To be, or not to be [taxed]?
That is the question.
It appears that William Shakespeare had been posing the same question that treasurers and other board members of New York co-ops have been asking their accountants for the past five years.
As corporations, residential co-ops are required to pay corporate income tax, making yearly filings on Internal Revenue Service Form 1120. Generally speaking, the income of a cooperative housing corporation includes the maintenance charges collected from shareholders, interest earned on reserve funds and escrow accounts, income from the laundry room and other commercial tenants, and so on. Of course, to the extent that any of the foregoing is tax exempt or characterized as a capital contribution (maintenance pay-ments used for capital improvements such as new windows, new boiler, new roof, etc.), it will not be deemed as income subject to taxation.
Just like any other corporate taxpayer, a cooperative housing corporation may deduct allowable expenses to offset its income, such as real estate taxes, interest expense on indebtedness, professional fees, management fees, insurance costs, payroll expenses, repairs, supplies, etc. In addition, a co-op may deduct depreciation on the building. Since maintenance fees are based on the annual cash needs of the building, most co-ops will end their year with no net income or a loss.
The Controversy
In 1990, the IRS issued Revenue Ruling 90-36 which held that Section 277 of the Internal Revenue Code applied to cooperative housing corporations that can pass through real estate tax and mortgage interest deductions to their shareholders. (Known as Section 216 co-ops, most housing co-ops in the New York area fall into this category.) Section 277 of the Code provides that a social club or other membership organization that is operated primarily to furnish services or goods to members and is not exempt from taxation may deduct expenses attributable to furnishing services, insurance, goods or other items of value to members only to the extent of income derived during such year from members or transactions with members...
To the extent that deductions are disallowed under this section they are deferred to a subsequent year during which membership income will be sufficient to absorb the deduction. In effect, this revenue ruling meant that housing cooperatives could no longer offset ordinary operating losses and depreciation against non-member income, including interest income, commercial rents, laundry income, etc. Of course, the effect was to immediately increase the corporate tax burden of housing cooperatives.
As a result of tax assessments made pursuant to Revenue Ruling 90-36, several co-ops decided to challenge the Internal Revenue Service. Trump Village III, a 1400-unit Brooklyn co-op, was among the first.
The Rationale
The IRS takes the position that Congress enacted Section 277 to prevent membership organizations from escaping tax on business or investment income by using this income to serve its members at less than cost and then deducting this book loss. They claim that wealthy country clubs were using profits derived from providing facilities to non-members (i.e., weddings, outings, etc.) to offset losses for services and food provided to the club ffb 's members.
The cooperative housing community has taken the position that it was never the intent of Congress to have Section 277 apply to residential cooperatives. Specifically, the statute only speaks of social clubs and membership organizations. Moreover, long before the enactment of Section 277, the legislature had enacted Section 216 which provided that tenant/shareholders were to be treated on par with single family home owners. To enforce Section 277 of the Code against residential cooperatives would effectively negate the parity between tenant/shareholders and home owners originally intended by Congress, and would subject tenant/shareholders to a form of double taxation. It is further claimed that the intent of Section 216 clearly takes precedence over the less specific mandates of Section 277.
The Issues Raised
In 1988, Richard Siegler, a partner with Stroock & Stroock & Lavan, filed the challenge against the IRS on behalf of Trump Village III and in August 1989, the case went to trial. In the suit, the co-op raised several issues. They asserted that they were neither a social club nor a membership organization within the meaning of the Internal Revenue Code. The co-op also argued that they had stockholders, not members and that they charged rent not membership fees. Interest income, laundry income, garage income, etc., should be classified as membership income in that it was generated by transactions which actually facilitated the accom-plishment of the co-op's activities in providing housing accommodations for its members, the challenge stated. Limited equity Mitchell-Lama co-ops, such as Trump Village, claimed to be exempt from the application of Section 277, on the grounds that they are governed by the provisions of Subchapter T which pre-empts the application of the more general rule of Section 277. Simply put, Subchapter T does not contain the Code Section 277 prohibition against the set-off of non-membership income by member related operating losses. Instead, a more favorable rule prevails which permits all income generated from activities designed to accomplish the cooperative purpose to be treated uniformly. Accordingly, operating membership losses could be offset against interest and other income derived from activities designed to primarily facilitate the cooperative purpose.
The Trump Village Decision
On June 22, 1995, after almost six years of deliberation, the United States Tax Court rendered its decision in Trump Village Section III, Inc. v. Commissioner of Internal Revenue. In rendering his decision, Judge Laurence Whalen found that Trump Village III, a limited equity Mitchell-Lama housing cooperative, was not subject to the application of Section 277 of the Code and therefore did not have to pay tax upon the interest income earned from its reserve and escrow accounts.
Disappointingly, however, the decision, as rendered, has very narrow applicability to the co-op community as a whole. Although Trump Village had raised all of the general co-op arguments in fending off their tax liability, Judge Whalen, in his decision, seized upon the one argument that was unique to the limited equity Mitchell-Lama co-ops. Specifically, the Court held that Trump Village was a cooperative subject to Subchapter T and therefore was not subject to the restrictions of Section 277
One of the Court's operative distinctions which caused Trump Village to be classified under Subchapter T, as opposed to Section 277, was that each member has one vote and one vote only to consider and resolve problems affecting the conduct of the cooperative. The rule of one man, one vote, is contrary to a market rate co-op wherein each shareholder has one vote for each share of stock owned in the corporation.
The Continuing Saga
Some co-ops have filed under Section 277 and paid their tax under protest. Others have filed but refused to pay. Others have simply ignored the issue. They sit with the sword of Damocles suspended immediately over their financial heads. It was hoped that Trump Vill d6e age would finally resolve the issue of how to treat income derived from sources other than shareholders.
The issue must be resolved shortly, as there are half a dozen other co-ops that have brought suits against the IRS and whose cases are still pending. Siegler's firm is already representing two other Manhattan co-ops, The Dakota and Stewart House, which are awaiting final decisions. A resolution can be accomplished in one of several ways. The Tax Court may resolve the issue by deciding one of the several market rate co-op cases which are backed up behind the Trump Village case. Congress can ultimately pass, and the President sign, a bill clarifying Section 277 of the Code to explicitly exempt cooperative housing corporations from its purview. [In 1992 Senator Moynahan was the sponsor of a bill which specifically exempted housing cooperatives from the effects of Section 277. The bill was vetoed by then President Bush].
Whether the 277 issue is solved by the legislature or by the Tax Court, it is hoped that action is taken swiftly so that the issues at hand can be clarified and the cooperative housing community and their professionals can direct their attention to other matters.
Mr. Braverman is senior partner of Braverman & Associates P.C., a Manhattan law firm specializing in cooperative and condominium housing law.
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