Determination 1329022: IRS revokes a homeowners association’s section 501(c)(4) exemption over private roads

View official IRS release (PDF)

Plain-English summary

The IRS revoked a homeowners association’s exemption under IRC § 501(c)(4). The organization maintained private roads and other property for owners, but its signs and access rules limited use of those common areas to owners and their guests, so it did not meet the public-access requirement described in the determination. The IRS concluded that the organization could qualify under IRC § 528 as a taxable homeowners association for one tax year, but not for another year because logging income caused it to fail the applicable income test. The determination also treated the logging company’s road-use payment as unrelated business income and allowed allocation of directly connected road-maintenance expenses under IRC § 512.

Ruling snapshot

• Question: Did the organization qualify for continued exemption under IRC § 501(c)(4), and how should its assessments and logging income be treated under IRC §§ 528 and 512?
• Outcome: Revocation. The organization failed the § 501(c)(4) public-access requirement, could use § 528 for only the qualifying year, and owed tax on the non-exempt logging activity.
• Key authorities: IRC §§ 501(c)(4), 511, 512, 528; Treas. Reg. §§ 1.528-1, 1.512(a)-1; Rev. Rul. 74-99; Flat Top Lake Ass’n, Inc. v. U.S.

Full text (IRS public release)

internal Revenue Service Department of the Treasury
1100 Commerce Street MC 4980 DAL
Dallas, TX 75242 501-04.00

Release Number: 201329022
Date: July 7, 2012

LEGEND Taxpayer Identification Number:
ORG - Organization name Form:
XX - Date Address - address Tax Period(s) Ended:

Person to Contact/ID Number:

ORG

ADDRESS Contact Numbers:
Phone:
Fax:

CERTIFIED MAIL - RETURN RECEIPT REQUESTED
Dear ;

In a determination letter dated June, 19XX, you were held to be exempt from
Federal income tax under section 501(c)(4) of the Internal Revenue Code (the
Code).

Based on recent information received, we have determined you have not
operated in accordance with the provisions of section 501(c)(4) of the Code.
Accordingly, your exemption from Federal income tax is revoked effective May 1,
20XX. This is a final letter with regard to your exempt status.

We previously provided you a report of examination explaining why we believe
revocation of your exempt status was necessary. At that time, we informed you of
your right to contact the Taxpayer Advocate, as well as your appeal rights. On [
date ] you signed Form 6018-A, Consent to Proposed Action, agreeing to the
revocation of your exempt status under section 501(c)(4) of the Code.

You are required to file Federal income tax returns for the tax period(s) shown
above. If you have not yet filed these returns, please file them with the Ogden
Service Center within 60 days from the date of this letter, unless a request for an
extension of time is granted. File returns for later tax years with the appropriate
service center indicated in the instructions for those returns.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer
Advocate assistance is not a substitute for established IRS procedures, such as
the formal appeals process. The Taxpayer Advocate cannot reverse a legally
correct tax determination, or extend the time fixed by law that you have to file a

petition in a United States court. The Taxpayer Advocate can, however, see that
a tax matter that may not have been resolved through normal channels gets
prompt and proper handling. You may call toll-free, 1-877-777-4778, and ask for
Taxpayer Advocate Assistance. If you prefer, you may contact your local
Taxpayer Advocate at:

If you have any questions, please contact the person whose name and telephone
number are shown at the beginning of this letter.

Thank you for your cooperation.

Sincerely,

Nanette M. Downing
Director, EO Examinations

Internal Revenue Service Department of the Treasury

TE/GE Exempt Organizations
915 Second Avenue, M/S W540
Seattle, Washington 98174

Date: November 15, 2011 Taxpayer Identification Number:
Form:
Tax Period(s) Ended:
Person to Contact/ID Number:

ORG Contact Numbers:
ADDRESS Telephone:

Fax:
Dear ;

We have enclosed a copy of the preliminary findings of our examination, explaining why we
believe revocation of your exempt status under section 501(a) of the Internal Revenue Code
(IRC) is necessary. Your organization may instead make an election to be treated as a taxable
homeowner's association under IRC § 528.

If you accept our findings, please sign and return the enclosed Form 6018-A, Consent to
Proposed Action, to the individual listed above. We will then send you a final letter revoking
your exempt status. Please also file Federal income tax return Form 1120-H for the tax year
ending April 30, 20XX, with the individual listed above.

If you disagree with our findings, please provide in writing any additional information you believe
may alter the findings. Your reply should include a statement of the facts, the applicable law,
and arguments that support your position. Please also include any corrections to the facts that
have been stated, if in dispute.

Upon receipt of your response, we will evaluate any additional information you have provided
prior to issuing any final report of examination.

Please respond within 30 days from the date of this letter.
Thank you for your cooperation.

i Sincerely,

Anne Jewell
Revenue Agent

Enclosure:
Form 886-A, Explanation of Items
Form 6018-A, Consent to Proposed Action

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX
LEGEND
ORG - Organization name XX - Date EIN - ein State - state County -
county POA - poa Treasurer - treasurer RA-1 - 18° RA CO-1, CO-2, C0-3,

CO-4 & CO-5 - 187, 252, 3RP) aT ¢ ST COMPANIES
ISSUES:

1. Does ORG (ORG) qualify as a tax exempt homeowners association under § 501(c)(4) of the
   Internal Revenue Code (IRC)?

2. Does ORG qualify as a for-profit homeowners association under IRC § 528?

3. What are the exempt and non-exempt function income and expenses as defined in IRC § 5287

4. If so, what are the tax implications of the revocation and reclassification of the organization under
   IRC § 528?

An alternative position based on if the organization continued to qualify as an organization exempt under
IRC § 501(c)(4) is included at the end of the primary position.

