Homeowner (and condominium) associations hold an unusual place in the tax world. On the one hand, most do not squarely meet the definition of a 501(C) nonprofit. On the other, they are not in business pursuing a profit. In fact, the vast majority of HOAs are small, volunteer-run associations that function solely to enforce covenants and maintain the common areas of their residential members.
Before The Tax Reform Act of 1976, HOAs that were not approved as 501(C) nonprofit organizations were treated as for-profit corporations for tax purposes and required to file Form 1120, a business return.Form 1120 forced payment of tax on dues and assessments that exceeded expenses for each tax year.The Tax Reform Act of 1976, however, created Section 528 of the Internal Revenue Code and a special carve-out for qualifying homeowner associations. Section 528 defines what an HOA is for tax purposes and gives those meeting the definition the opportunity to file Form 1120H Tax Return for a Homeowners Association.This definition has five basic tests: 1) Exempt Purpose Test, 2) Exempt Function Income Test, 3) Exempt Function Expense Test, 4) No Private Inurement Test, and 5) Election to apply section 528 for that tax year.Your HOA must pass all five tests to file Form 1120-H for a particular tax year.
There are articles on Overnightaccountant.com that discuss other parts of this definition.This article will focus on test number four, the no private inurement test. The no private inurement test is not as cut and dry as other homeowner association tests. Therefore, applying this rule to specific situations may require the assistance of a qualified attorney.
What is Private Inurement? The term private inurement is defined in the nonprofit section of IRS regulations and refers to an instance when the earnings or resources of an organization are used to disproportionately benefit any person or group of persons having a personal or private interest in the function of the organization. Most commonly, these persons are those in a position to control or influence the organization such as board members or directors.
To be considered an HOA for tax purposes under IRC Code section 528 (and qualify to file Form 1120H) homeowner associations must follow the same private inurement rules that apply to bona fide nonprofits under treasury regulations in Section 501(C).
So what does private inurement mean for HOA’s: As discussed earlier, most HOAs exist in a tax no-man’s-land. Most are not nonprofits that function to promote the public good. Nor are they in business to make a profit. Sections 528 rules say, “Hey! We will let your HOA file this compromise-form, Form 1120-H if it functions more like a nonprofit than a business.” The no private inurement rule is a core nonprofit tenet. If your nonprofit is using funds or resources to disproportionately benefit one or more insiders, it could lose its nonprofit status, making it a business for tax purposes. The result: the organization becomes a taxable entity, possibly retroactively, and could owe taxes (and penalties) for all the years it was determined to be a business.
Fortunately, the chance of an organization losing its nonprofit status due to a single private inurement oversight is relatively rare. It should be noted, however, that systematically breaking the private inurement rules can become extremely easy over time as it easily bleeds into the culture of an unwitting board of directors.
Two More Items to Consider: Before sharing a few examples of situations that may constitute private inurement, there are two important items HOA board members should consider:
First: The IRS often learns about private inurement from a disgruntled association member – and we all know how many folks love their HOAs!
Second: More extreme instances of private inurement can potentially result in the board or individual directors being sued civilly by association members.In some cases, the inuring board member(s) could even face criminal prosecution.
Examples of Private Inurement: Private inurement can take many forms and can be easy to stumble into, even with the best of intentions. It is, therefore, important that board members understand situations that may require a closer look and the assistance of an attorney. Below are a few examples of situations that may create claims of private inurement (whether a particular occurrence constitutes private inurement is a topic to be consulted with an attorney):
Take Away: Private Inurement is an easy trap to fall into. Falling into the private inurement trap doesn’t just threaten a homeowners association’s ability to file form 1120-H. It can create a slew of other problems for the HOA and its’ board. The easiest way to avoid complaints of private inurement from HOA members (and others) is to create strict policies that prevent its mere appearance and to consult with an attorney before entering into any transaction or agreement that could potentially lead to private inurement.
We hope this article has helped you to better understand the No Private Inurement Test for HOA’s and form 1120-H. Please remember that all HOAs must file a tax return every year. If your HOA is among the vast majority of HOAs that pass the No Private Inurement Test, we invite you to learn how to prepare your own Form 1120-H. Our Form 1120-H Basics course can be used year after year to help you prepare your HOA’s 1120-H—- saving thousands of dollars in preparer fees!
All courses and articles are for informational purposes only and do not constitute tax advice. Taxes are complicated - do not act on course information without consulting a professional. Always refer to treasury regulation before making any tax decision. Read the full disclaimer.
I really appreciate you doing the class. It was quite helpful.- Debbie Y, Greensboro, NC, 1099-NEC & 1099-MISC Training Course Course
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The course was excruciatingly detailed, which I appreciate. I definitely recommend this course to anyone who even thinks they may need it.- Greg, Brookfield, IL, 1099-MISC Basics Course