By Nick Haralambopoulos
One of the most important planning tools for an Association is its annual budget. It is important that the Association’s budget be as complete and accurate as possible so the Board is able to monitor the Association’s financial status and set maintenance assessments at an appropriate level. Usually an Association’s operations will generate a surplus or a deficit. Therefore, when discussing surpluses, deficits and working capital, it is important to use the Association’s budget as a frame of reference.
Accordingly, each year the Board should evaluate and understand the underlying causes that create either a deficit or surplus. Understanding and identifying the variances in the budget that lead to a deficit or surplus will better help the Board mitigate these variances in the future and help to create a more accurate budget in subsequent years. It is important to note that some deficits or surpluses are planned for in the budget. (Note: This article focuses on the Operating Fund’s surpluses and deficits - rather than the Deferred Maintenance or Replacement Funds.)
The long established practice in CIRA budgeting is that an Association needs to fund the peaks and valleys in its cash flow; typically, this is through the use of working capital. Each Association should determine what a reasonable balance is to maintain based on its operating needs and if necessary, start to accumulate an amount as an operating reserve. Having a reasonable amount of working capital funds on hand will help to keep the Association financially strong and enable them to have the cash available to meet unanticipated operating expenses. Working Capital is typically funded by Working Capital Fund contributions, Accumulated Surpluses or a combination of both. Below is a list of common reasons why Associations require working capital:
- To be more liquid - accumulating funds to pay vendors on a timely basis.
- To provide a “buffer” against the potential for adverse impacts of the seasonal nature of cash flows or expenses (i.e. large insurance bill)
- To fund unanticipated large expenses (i.e. excessive snow clearing, etc.)
Role of Working Capital Funds
It is crucial that Board Members understand the permitted uses of working capital as outlined in the Association’s governing documents. It is generally not advised to use working capital to offset an operating deficit. This strategy is generally not in the best long-term financial interest of the Association. Later, this article will discuss some of the various approaches to reduce and/or eliminate a deficit. As mentioned earlier, the Board should ultimately determine what a reasonable working capital balance is to maintain based on their operating needs. The use of accumulated working capital funds in excess of the Association’s operating needs should be dictated by the Association’s governing documents and it is recommended that the Association consult with their attorney to review their policies and governing documents to ensure they are in compliance.
Approaches to Deficit Reduction/Elimination
The first thing a Board must do in addressing a deficit is to understand what caused the deficit. The Board should analyze the budget to actual comparison of operating expenses at the end of the year to identify the line items where actual costs exceeded the budgeted amount. The Board can determine if this was a onetime variance or if the budgeted line item needs to be readdressed and/or increased (or decreased) in subsequent years. This can help the Board prevent a recurrence of the deficit while considering approaches to reduce or eliminate it, which include:
- Budgeting for a surplus in the subsequent year. This will help to extinguish the current year’s deficit and bring the Association’s operating equity to a breakeven point. If the deficit is significant, the Board should consider creating a multi-year plan to reflect annual budgeted surpluses to address the deficit. The Board should also ensure that no additions to the deficit are incurred.
- Considering passing a special assessment. This may be appropriate for unusual circumstances, such as severe winters with substantially greater than average snowfall or unexpected storm damage costs which may not be covered under the Association’s insurance policies.
- Whichever approach the Board uses, they should solve the budget issue which created the deficit, while also implementing a plan to eliminate it. This will allow the Association to maintain membership assessments at a level to support the monthly expenditures.
Opportunities Created by a Surplus
- One possibility for the use of an accumulated surplus is to return it to the unit owners. This approach may not be in the best long-term financial interest of the Association. If the surplus is consistent with the forecasted budget, then the Board should use the surplus in the manner anticipated by the budget. Other approaches include choosing to:
- Spread the surplus out over several years to mitigate otherwise necessary maintenance fee increases by including a portion in the subsequent year’s budget.
- Include the surplus in the subsequent year budget as an allocation to another fund, such as the replacement or deferred maintenance fund. For the replacement fund, this can help fund contributions to the replacement fund to be in line with the engineer’s recommended funding.
- Utilizing the surplus for special projects that may be needed.
Tax Implications of Surpluses and Deficits
A detailed discussion of the tax implications of surpluses and deficits is beyond the scope of this article. A key tax issue relates to whether the Association files a Form 1120 or a Form 1120H, which is based on an annual election and meeting certain criteria. Associations that file a Form 1120 must be cognizant of the appropriate treatment of a surplus to ensure compliance with IRS regulations. In most cases, when a surplus exists, that Association should consider filing an 1120H. It is strongly recommended that individual Associations consult with their tax advisors for guidance related to their own specific situation.
As mentioned previously, one of the most important planning tools the Association has is their annual budget. It is essential that the Association’s Board monitor their actual expenses as compared to the budget and understand the reason behind what caused any surplus or deficit. If a surplus or deficit exists, the Board should address this through a careful budgeting process. An important corollary is to “know your documents.” They often contain important guidelines for the use of working capital.
If you have any questions regarding the above material, please contact your Wilkin & Guttenplan advisor.