FACTS:

ORG, _ . (ORG) is currently classified as a tax-exempt organization under § 501(c)(4) of the Internal
Revenue Code (IRC). Per the Articles of Incorporation (“Articles”), the organization was originally organized
in State on October 3, 19XX. These Articles were later amended on October 3, 20XX to expand the stated
purpose. The organization was created to “acquire, maintain and conduct building and property and
activities for a community life and center at the ORG as above described, to engage in educational and
recreational facilities for members; to acquire other property and construct buildings for such proposes; to
foster and promote good citizenship among is members; to promote and foster educational, recreational:

_ physical and social activities of its members and their friends; to engage in such activities as shall raise the
standards of civic morality and community welfare.” The 19XX Articles were expanded with the following
language during the 20XX revision, “ORG’s primary purpose is to own, repair, maintain, and improve the
roads within the ORG, and to collect and disperse road maintenance fees related to the private roads within
the plats of the Assessor's Plat of ORG in Volume 16 of Plats, records of County, State, or in Volumes 17,
18, and 19 of said records, or any additions thereto as platted.”

The bylaws were also amended at this time. The current bylaws provide the following definition of a
member:

“,..any Property Owner who chooses to pay an annual membership fee established by
the Board of Directors to ORG for the rights to enjoy ORG Member Properties and the
secondary purposes of ORG as outlined in the Amended Articles of Incorporation.”

On October 22, 20XX, a Form 2848, Power of Attorney and Declaration of Representative, was received by
the Internal Revenue Service allowing POA authority to discuss income tax for the tax periods ending April
30, 20XX through April 30, 20XX.

Form 886-A (1-1994) Catalog Number 20810W Page 1 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

om 886-4 1304) EXPLANATIONS OF ITEMS

Name of taxpayer : Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -

On September 20, 20XX, a Letter 3611 and Publication 1, Your Rights as a Taxpayer, and a Form 4564,
Information Document Request (‘IDR”), were issued to notify the organization of an examination of the

Form 990, Return of Organization Exempt from Income Tax, for the year ended April 30, 20XX. The initial
appointment was held November 5, 20XX, at POA’s office. Treasurer, the Treasurer, and POA, POA, were -
present on behalf of the organization. The following is a summary of the relevant points of the initial
interview (questions asked in bold and response in italics).

To get a full understanding of your organization, please describe the history of your organization
and all of its activities.

The organization was started in 19XX as a group of owners who purchased property from the RA-1. The
original plan nad 1100 lots which were completely undeveloped and were mostly for tents. The mission is
to manage and maintain the roads of ORG. The roads were later deeded to ORG. The organization has
changed several times over the years based on who has had power over the board of directors. The
organization has been involved in 2 major law suits. The first in 20XX was based around additional
assessments made to replace a bridge, the organization won the right to make assessments against the
owners based on a formula but the formula was not specified. According to the organization, this suit also
stated that the organization was not a homeowners association under state law. The formula determined
was based on how many of the main and side roads were used when accessing the properties. The
second law suit was a class action suit against the owners of the organization who were not paying
assessments. This suit validated the formula used before with minor changes to make it more fair. The new
formula was % the old formula and % the assessed value of the property. The suit also allowed the
organization to place liens or even foreclose on properties. The organization currently has 95 owners in
collections. This case also allowed them to collect for administrative and legal costs.

The organization had a road budget of $$ and an Admin budget of $~$ (used for bookkeeping and lawyers
as the organization has no employees). The organization is also in the process of selling some of their
properties (some gained through foreclosure and some were road accesses). The properties owned by the
organization include two beach access points and a stretch of river beach.

What are the rules for non-owners being on the property?

The road is not open to the public except in limited ways. The CO-1 road to the first arch is
public access and the organization has an easement across the land from the first arch to the
second arch (~1.5 miles). ORG owns the roads while the CO-1 has an easement. Per the CO-1,
the only people who should be on the roads after the first gate are owners or those on official
CO-1 business. The remainder of the road is marked as being for property owners and guests
only. There are signs on both arches which state that the road is private.

The organization requires stickers to be present on cars that enter the property. If the sticker is
not present on the car, the organization will place a note on the car. When asked, the treasurer
Stated that usually if a person is on the property, they are instructed to carry out their business,

leave the premises and that they are not to return.

"Fe

Does the organization have a gate or security guard shack?

The organization does have a guard shack but it has not been used in years.

Form 886-A (1-1994) Catalog Number 20810W Page 2 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

How commonly does the organization receive income from logging?

This happens once every 100 years or so and was not for the sale of lumber but instead was
compensation for use of the roads. The organization was paid $$.00. The lumber company was
required to pay repair costs for any damage done to the roads. Per the treasurer, the money
was used to pay for flood damage and the class action lawsuit.

For what reason was the organization property logged?

The logging was occurring on the land on the other side of the property and the logging
company had an easement across the organization in order to reach their property.

What access is given to the general public to view the waterfalls and the river?

The public are not given access to view the waterfalls and river. The waterfalls are located
beyond the area with the CO-1 easement.

What benefit do you provide to the general public?
No benefit is provided to the public.

What are the requirements for being a property owner?

They must own property within the organization’s serviced area.

What classes of members or property owners are there and are there any differences in voting
rights? =~

There are no classes of property owners and in order to vote you must be in good standing (have paid all
assessments).

What are the dues & initiation fees for the various classes of members?
Assessments are between $$ and $$ a year based on the formula.

Does the organization own, lease or sublease any real property? If so, is the property encumbered
by debt?

