An IRS audit can be both a nuisance and a financial setback for a homeowner association. But HOAs often set themselves up for scrutiny due to sloppy books and record keeping. The best way to avoid an audit is to play Boy Scout and be prepared. Here's how:

HOAs may file taxes using either a Form1120-H (designed for HOAs and carries a taxrate of 30 percent) or Form 1120 (designed for corporations and carries a taxrate of 15-39 percent). The form issue becomes more relevant depending how the HOA deals with operating funds that otherwise might be taxable income, such as a cash settlement from a construction defect lawsuit.

IRS Revenue Ruling 70-604 allows an HOA to exclude excess membership income from taxation by returning the excess to its members. The HOA can make an annual election to return the excess either by refunding the excess to the members or applying it to the next year's homeowner fees. Documenting the HOA's specific action is essential. If the IRS can find no written record of the roll over election by the HOA members (not the board) made prior to the filing of the year's tax return, they may conclude that the funds are fully taxable. So, every HOA that has excess taxable funds should adopt a resolution at the annual meeting.

Using the 1120-H method is easy and poses little risk of an audit. The HOA simply refunds each unit owner's share of the excess membership income. However, using 1120 to report the roll over of excess funds from one year to the next is especially prone to IRS inquiries. The HOA should make sure that the amount rolled over is absorbed in the following year. In some cases, the HOA may treat part of it as a contribution to reserves. To do so, it must meet the following criteria:

• The financial records must delineate between operating and capital reserve activities.

• The Reserve Study supports the need for capital improvements.

• Cash accounts for operating and reserves are kept separate.

• Tax returns clearly distinguish reserve from operating transactions.

If you report interest income on the HOA's tax return, assume the IRS will be keenly interested in what expenses were allocated against it, and in other nonexempt or nonmember income to lower the taxes due. The IRS demands thorough records to substantiate expense allocation against various types of income. Consider an HOA with that, say, rents out the clubhouse to nonmembers for a fee. The IRS will require that these HOAs explain the basis for expense allocations (like, hours of janitorial services).

IRS Audits will review the following:

• Copies of prior year tax returns.

• Financial books including general ledger, cash receipts, and cash disbursements.

• Minutes of annual and board meetings.

• Copies of excess income elections passed by the membership.

• Copies of annual budgets.

• Copies of account statements holding reserve funds.

• Invoices and canceled checks to support expense deductions.

When selecting a property manager or accountants, make sure they are familiar with applicable IRS rules which are continuously evolving. Your property manager needs to know how to allocate various expenses so your HOA can properly compute its taxable income and file the return.

Reduce the chance of an audit:

1. Review the return closely for errors and check all calculations carefully.

2. Include the Employer Identification Number (EIN).

3. File on time, even if you can't pay the tax.

4. Use the correct tax rates. Form 1120-H is a flat tax rate of 30 percent. Form 1120 has a graduated tax rate ranging from 15 to 39 percent.

5. File a complete tax return and attach forms, schedules, supporting statements and explanations.

6. File all related tax forms like W-2, W-3, 1096, and 1099-MISC. Every HOA must file Form 1099-M1SC if it pays rents, commissions, or non-employee compensation of $600 or more to a person or partnership during the calendar year.

7. Pay taxes owed on time. Mail the payment with Form 8109 to a qualified depository.

8. Sign the return. The tax return must be signed and dated by the president or officer authorized to sign. The paid preparer must complete the required preparer information and sign the return in the space provided.

9. List your current address. If you've changed mailing addresses, check the "change of address" box.

10. Reply promptly to IRS inquiries.

11. Keep a copy of all tax returns and attachments for ten years.

If the IRS audits your HOA:

Leave adequate time to prepare. Scrutinize the audit notice to determine the various financial records that will be needed for the review process. Usually the IRS will reschedule to a more convenient time if you ask them to do so.

Hire an accountant to handle the audit. Those who prepared the tax return are most familiar with the return under review, and usually have prior experience with IRS audits.

Provide complete records to the accountant. The sooner the accountant receives the records, the better.

So there you have it. Boy scouts are drilled in the discipline of preparedness because one never knows what the future will bring. But those that are prepared generally can avoid the avoidable and IRS audits usually fall into this category. Those that pass this test qualify for the Audit Avoidance Merit Badge.