by reading Presentation Of Contract Assets And Contract Liabilities In ASC 606).
Rolling retained earnings into your reserve or letting them accumulate in your operating account does not satisfy the requirement of reconciliation.
If you need more funds in your reserve, budget for it!
If you need more funds in your operating account, budget for it! - OR - create a special assessment.
Holding your homeowners' prior year assessments hostage is an inappropriate way to "buffer" your financial accounts.
DO YOU KNOW YOUR STATE'S SURPLUS FUNDS LAW?
DO YOU KNOW YOUR STATE'S SURPLUS FUNDS LAW?
Don't play "gone in 60 seconds" with your surplus funds.
Community association statutes in multiple states contain surplus funds language promulgated by the Uniform Condominium Act (UCA) and Uniform Common Interest Ownership Act (UCIOA). The annotation provided below from New Mexico's adoption of this surplus funds standard clarifies the intent of the plain language: an alternative uses of surplus funds MUST be specified in an association's declaration (CC&Rs).
Allocating surplus funds to a reserve account generally fails to directly and/or measurably reduce future common expense assessments and may therefore be illegal UNLESS your declaration / CC&Rs provides latitude to the Board to make such a decision.
While the article below incorporates references for North Carolina, the surplus funds law in North Carolina and many other states is materially similar.
HANDLING EXCESS ASSESSMENTS
Where a community association has received assessments from its members during the year in excess of its budgeted expenses, the Internal Revenue Service ("IRS") determined, in Revenue Ruling 70-604, that the excess amounts are not taxable income to the association itself where the members vote at the end of the year either to: (1) apply excess assessments to their future assessments; or (2) rebate the excess amounts back to the members. The IRS made this key ruling with respect to excess assessments received by a condominium management corporation. In its ruling, the IRS noted that the stockholder-owners of the condominium association held a meeting each year at which they decided what to do with any excess assessments not actually used for association expenses. Your community association's membership will need to do the same to take advantage of this tax exemption—take a vote (either in person or by written ballot) before the association files its Form 1120.
After issuing this ruling, the IRS clarified, in several informational letters, that the ruling did not mean that condominium and homeowners associations could retain excess assessments from year to year in a working capital reserve without recognizing the amounts as taxable income. Accordingly, your community association may not apply excess assessments to its reserve account. It must either: (1) return the excess assessments to the membership or (2) apply the excess assessments to the next fiscal year, thereby reducing the subsequent year's annual assessment.
Mo Money, Mo Problems? No Biggie for a Homeowner's Association, Right?Tax Burdens under Homeowners Association — The National Law Review
Illinois Condominiums: 765 ILCS 605/9(c)(5)
(5) At the end of an association's fiscal year and after the association has approved any end-of-year fiscal audit, if applicable, if the fiscal year ended with a surplus of funds over actual expenses, including budgeted reserve fund contributions, then, to the extent that there are not any contrary provisions in the association's declaration and bylaws, the board of managers has the authority, in its discretion, to dispose of the surplus in one or more of the following ways:
(i) contribute the surplus to the association's reserve fund;
(ii) return the surplus to the unit owners as a credit against the remaining monthly assessments for the current fiscal year;
(iii) return the surplus to the unit owners in the form of a direct payment to the unit owners; or
(iv) maintain the funds in the operating account, in which case the funds shall be applied as a credit when calculating the following year's annual budget.
If the fiscal year ends in a deficit, then, to the extent that there are not any contrary provisions in the association's declaration and bylaws, the board of managers has the authority, in its discretion, to address the deficit by incorporating it into the following year's annual budget.
If 20% of the unit owners of the association deliver a petition objecting to the action under this paragraph (5) within 30 days after notice to the unit owners of the action, the board of managers shall call a meeting of the unit owners within 30 days of the date of delivery of the petition. At the meeting, the unit owners may vote to select a different option than the option selected by the board of managers. Unless a majority of the total votes of the unit owners are cast at the meeting to reject the board's selection and select a different option, the board's decision is ratified.
New Mexico 47-7C-14 - Surplus funds
Unless otherwise provided in the declaration, any surplus funds of the association remaining after payment of or provision for common expenses and any prepayment of reserves shall be paid to the unit owners in proportion to their common expense liabilities or credited to them to reduce their future common expense assessments.
North Carolina § 47F-3-114. Surplus funds
Unless otherwise provided in the declaration, any surplus funds of the association remaining after payment of or provision for common expenses, the funding of a reasonable operating expense surplus, and any prepayment of reserves shall be paid to the lot owners in proportion to their common expense liabilities or credited to them to reduce their future common expense assessments.