The organization owns roads and other properties. None are encumbered by debt.

Per the transcript of the class action law suit posted on the organization’s website, the organization is not
primarily a membership based organization. The determination was made that the organization may solicit
voluntary membership and dues for all purposes besides the maintenance of the roads.

The law suit establishes the validity of the agreement between ORG and the CO-1. This agreement
establishes a basis for dues assessments to the ORG members to maintain the .6 of a mile that is owned
by the CO-1.

Form 886-A (1-1994) Catalog Number 20810W Page 3 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

The law suit finds that the administrative costs of the organization, including legal fees from this lawsuit,
may be assessed against the owners.

The Class Action finds that the correct assessment formula would be % of the implied easement formula
(IE) and % the assessed value of the property. The determination of commercial use of the property is also
important as commercial activity increases traffic on the roads. The determination was made that a
surcharge of $ per lot may be assessed for commercial use.

The minutes for the board meeting held March 7, 20XX, state that there was an issue with guests being on
the property and being told that they were not allowed to have access to the property. The organization
requires that owners display a sticker on their car to show that they are allowed to park on the property.
Guests would receive a hanging tag. These plans were finalized January 9, 20XX with each owner
receiving two guest tags with the option to purchase more for $ a pair. The minutes for June 6, 20XX state
that a sign should be posted at CO-2 to notify non-residents that only residents and their guests may park
on CO-3. Money was allocated for this activity.

During the tour of the facility, several posted signs were observed. The signs stated that the roads are
private roads for owners only. Signs were observed on both the first and second arches.

The following are the income and expenses as reported by the organization.

Income Statement
20XX04 20XX04

Income

Administrative Income (Income for admin. Use)

Asphalt (Crushed Asphalt)

Road Income (Income for Road Maintenance)

Security (Police patrols)

Special Assessment (Repair Flood Damage 20XX)
Archway Slide Area
Guard Shack/Mailbox Roadbed (Raise roadbed)
CO-2 Roadway (Repair flood damage)
Washout (Repair road along tracks)

Total Special Assessment

Total Income

Cost of Goods Sold
Road Expenses

Asphalt Grindings
Compacting (Compacting Road Material)
Culverts
Dozer
Grading
Gravel
Hauling
Labor

Form 886-A (1-1994) Catalog Number 20810W Page 4 publish.no.irs.gov. Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

Rental Equipment
Road Expense Supplies
Snow Removal
Street Lighting
Street Signs
Track-Hoe (Rental)
Water Truck
Road Expense - Other
Total Road Expense
Total Cost of Goods Sold

Gross Profit

Expense
Administrative Cost
Annual Meeting
Bank Service Charges (Bank Service Charges)
Donations
Insurance (Insurance)
Licenses and Permits (Licenses)
Miscellaneous (Miscellaneous)
Office Supplies (Office Supplies
Postage and Delivery (Postage and Delivery)
Professional Fees (Professional Fees)
Accounting (Accounting Fees)
Legal (Legal Fees)
Administrative Costs - Other
Total Administrative Cost
Grader Shed Expense
Total Expense

Other Income/Expense
Other Income
Interest Income (Interest Income)
Other Income (Other Income)
Total Other Income

Net Income

Per further discussion, it was noted that the logging company owned property within the organization's
boundaries. The logging company paid a total of $$ as a “special assessment” for the use of the roads by
the logging trucks. The logged area was located behind the land owned by the organization. The logging
activity was in process from October 20XX through April 20XX, a total of 26 weeks.

Per the ORG response to an IDR dated January 4, 20XX, the organization noted two expenses which could
be directly related to the existence of logging trucks on the roads. These expenses as shown below are for

Form 886-A (1-994) Catalog Number 20810W Page 5 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

lumber and repairs on a bridge within the organization’s boundaries. The expenses were incurred in the
next fiscal year, ten months after the end of the logging activity.

Date Payee Amount
11/18/20XX CO-4 $$
11/23/20XX, aa. CO-5 $$

Per an ORG IDR response, there are a total of 405 property owners in the organization. Of these, 160 are -
permanent residents who are likely to drive on the roads an average of twice a day, once as they leave and
once when they return.

The remaining 245 property owners are non-residents and more likely to use the roads on a more
intermittent basis. On average, they may drive the roads twice per time in residence. Per the ORG IDR
response, it is likely that the non-residents used the facility an average of 7 times during the six months that
the logging company was using the roads.

Per the ORG IDR response, “A large logging truck does much more damage to a road than a passenger
car or pickup ‘ruck. For purposes of this analysis, it is assumed that a logging truck does twice as much
damage as a passenger car or pickup truck.”

ORG spent a total of $$ on road maintenance during the year ended April 30, 20XX.
LAW:
IRC § 501(c)(4)

IRC § 501(c)(4)(A) holds that civic leagues or organizations not organized for profit but operated
exclusively for the promotion of social welfare, or local associations of employees, the membership of
which is limited to the employees of a designated person or persons in a particular municipality, and the net
earnings of which are devoted exclusively to charitable, educational, or recreational purposes. It also
requires that no part of the net earnings of such entity inures to the benefit of any private shareholder or
individual.

Revenue Ruiing 74-99, 1974-1 C.B. 131, modifies Rev. Rul. 72-102, to make clear that a homeowners’
association oft the kind described in Rev. Rul. 72-102 must, in addition to otherwise qualifying for
exemption under section 501(c)(4) of the Code, satisfy the following requirements: (1) It must engage in
activities that confer benefit on a community comprising a geographical unit which bears a reasonably
recognizable relationship to an area ordinarily identified as a governmental subdivision or a unit or district
thereof; (2) It must not conduct activities directed to the exterior maintenance of private residences; and (3)
It owns and maintains only common areas or facilities such as roadways and parklands, sidewalks and
street lights, access to, or the use and enjoyment of which is extended to members of the general public
and is not restricted to members of the homeowners’ association.

