Spring 2017 CPA Newsletter
Volume 33 Issue 2
By Jordan Burkhalter, CPA
The operating surplus is an area of an Association’s financial statements that is often misunderstood and can generate a lot of questions from Board Members. Most Board Members think “the bigger the surplus, the better the Association is doing financially,” especially when the Association begins to accumulate an operating surplus. However, it is important to know that while having an operating surplus is a good situation to be in, there are certain negative aspects to consider as well. In this article, I will explain the importance of having an operating surplus, the implications it presents, and ways to utilize operating surpluses for the betterment of the Association.
What is an Operating Reserve?
It is not practical to believe that any Association will run at a breakeven point throughout the course of an entire year. Even the most thorough budgets and knowledgeable Boards have
cyclical expenses, and may experience an unforeseen emergency that will require immediate attention. Therefore, having an accumulated operating surplus as an operating reserve will allow the Association to pay for expenses over the budgeted amount as they arise throughout the year. The first thing a Board must do with respect to a surplus is estimate a reasonable balance to maintain as an operating reserve, based on the Association’s projected operating needs.
Having a surplus in the operating fund provides the Board the luxury of being able to manage cash flow requirements throughout the ebbs and flows of expenses during the year. Not all operating expenses are incurred evenly throughout the year the way that janitorial or management services are; take, for example, snow clearing and insurance. Snow removal services are often very large expenses incurred over a short period of time. Additionally, insurance policies often require a large down payment at the beginning of the policy period. The existence of an operating reserve allows the Board to have the funds available to pay for these expenses, even though they may exceed the amount of maintenance assessments collected over the same period of time.
There is also the possibility of unforeseen maintenance issues that require prompt attention. This may include repairing unanticipated roof leaks after a bad storm or repairing a water main break. Having an operating reserve will help keep the Association financially strong and enable them to have the cash available to pay for these unanticipated expenses as they arise.
You are probably thinking “How do I know what a reasonable operating surplus is? How much is too much?” These are excellent questions but unfortunately, there is no one-size-fits-all answer. Each Association is different and may require a different threshold for their operating surplus. A good guideline for Boards to use for maintaining an operating surplus is to base the amount on a reasonable percentage of current operating maintenance assessments. This amount can always be adjusted, based on the Association’s actual needs.
Implications of an Excessive Operating Surplus
If you find yourself in the situation where the Association’s operating reserve is continuously growing year after year as a result of large surpluses, you will have to consider the implications this will have on the Association. Associations collect maintenance assessments based on the “pay as you go” philosophy. This means that unit owners pay their monthly fees with the
expectation it will fund operating expenses that benefit the Association during the time that they live there. With the existence of a large surplus, the monthly fees paid today will theoretically be funding future operating expenses, and current operating expenses are covered by maintenance assessments collected in a prior year. This way of funding is contradictory to the pay as you go philosophy, as current unit owners are paying for future expenses in advance. If this occurs, you may also have a unit owner thinking “are the Association’s maintenance assessment fees I am paying set too high?” To the unit owner, the fee they are paying should not be accumulating to fund future operating costs.
While current versus future operating expenses are important to think about, tax implications of an operating surplus are the most important factor of all. Associations are classified as corporations that are subject to tax on income. If the Association accumulates an operating surplus, that surplus must be deferred to future years so that is not considered taxable income for the current year. Associations have the option to file two different tax forms – Form 1120 or Form 1120-H. Associations that file a Form 1120 and have an operating surplus must be take appropriate steps and actions to defer an operating surplus. The IRS provides guidance as to these steps. If the surplus is not deferred following the guidance as detailed by the IRS, the IRS may deem that the operating surplus should be included as revenue and result in taxable income. For some Associations, this surplus can be rather large and result in a hefty tax bill.
An alternative filing method for Associations with large operating surpluses is to file as a Condominium and/or Homeowner Association using the tax Form 1120-H. This tax filing method makes no reference to the existence of an operating surplus, nor does it track operating surpluses. An alternative filing method for Associations with large operating surpluses is to file as a Condominium and/or Homeowner Association using the tax Form 1120-H. This tax filing method makes no reference to the existence of an operating surplus, nor does it track operating surpluses. While the tax rate under this filing option is higher than under Form 1120, this option will shelter operating surpluses from possible taxation. However, there are very specific requirements that must be met to be able to file Form 1120-H, so it is strongly recommended that individual Associations consult with their tax advisors for guidance related to which form to file for their particular Association.
How to Utilize an Operating Surplus
While there are some negative implications of having an operating surplus, this is still considered to be a relatively good “problem” to have. There are several actions a Board can take to utilize an operating surplus which will have a positive impact on the Association.
One possible use of an accumulated surplus is to return it to the unit owners. However, this approach may not be in the best long-term financial interest of the Association. We all know that expenses usually only go one way, and that is up. Rising expenses can only mean one of two things for an Association– increased maintenance assessments or a special assessment. A better solution to utilize an accumulated surplus would be to include the surplus as revenue in the operating fund in future year’s budget. By spreading out the inclusion of the operating surplus over a few years, it will mitigate any otherwise necessary increases in maintenance assessments to cover the rising costs of expenses. Another option to reduce an Association’s operating surplus is to include the surplus in the subsequent year’s budget as an allocation to the replacement fund. This is a great opportunity to help increase replacement fund contributions to be in line with the engineer’s recommended funding, or increase the fund balance to be in line with the engineer’s estimated replacement fund balance. It is important that these additional contributions are included in the budget to ensure that the Association is following industry guidelines based on interpretations of the sections of the Internal Revenue Code, which serve as a basis for classifying replacement fund contributions as capital contributions, therefore excluding them from being considered taxable income.
Finally, the Association can utilize the surplus for any special projects that may have been delayed over the last few years. A special project may even be capital replacement projects that are included in the Association’s reserve study. Industry guidelines only prohibit the use of replacement funds for operating expenses, not the other way around. The Board may also utilize the operating surplus to fund an enhancement that is not included in the reserve study. For example, perhaps the Board has been contemplating installing solar panels on the roof of the clubhouse. The Board, per industry guidelines, may not use replacement fund monies since the solar panels were not included as a replacement item in the Association’s current reserve study and therefore not reserved for over the years. This can be a great opportunity for the Board to not only utilize the operating surplus, but to enhance the community when the funds are available without the need to increase maintenance assessments or pass a special assessment. If this is the route the Board takes, however, it is extremely important to remember to make sure the new enhancements are included in the Association’s next reserve study update.
Operating surpluses, although they do come with their fair share of nuances, are a good “problem” for an Association to have, considering the alternative of the operating fund running with a deficit. The Board should be aware of the different challenges and opportunities that an operating surplus may pose to the Association. The operating surplus should be monitored closely and managed properly so that it does not balloon into an extremely large amount that may become difficult to manage. As each Association is in a different situation, it is prudent for Board Members to be aware of the options available when creating and utilizing an operating surplus, while also understanding the various implications that an operating surplus may have.