We do not give legal advice in this form. You may which to consult with the tax attorney that represents the HOA, or with your own tax attorney for that matter so that you can make an informed decision.

Our HOA is currently making this election (which apparently has to be done each year).  I’ve read that there’s no downside risk whether you vote to have the excess membership applied to next years assessment or to have the funds refunded.  

But the real problem or concern should be what happens to the HOA’s reserves and its ability to make improvements and repairs to property that doesn’t need annual repairs but on a longer term basis, i.e. pool repairs, fences, painting, if they either refund the excess membership income or apply the excess to next years assessments.  That may reduce the reserves for future repairs.  I’m not familiar with all the HOA requirements and how they accounted for the assets in the beginning.  Also, your HOA can file Form 1120H rather than the 1120, but haven’t determined the difference yet, still researching.

There is the 3rd option to pay the tax and keep the funds in the HOA.  

The 70-604 election is an effective tax planning tool for condo and homeowner associations, if done correctly. It should not be used broadly as a way to fund reserves, even though one might reason that it is easy to simply take the excess of membership income over membership expenses for the year and contribute it to the reserve funds. That would violate the intent of the assessment. Reserve assessments should be separate from operating assessments. The 70-604 election only applies to excess operating income. It allows the association to effectively refund the excess and then turn around and re-assess it as part of the following year's operating assessment.