Flat Top Lake Ass'n, Inc v. US holds that an organization will not qualify for tax exempt status under IRC §
501(c)(4) if it restricts its facility and activities only to members. It sites Rev Rul 74-99 which states that a
homeowner's association must serve a “community” which bears a reasonably, recognizable relationship to
an area ordinarily identified as a governmental subdivision or unit. Second it must not conduct activities

Form 886-A (1-1994) Catalog Number 20810W Page 6 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

directed to the exterior maintenance of any private residence, Third common areas or facilities that the
homeowners’ association owns and maintains must be for the use and enjoyment of the general public.

IRC § 528

IRC § 528(a) holds that a homeowners association (as defined in subsection (c)) shall be subject to
taxation under this subtitle only to the extent provided in this section. A homeowners association shall be
considered an organization exempt from income taxes for the purpose of any law which refers to
organizations exempt from income taxes. A tax is imposed for each taxable year on the homeowners’
association taxable income of every homeowners association. Such tax shall be equal to 30 percent of the
homeowners’ association taxable income. -

IRC § 528(c) defines a homeowners association as an organization which is a condominium management
association, a residential real estate management association, or a timeshare association if such
organization is organized and operated to provide for the acquisition, construction, management,
maintenance, aiid care of association property, 60 percent or more of the gross income of such
organization for the taxable year consists solely of amounts received as membership dues, fees, or
assessments from owners of residences or residential lots in the case of a residential real estate
management association, or 90 percent or more of the expenditures of the organization for the taxable year
are expenditures for the acquisition, construction, management, maintenance, and care of association
property and, in the case of a timeshare association, for activities provided to or on behalf of members of
the association, no part of the net earnings of such organization inures (other than by acquiring,
constructing, or providing management, maintenance, and care of association property, and other than by
a rebate of excess membership dues, fees, or assessments) to the benefit of any private shareholder or
individual, and such organization elects (at such time and in such manner as the Secretary by regulations
prescribes) to have this section apply for the taxable year.

IRC § 528(c)(3) defines the term “residential real estate management association” as any organization |
meeting the requirements of subparagraph (A) of paragraph (1) with respect to a subdivision, development, |
or similar area substantially all the lots or buildings of which may only be used by individuals for residences.

IRC § 528(c)(5) defines “association property” as property held by the organization, property commonly
held by the members of the organization, property within the organization privately held by the members of
the organization, and property owned by a governmental unit and used for the benefit of residents of such
unit.

IRC § 528(d) For purposes of this section, defines homeowners association taxable income as an amount
equal to the excess (if any) of the gross income for the taxable year (excluding any exempt function
income), over the deductions allowed by this chapter which are directly connected with the production of
the gross income (excluding exempt function income). The section also allows for the following
modifications, there shall be allowed a specific deduction of $100, no net operating loss deduction shall be
allowed under Link section 172, and no deduction shall be allowed under part VIII of subchapter B (relating
to special deductions for corporations).

IRC § 528(d)(3) defines “exempt function income” as any amount received as membership dues, fees, or
assessments from owners of real property in the case of a residential real estate management association.

Federal Tax Regulations (Regulations) §1.528-1., Homeowners associations

Form 886-A (1-1994) Catalog Number 20810W Page_7 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A .
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN . 04/30/20XX -
04/30/20XX

(c) Residential real estate management association. —Residential real estate management associations
are normally composed of owners of single-family residential units located in a subdivision, development,
or similar area. However, they may also include as members owners of multiple-family dwelling units
located in such area. They are commonly formed to administer and enforce covenants relating to the
architecture and appearance of the real estate development as well as to perform certain maintenance
duties relating to common areas.

TAXPAYER’S POSITION:
The taxpayer's position is being solicited at this time.
GOVERNMENT’S POSITION:
Issue #1
Does ORG (ORG) qualify as a tax exempt homeowners association under § 501(c)(4) of the IRC?

ORG does not qualify as a tax exempt homeowners association. Per the findings of Revenue Ruling 74-99
and Flat Top Lake Ass'n Inc v. U.S., there are three requirements for a homeowners association to be
considered tax exempt under IRC § 501(c)(4). One, the organization must engage in activities that confer
benefit on a community comprising a geographical unit which bears a reasonably recognizable relationship
to an area ordinarily identified as a governmental subdivision or a unit or district thereof. Two, it must not
conduct activities directed to the exterior maintenance of private residences. Finally, it must own and
maintain only common areas or facilities such as roadways and parklands, sidewalks and street lights,
access to, or the use and enjoyment of which is extended to members of the general public and is not
restricted to members of the homeowners’ association.

The organization satisfies the first and second requirements for exemption but does not satisfy the third

requirement. The organization, as stated during the initial interview and seen during the tour of the road,

does not allow members of the general public access to their road or the common areas maintained by the
organization. As noted in the facts above, ORG will ask persons who do not have a parking decal or

hanging tag not enter their property again. The organization also posted signs in several locations along

the road which state that only members and their guests are allowed access to the road. As such, the

communal property of ORG is not made available to the general public and the organization can not qualify |
under IRC § 501(c)(4). . |

Issue #2
Does ORG qualify as a for-profit homeowners association under IRC § 528?

Per their bylaws, ORG is organized as a for-profit homeowners association under IRC § 528, as a
residential real-estate management association.

