What Is the “Seventy Dash Six-Oh-Four” Election or Revenue Ruling 70-604?
The “seventy dash six-oh-four” is a shortcut way of referring to IRS Revenue Ruling 70-604. This is a ruling issued by the Internal Revenue Service in 1970 which is an effective and powerful tax planning tool. Unfortunately, many associations do not fully understand the reasons and ramifications of this ruling. It is good that you asked and are interested in further information about it.
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Basically, it is a tax election that states that any excess membership income remaining at the end of the year is carried over into the next year, or is refunded to owners. This election may allow the Association to file form 1120 (rather than form 1120-H) for its Federal taxes and pay tax at 15% on the first $50,000 of taxable income rather than 30%. (Note: taxable income is generally interest and possibly other nonmember income).
The IRS has not issued much in the way of official guidance on the use of Revenue Ruling 70-604, but based upon audit activity across the nation, informal communications with IRS personnel, and a draft audit guide for IRS auditors, we know somewhat of their thinking on this matter. Below are a few of the issues involved and the information we have available at this time. It is our firm’s opinion that an Association should be conservative in its financial practices, so we do not encourage Association’s to take undue tax risks. However, with the lack of absolute guidance from the IRS there are some practitioners and some Associations which feel comfortable with taking more risk on their tax returns. This should be done with caution and knowledge of the ramifications.
Who Must Make This Election? The original ruling stated “the membership” made the election. In audits and in the draft audit guide, the IRS has upheld that the members must make this election using whatever approved voting process is allowed by law – thus, it can be at an annual meeting using proxies, by mailing ballots, etc. Some associations argue that the board is an agent of the membership and they should have the right to make the election. This may be valid if taken to a court of law, but at this time the IRS has not agreed with this stance. In the San Diego audits of several years ago, the CPA was making this election for the membership and this was disallowed.
When Does the Election Need to Be Made? The IRS has been entirely silent on this matter. It appears reasonable that the election should be made before the tax return is filed, and many of us believe that it is better if the election is made before year-end.
Can the Election be Made Every Year? Most CPAs agree that an Association should make the election every year, then the accountant will determine whether or not it is in the best interest of the Association to use such an election.
The IRS issued correspondence that indicates that the 70-604 election cannot be used two year’s in a row. Also, in the recent draft audit guide the ruling is consistently referred to as a “one year carryover”. That is, the excess from year one must be “absorbed” in year two. Thus, it appears that 70-604 must skip a year between usage. Our firm feels that there is much less risk in taking this position.
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How are the Association financial statements affected? This is a tax only election, so does not affect how the financial statements are presented to the owners. However, some CPAs recommend that the next year’s budget should include a “shortfall” which is absorbed by the prior year excess income. The difficulty in this is that the election is made and the budget prepared before the amount of the excess income is known. Thus, this is not a reasonable reality. If there is significant excess income, at the time the tax returns are prepared the association may want to address this matter and record in the minutes where the excess will be used. Another possibility may be to transfer some of this excess to the replacement fund (reserves), but be aware that the 70-604 election does not allow that the excess be transferred to reserves. It requires it to be carried over to the next year or refunded. Thus, to transfer the amount to reserves requires two steps 1) to make the election to carryover from the prior year, then 2) in the subsequent year to make an additional contribution to capital reserves – based upon a reserve study or other justification and notification to the membership. The Association should consider consulting with their accountant to ensure that this properly done.
To recap: Have the membership make the election Make the election before the end of the fiscal year Use only one year, then either “absorb” the excess membership income the next year or change to form 1120-H for one year Consider documenting usage of net membership excess if the amount is material If the above items are considered, Revenue Ruling 70-604 can be an effective tax planning tool for the majority of community associations.