Washington: RCW 64.34.356 - Surplus Funds
Unless otherwise provided in the declaration, any surplus funds of the association remaining after payment of or provision for common expenses and any prepayment of reserves shall, in the discretion of the board of directors, either be paid to the unit owners in proportion to their common expense liabilities or credited to them to reduce their future common expense assessments.
Washington: RCW 64.90.475 - Accounts and Records - Reconciliation
(1) The association must establish and maintain its accounts and records in a manner that will enable it to credit assessments for common expenses and specially allocated expenses, including allocations to reserves, and other income to the association, and to charge expenditures, to the account of the appropriate units in accordance with the provisions of the declaration.
(2) To assure that the unit owners are correctly assessed for the actual expenses of the association, the accounts of the association must be reconciled at least annually unless the board determines that a reconciliation would not result in a material savings to any unit owner. Unless provided otherwise in the declaration, any surplus funds of the association remaining after the payment of or provision for common expenses and any prepayment of reserves must be paid annually to the unit owners in proportion to their common expense liabilities or credited to them to reduce their future common expense assessments.
DECLARATION / CC&Rs
N.B. Actual expenses exclude non-cash items like depreciation.
N.B. Both aforementioned statutory examples include unless provided otherwise in the declaration. If your declaration (CC&Rs) contains its own criteria, that's how you reconcile. The language below mandates an automatic reconciliation unless the Board holds a vote to determine otherwise.
In order that the Unit Owners are correctly assessed for the actual expenses of the Association, unless the Board determines a reconciliation would not result in a material savings to any Unit Owner, the accounts of the Association shall be reconciled at least annually, and any material surpluses (or deficits) in the accounts shall be credited to the benefit of or paid to (or charged to the account of or assessed against) the Unit Owners who paid the surplus (or owe the deficit).
A more precise version of the language above sets parameters that help avoid subjectivity under certain conditions.
To assure that the Units are correctly assessed for the actual expenses of the association:
(a) The association shall determine its prior annual operating surplus or deficit within 185 days of its fiscal year-end and record such figures in the minutes of the next regular meeting of the Board following such determination.
(b) The entire amount of all surpluses and deficits excluding the portion of capitalized expenses to be depreciated in future periods, non-cash items such as depreciation, unrealized gains and losses on investments, expenses that were budgeted and incurred but not paid during the prior fiscal year and amounts reconciled from a prior period that exceed three percent (3%) of the Association’s annual operating budget must be reconciled.
(c) Surpluses and deficits excluding the portion of capitalized expenses to be depreciated in future periods, non-cash items such as depreciation, unrealized gains and losses on investments, expenses that were budgeted and incurred but not paid during the prior fiscal year and amounts reconciled from a prior period that do not exceed three percent (3%) of the Association’s annual operating budget may be reconciled at the discretion of the Board.
(d) Reconciliation of surpluses (or deficits) shall be credited to the benefit of or paid to (or charged to the account of or assessed against) the Units that paid the surplus (or owe the deficit). Special assessments for reconciliation of prior year deficits require notice pursuant to RCW 64.90.525 but do not require ratification by the members.
(e) All reconciliation actions must be completed within 275 days of the association’s fiscal year end.
FEDERAL TAX IMPLICATIONS
FEDERAL TAX IMPLICATIONS
Operating surpluses may have Federal tax ramifications for your association. The Revenue Ruling 70-604 election must be ratified by over half the votes in attendance at an Annual Meeting in order for to elect to file the Form 1120 instead of 1120-H.
View tips for Form 1120-H. Refer to SECTION 19 - INCOME TAX MATTERS as well as APPENDIX A1 and APPENDIX A2: 70-604 ELECTION LETTER RECOMMENDED FORMAT in the Schwindt & Co. Treasurer's Accounting & Procedures Manual for more information.
The Form 1120-H corporate tax rate is 30% given that the form itself is quite simple. The Form 1120 corporate tax rate is the standard 21%. CICs that have a majority of their cash invested and earning consistent returns may have non-membership income such that the Form 1120 provides a superior tax-advantaged election because it reduces the Federal income tax bill. 5% or 10% of $50,000 or $100,000 (or whatever your annual interest income may be) can be a material savings over time. The amount saved on an annual basis should exceed whatever additional costs are involved with filing the Form 1120. Check with your CPA.
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