IRC § 528 defines a homeowners association as an organization which is organized and operated to
provide for the acquisition, construction, management, maintenance, and care of association property. A
residential real-estate management association is any organization meeting the requirements of a
subdivision, development, or similar area substantially all the lots or buildings of which may only be used by
individuals for residences.

Form 886-A (1-1994) Catalog Number 20810W Page 8 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

Given the conclusion reached in Issue #1, ORG is operated to manage and maintain the roads of CO-3.
Per the current articles of incorporation, the organizations primary purpose “is to own, repair, maintain, and
improve the roads within the ORG, and to collect and disperse road maintenance fees related to the private
roads within the plats of the Assessor’s Plat of ORG in Volume 16 of Plats, records of County, State, or in
Volumes 17, 18, and 19 of said records, or any additions thereto as platted.” This furthers the argument
that the organization is organized in such a way as to qualify for exemption under IRC § 528.

Issue #3
What are the exempt and non-exempt function income and expenses as defined in IRC § 528?

Per IRC § 528(d), the taxable income of a homeowners association is the gross income for the taxable year
less any exempt function income and any deductions that are directly connected with the production of the
gross income. IRC § 528(d)(3) further defines “exempt function income” as any amount received as
membership dues, fees, or assessments from owners of real property in the case of a residential real
estate management association.

As noted in the initial interview and the books and records of the organization, the organization receives the
majority of their money from assessments made for road and administrative fees. These amounts would be
considered “exempt function income” to an IRC § 528 organization. The organization’s purpose is to
conduct activities which support the community as a whole rather than provide a specific benefit. To
support this purpose the organization may impose annual or special assessments for road maintenance.

As noted in the initial interview, the organization also received $$ from a logging company for use of the
road. This invoine was classified as a “special assessment.” The fundamental difference between a special
assessment for road maintenance and the “special assessment” made against the logging company is in
the purpose for which it is assessed. A valid special assessment would be assessed against the entire
property owner community or a distinct portion of such community in order to pay for an unusual repair,
such as the replacement of a culvert or to fix the damage from a flood. In comparison, the “special
assessment” made against the logging company was not made in response to the need for an unusual
repair, nor was it an assessment that was paid by any distinct portion of the community. The assessment
was instead a payment for use of the road by an outside party to alleviate some of the cost of maintaining
the road as well as paying for any additional costs associated with increased traffic. As such, this income
would not be considered “exempt function income.”

The total exempt function income is $ in the year ended April 30, 20XX and $ in the year ended April 30,
20XX. The non-exempt function income includes all investment and other income that is not related to the
exempt purpose of an IRC § 528 organization. This is income is as follows.

Non-Exempt Function Income
20XX04 20XX04
Interest Income”
Other Income
Other Income - Logging

Form 886-A (1-1994) Catalog Number 20810W Page 9 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

(Rev B86 904) EXPLANATIONS OF ITEMS

Name of taxpayer ” : Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

The Non-exempt function expenses are those expenses which are directly connected to the production of
the non-exempt income. In this instance, while the organization may not deduct any portion of expenses
from the interest income as it has not directly related expenses, it may deduct any expenses which are
directly related to the income from the logging company. These expenditures have been allocated using the
method below:

Per IRC § 528(d), the organization may deduct only those expenses which are directly related to the
production of the non-exempt function income.

The organization identified the following transactions as directly related to damage caused by the logging

trucks.

Date Payee Amount
11/18/20XX CO-4 $$
11/23/20XX CO-5 $$

While these transactions are directly related to the unrelated business activity, they may not be deducted in
the year ended April 30, 20XX as they were not incurred until the following year. However, these costs are
fully deductable in the following year as valid road maintenance expenses.

The organization may deduct an allocated portion of the years total road maintenance expenses to the
unrelated business activity. Using a slightly modified version of the allocation method provided by ORG, the
road maintenance costs may be allocated using the estimated road use by logging trucks shown below.

Estimated Road use by Logging Trucks

Trips made by logging trucks
Damage Severity Factor
Weighted Number of trips

Trips made by Property Owners
Total Trips made

Percentage of Trips made by logging Trucks %

The estimated number of trips made by logging trucks was calculated using the following calculation
method provided by ORG.

Estimated number of Trips by Logging Trucks

Number of Trips per Day
Number of Days per Week

Number of Weeks
(October 20XX through April 20XX)
Estimated Trips Made

Form 886-A (1-1994) Catalog Number 20810W Page 10 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended

ORG EIN 04/30/20XX -
04/30/20XX

The explanation for the damage severity factor per ORG is as follows, “A large logging truck does much
more damage to a road than a passenger car or pickup truck. For purposes of this analysis, it is assumed
that a logging truck does twice as much damage as a passenger car or pickup truck.” The organization
used a damage severity factor of 3 to represent this increased damage.

The estimated number of trips by property owners was calculated using the following calculation method
provided by ORG.

Estimated number of Trips by Property Owners

Number of Permanent residents
Permanent Resident trips per week
(Two per day)

Number of Weeks
Estimated Trips made

Non Residents (seasonal, weekend)
Non Resident Trips (one in one out)

Average number of days used by nonresidents during the time the logging company was
also using the road

Estimated number of trips by property owners

In addition to the allocation factor shown above, the agent also allocated the portion of road maintenance
expenses that would have been incurred during the logging assuming that the maintenance expense was
incurred evenly over the course of the year. This calculation has been shown below.

Allocated Total Maintenance Expenses

Total Road Maintenance Expenses $$
Weeks per Year
$
Weeks used by Logging Company
Total Maintenance Costs during Logging $

This maintenance cost figure is then multiplied by the estimated use by logging trucks to calculation the
_total maintenance expense allocable to the logging activity as shown below.

