IRS' new math adds up to nasty tax surprise.

Nestled for 23 years in the obscurity of the Internal Revenue Code, a little-known provision enacted by Congress in 1969 now threatens to wreak financial havoc with cooperative housing corporations.

Section 277 of the Internal Revenue Code was enacted specifically to be applied to: " ... social clubs or other membership organizations which are operated primarily to provide services or goods to members and which are not exempt from taxation ... "

Most cooperative housing corporations have stockholders, not members, and they rent housing, rather than furnishing goods or services. So until 1985 it was generally assumed that Section 277 did not apply to their operations.

In 1985, however, the Internal Revenue Service by a private letter ruling took the position that Section 277 does indeed apply to cooperative housing. To make matters worse, the IRS is now enforcing its position, in many cases levying additional taxes along with penalties and interest.

The New Interpretation

By and large, cooperative tax accounting adds together income from all sources, including shareholders' rent (maintenance); income from investments on reserve and contingency funds; and rental income from stores or professional apartments. The sum of that income is reduced for tax purposes by the cooperative's deductible expenses, such as real estate taxes, fuel, repairs and maintenance, interest on debt and depreciation.

Since these deductions usually exceeded income (particularly after depreciation), most cooperatives ended their fiscal years without having to pay Federal income taxes.

Applying Section 277 to cooperative housing operations, however, creates a significantly different picture.

The IRS argues that under Section 277, a cooperative's income must be classified into: (1) Income derived from membership (its stockholders), and (2) Non-member income - revenue from all other sources (commercial rentals, investment interest and so on).

Having classified these forms of income separately, the IRS further goes on to require that the expenses of a cooperative, including depreciation, be similarly separated into those attributable to the revenue obtained from members versus that from non-members.

This leads to the central point of the new interpretation: The IRS will now allow deductions on non-member income only on expenses specifically related to the production of that income.

The end result: Cooperative housing corporations, many of which went for years without facing Federal income taxation, now can be taxed on non-member income which exceeds non-member expenses. A cooperative with substantial non-member income, now suddenly faced with such a bill, obviously would have to increase maintenance fees to defray this unanticipated tax expense.

A number of New York cooperatives have had or are having their past tax records audited based on this new IRS interpretation of Section 277. Several have received statements of adjustment stating that they now owe more income taxes for these years - along with interest and penalties on the unpaid sums IRS agents now claim!

Seeking Legislative Relief

Several cooperatives are protesting these new rulings, either through administrative proceedings before the IRS, or through lawsuits focusing on the Section 277 interpretation.

Various attempts also were made in the session just ended to obtain Congressional relief from the harsh application of Section 277 to housing cooperatives.

New York Senator Daniel Moynihan and several co-sponsors in the House had enacted an amendment to a tax bill that would offer prospective relief from some of the devastating effects of applying Section 277 against low- to moderate-income housing cooperatives. But the bill including the Moynihan amendment was vetoed by President Bush for reasons relating to other measures contained in the overall legislation.

Another tax bill carrying such an amendment was narrowly approved by the House and passed easily by the Senate before its adjournment Oct. 8. But again, it appeared almost certain that this omnibus bill would be headed for a Presidential veto because of numerous other tax revisions it contains that are in hot dispute this election year.

Republican Senator Robert Dole has suggested the embattled bill be stripped down to crucial essentials such as real estate relief and the low-income housing tax credit, but bipartisan agreement on such a move seems unlikely.

But while the outlook for help seems bleak right now, it is important to continue lobbying and informational efforts. New York cooperatives, numbering as they do the largest group of housing cooperatives in the nation, would do well in their own self-interest to press for remedial legislation - or someday have to hike maintenance fees sharply to meet an unexpected income tax liability.