Total Maintenance Costs during Logging . $
Percentage of use by logging trucks %
Total Allocable Expenses $

Form 886-A (1-1994) Catalog Number 20810W Page_11 _publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

Given the above calculation the organization may deduct a total of $ from the income received from the
logging trucks using the roads.

As such the total net non-exempt function income is shown in the following table.

Net Non-Exempt Function Income
20XX04 20XX04
Interest Income
Other Income
Other Income - Logging

Other Expenses - Logging
Net Non-Exempt Function Income

Issue #4

If so, what are the tax implications of the revocation and reclassification of the organization under
IRC § 528?

Given the conclusions reached in Issues #1 through 3, the organization can possibly qualify as an
organization exempt under IRC § 528. However, this Code section requires that in any given year the
organization have either 60% of the total income of the organization consist of membership dues, fees, or
assessments from owners of residences or residential lots, or 90% or more of the expenditures of the
organization are for the acquisition, construction, management, and care of association property.

ORG, given the income statement shown above, has the following percentages of income from
membership dues, fees and assessments.

Percentage of Exempt Function Income
20XX04_ 20XX04
Exempt Function Income
Total Income

As noted in the figures above, the organization meets the 60% exempt function income test in only the year
ended April 30, 20XX. The year ended April 30, 20XX, did not qualify due to the non-exempt function
income received from the logging company.

ORG, given the income statement above, has the following percentages of expenditures made for the
acquisition, construction, management, maintenance, and care of association property. This figure includes
all expenditures made including those made as a result of the logging trucks using the road.

Percentage of Exempt Function Expenditures
20XX04 20XX04

Exempt Function Expenses

Form 886-A (i-i984) Catalog Number 20810W Page_1 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

Total Expenses

The organization also does not qualify for this Code section under the expenditure test as in nether year do
they meet the 90% requirement. As such, the organization may not make the election to be treated as a
homeowners association under IRC § 528 for the year ended April 30, 20XX but may for the year ended
April 30, 20XX.

IRC § 528(d) defines a homeowners association taxable income as the amount equal to the excess (if any)
of the gross income, less the exempt function income, for the taxable year, less any deductions which are
directly connected with the production of those non-exempt activities. Exempt function income is defined as
any membership dues, fees, or assessments from owners of real property.

The calculation of taxable income for the year ended April 31, 20XX has been shown in the first table below
and includes investment income and any additional income that is received by the organization in a given
year.

Form 1120-H
U.S. Income Tax Return for Homeowners Associations
For Year Ended April 31, 20XX
20XX04
Type of homeowners association: Residential Real Estate Association

Total Exempt Function Income. Must meet % gross income test

Total Expenditures made for purposes described in % expenditure test
Association's total expenditures for the tax year

Tax-exempt interest received or accrued during the tax year

mOoOQwW >

Gross Income

Dividends

Taxable interest

Gross Rents

Gross Royalties

Capital gain net income

Net gain or (loss) from Form 4797
Other income

Gross income. Add lines 1 through 7

CONOR WND =

Deductions

9 Salaries and Wages
10 Repairs and maintenance
11 Rents
12 Taxes and licenses
13 Interest
14 Depreciation

Form 886-A (1-1994) Catalog Number 20810W Page_13 _publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX
15 Other Deductions
16 Total Deductions. Add lines 9 through 15. $ -
Taxable income before specific deduction of $. Subtract line 16 from
17 line 8.

18 Specific Deduction of $
Tax and Payments

19 Taxable income. Subtract line 18 from line 17.
20 Enter 30% of line 19

21 Tax Credits

22 Total Tax. Subtract line 21 from line 20

The second table calculates the taxable income for the year ended April 31, 20XX as that year does not
qualify for the IRC § 528 election. This has been calculated using the corporate tax rate.

TO, Form 1120
U.S. Corporation Income Tax Return
For Year Ended April 31, 20XX

a. Gross Receipts

b. Less: Returns and allowances

c. Balance

Cost of Goods Sold

Gross profit. Subtract line 2 from line 1c
Dividends

Interest

Gross Rents

Gross Royalties

Capital Gain net Income (Schedule D (Form 1120)
Net gain or (lossO from Form 4797, Part Il, line 17
Other Income

Total Income

-OODOOAN DOA W LD

= —

12 Compensation of officers, directors, etc -
13 Salaries and wages -
14 Repairs and maintenance -
15 Bad Debts -
16 Rents -
17 Taxes and Licenses -
18 Interest -
19 Charitable Contributions -
20 Depreciation -

Form 886-A (1-1994) Catalog Number 20810W Page 14 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX
21 Depletion. -

22 Advertising -
23 Pension, profit-sharing, etc. plans -
24 Employee benefit programs -
25 Domestic production activities deduction -
26 Other deductions
27 Total Deductions
28 Taxable Income before net operating loss deduction and special deductions
29 Less:

a. Net operating loss deduction -

b. Special deductions -

Taxable Income |
Tax Due

CONCLUSION:

As noted in the above analysis, the organization does not qualify for exemption under § 501(c)(4) of the
IRC but does qualify under IRC § 528 as a taxable homeowners association for the year ended April 30,
20XX. As such, the organization may make an election in the year ended April 30, 20XX and all
subsequent years when filing the Form 1120, to instead file the Form 1120-H if they continue to qualify. In
the year ended April 30, 20XX, the organization would be assessed $ in income tax.

In the year ended April 30, 20XX, the organization does not qualify for exemption under either IRC §
501(c)(4) or § 528. As such, they must file Form 1120 for the year in question. The tax to be assessed in
the prior year would be $.

Treatment under IRC § 528 is an election made every year upon the filing of the tax return. An organization

may qualify for exemption in one year but not the next due to unusual income. As such, the total tax to be
assessed against the organization is $.

ALTERNATIVE POSITON:

In the alternative, if the organization continues to qualify for exemption under IRC § 501(c)(4), should the
income from logging truck using the road received by the organization in the year ended April 30, 20XX be
considered unrelated businesses income under IRC § 511.

ISSUES:

1. Is the revenue received from the logging company related to the exempt purpose of the
   organization?

2. If not, what expenses may be allocated to the unrelated business income?

3. What is the total unrelated business income tax due?

Form 886-A (1-1994) Catalog Number 20810W Page 15 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS
(Rev. January 1994)

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX
FACTS:

On September 20, 20XX, a Letter 3611 and Publication 1, Your Rights as a Taxpayer, and a Form 4564,
Information Document Request (IDR) were issued to notify the organization of an examination of the Form
990, Return of Organization Exempt From Income Tax, for the year ended April 31, 20XX. The initial
appointment was held November 5, 20XX at the Power of Attorney’s Office. Treasurer, the Treasurer, and
POA, POA, were present on behalf of the organization. The following is a summary of the relevant points
of the initial interview in relation to the income from the Logging activity. |

How commonly does the organization receive income from logging?

This happens once every 100 years or so and was not for the sale of lumber but instead was
compensation for use of the roads. The organization was paid $ as well as the lumber company fixing
any damage done to the roads. Per the treasurer, the money was used to pay for flood damage and
the class action lawsuit.

For what reason was the organization property logged?

The logging was happening on the land on the other side of the property and the logging company had
an easement across the organization in order to reach their property.

Per further discussion, it was noted that the logging company owned property within the organization and
paid a total of $$ as a “special assessment” for the use of the roads by the logging trucks. The area being
logged is behind the area owned by the organization. The logging activity was in process from October
20XX through April 20XX, a total of 26 weeks.

Per the Information Document Request (IDR) response dated January 4, 20XX, the organization noted two
expenses which could be directly related to the existence of logging trucks on the roads. These expenses
as shown below are for lumber and repairs on a bridge within the organization. The expenses were
incurred in the next fiscal year, ten months after the end of the logging activity.

Date Payee Amount
11/18/20XX CO-4 $$
11/23/20XX CO-5 $$

Per IDR response, there are a total of 405 property owners in the organization. Of these 160 are
permanent residents who are likely to drive the roads an average of twice a day, once as they leave and
once when they return.

The remaining 245 property owners are non residents and more likely to use the roads on a more
intermittent basis. On average, they may drive the roads twice per time in residence. Per the ORG, it is
likely that the rion-residents used the facility an average of 7 times during the six months that the logging
company was using the roads.

Per ORG, “A large logging truck does much more damage to a road than a passenger car or pickup truck.
For purposes of this analysis, it is assumed that a logging truck does twice as much damage as a
passenger car or pickup truck.”

Form 886-A (1-1994) Catalog Number 20810W Page 16 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

ORG spent a total of $$ on road maintenance during the year ended April 30, 20XX.

ORG did not file a Form 990-T for the period in question.

LAW:

IRC § 512(a)(1) provides that the term “unrelated business taxable income” means the gross income
derived by any organization from any unrelated trade or business regularly carried on by it, less the
deductions which are directly connected with the carrying on of such trade or business.

Treasury Regulations (Regulations) §1.512(a)-1(a) defines “unrelated business taxable income” as the
gross income derived from any unrelated trade or business regularly carried on, less those deductions
allowed by chapter 1 of the Code which are directly connected with the carrying on of such trade or
business, subject to certain modifications referred to in §1.512(b)-1. To be deductible in computing
unrelated business taxable income, therefore, expenses, depreciation, and similar items not only must
qualify as deductions allowed by chapter 1 of the Code, but also must be directly connected with the
carrying on of unrelated trade or business. Except as provided in paragraph (d)(2) of this section, to be
“directly connected with” the conduct of unrelated business for purposes of section 512, an item of
deduction must have proximate and primary relationship to the carrying on of that business. In the case of
an organization which derives gross income from the regular conduct of two or more unrelated business
activities, unrelated business taxable income is the aggregate of gross income from all such unrelated
business activities less the aggregate of the deductions allowed with respect to all such unrelated business
activities. For the treatment of amounts of income or loss of common trust funds, see §1.584-2(c)(3).

Regulations §1.512(a)-1(b) defines expenses, depreciation, and other similar items that are attributable
solely to the conduct of unrelated business activities as those which are proximately and primarily related to
that business activity. Such expenses qualify for deduction to the extent that they meet the requirements of
IRC §162, IRC §167, or other relevant section of the Internal Revenue Code. Thus, the wages of personnel
employed full-time in carrying on unrelated business activates are directly connected with the conduct of
said activity and are deductable in computing unrelated business taxable income if they otherwise qualify
under the requirements of IRC §162.

Regulations §1.512(a)-1(c) provides that when facilities or personnel are used for both exempt activities
and the conduct of an unrelated trade or business, expenses, depreciation, and similar items shall be
allocated between the two activities on a reasonable basis. The portion of any such item so allocated to the
unrelated trade or business is proximately and primarily related to that business activity and shall be

allowable as a deduction in computing unrelated business taxable income to the extent provided by IRC
§162, IRC§ 167, or other relevant Code section.

TAXPAYER’S POSITION:
The taxpayer’s position is unknown at this time.
GOVERNMENT’S POSITION:

ISSUE #1

Form 886-A (1-1994) Catalog Number 20810W Page 1 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

——

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX
Is the revenue received from the logging company related to the exempt purpose of the
organization?

The income received from the logging company is not related to the exempt purpose of the organization.

Per the Bylaws of the organization, the organization is organized “acquire, maintain and conduct building
and property and activities for a community life and center at the ORG as above described, to engage in
educational and recreational facilities for members; to acquire other property and construct buildings fur
such proposes; to foster and promote good citizenship among is members; to promote and foster
educational, recreational; physical and social activities of its members and their friends; to engage in such
activities as shall fraise the standards of civic morality and community welfare.” As such, the organizations
purpose is to conduct activities which support the community as a whole rather than provide a specific
benefit. To support this purpose the organization may impose annual or special assessments for road
maintenance.

The fundamental difference between a special assessment for road maintenance and the “special
assessment” made against the logging company is in the purpose for which it is assessed. A valid special
assessment would be assessed against the entire property owner community or a distinct portion of such
community in order to pay for an unusual repair, such as the replacement of a culvert or to fix the damage
from a flood. In comparison, the “special assessment” made against the logging company was not made in
response to the need for an unusual repair, nor was it an assessment that was paid by any distinct portion
of the community. The assessment was instead a payment for use of the road by an outside party to
alleviate some of the cost of maintaining the road as well as paying for any additional costs associated with
increased traffic.

As such, the $$ paid by the logging company was a payment for use rather than a valid assessment and is
therefore unrelated to the exempt purpose of a IRC § 501(c)(4) homeowner's organization.

ISSUE # 2
If not, what expenses may be allocated to the unrelated business income?

Per IRC § 512(a)(1), the organization may deduct only those expenses which are directly related to the
production of the unrelated business income.

The organization identified the following transactions as directly related to damage caused by the logging
trucks.

Date ee, Payee Amount
11/18/20XX~* CO-4 $$
11/23/20XX CO-5 $$

While these transactions are directly related to the unrelated business activity, they may not bee deducted
in the year ended April 30, 20XX as they were not incurred until the following year. However, these costs
are fully deductable in the following year as valid road maintenance expenses.

The organization may take deduction of a portion of the years total road maintenance expenses as
allocated to the unrelated business activity. Using a slightly modified version of the allocation method

Form 886-A (1-1994) Catalog Number 20810W Page _ 18 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Scheduie number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

provided by ORG, the road maintenance costs may be allocated using the estimated road use by logging
trucks shown below.

Estimated Road use by Logging Trucks

Trips made by logging trucks
Damage Severity Factor
Weighted Number of trips

Trips made by Property Owners
Total Trips made

Percentage of Trips made by logging Trucks %

The estimated number of trips made by logging trucks was calculated using the following calculation
method provided by ORG.

’ Estimateu number of Trips by Logging Trucks

Number of Trips per Day
Number of Days per Week

Number of Weeks
(October 20XX through April 20XX)
Estimated Trips Made

The explanation for the damage severity factor per ORG is as follows, “A large logging truck does much
more damage to a road than a passenger car or pickup truck. For purposes of this analysis, it is assumed
that a logging truck does twice as much damage as a passenger car or pickup truck.” The organization
used a damage severity factor of 3 to represent this increased damage. The agent disagrees with the
damage factor used by the organization as it would represent three times as much damage rather than
twice as much damage. As such, the agent has used 2 as the damage factor.

The estimated number of trips by property owners was calculated using the following calculation method
provided by ORG.

Estimated number of Trips by Property Owners

Number of Permanent residents
Permanent Resident trips per week
(Two per day)

Number of Weeks
Estimated Trips made

Form 886-A (1-1994) Catalog Number 20810W Page 19 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

Non Residents (seasonal, weekend)
Non Resident Trips (one in one out)

Average number of days used by
nonresidents during the time the logging
company was-also using the road

Estimated number of trips by property owners

In addition to the allocation factor shown above, the agent also allocated the portion of road maintenance
expenses that would have been incurred during the logging assuming that the maintenance expense was
incurred evenly over the course of the year. This calculation has been shown below.

Allocated Total Maintenance Expenses

Total Road Maintenance Expenses
Weeks per Year

Weeks used by Logging Company
Total Maintenance Costs during Logging

This maintenance cost figure is then multiplied by the estimated use by logging trucks to calculation the
total maintenance expense allocable to the logging activity as shown below.

Total Maintenance Costs during Logging
Percentage of use by logging trucks
Total Allocable Expenses

Given the above calculation the organization may deduct a total of $ from the income received from the
logging trucks using the roads.

ISSUE # 3

What is the total unrelated business income tax due?
Per the calculations shown in Issue #1 and 2, the organization owes $ in unrelated business income tax.
This figure has been calculated as follows: Unrelated business income tax is a % tax on the unrelated

income less any directly related expenses.

Allocation of Income and Expenses from the Logging Company
Unrelated Business Income Tax

Total Income from Logging Operations

Allocated Maintenance Expenses

Form 886-A (1-1994) Catalog Number 20810W Page 20 _publish.no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
ORG EIN 04/30/20XX -
04/30/20XX

Net Income from Logging Operations
UBI Tax Rate
Total Unrelated Business Income Tax

CONCLUSION:

ORG allowed a logging company to use their roads for a fee. As this transaction is not typical of
organizations defined under IRC § 501(c)(4) it is considered to be unrelated to the exempt purpose of the
organization and is therefore subject to Unrelated Business Income Tax In this case the total tax due was
calculated at $ for the transaction in question.

Form 886-A (1-1994) Catalog Number 20810W Page 21 publish.no.irs.gov Department of the Treasury-Internal Revenue Service