[Excerpted from “Audit Proofing a Schedule C”, by Sharon Kreider, EA, CPA]
A Taxpayer May Work out of His or Her Home
A new nontraditional trend in
the business community finds many taxpayers working out of their personal
residences. When a portion of a home is used for business purposes, a percentage
of the total housing costs of these normally nondeductible personal expenses may
be deducted as business expenses by a taxpayer who is an individual.
But, there are limitations: As Congress feels it is necessary to prevent taxpayers
from misusing the office-in-home deduction, they passed a general limitation
that disallows all business deductions of
the taxpayer’s residence and then created narrow exceptions that requires
stringent "exclusive, regular and principal" rules to be followed
before this deduction is permitted.
Strict Office-in-home Rules Prevent Abuse
To deduct expenses related to
the business use of part of the home, the taxpayer must meet specific
requirements. Even then, the deduction may be limited. For home office expenses
to qualify for a deduction, the portion of the home that is used for business
must:
1. Be used exclusively, (however, exceptions exist)
2. On a regular
basis,
3. In connection with a trade
or business, AND
in one of the following ways:
4. As the principal
place of business for any of the
taxpayer’s trade or business; or
5. As a place of business for
meeting or dealing with patients, clients or customers in the ordinary course of
business, or
6. In connection with the
taxpayer’s trade or business if the taxpayer is using a separate structure
that is not attached to the dwelling (§280A(c)(1)).
The Exclusive Rule: The Room Must Be Exclusively Used for the Business
To qualify for business use of
the home deduction, there must be a specific room or area that is set aside and
used exclusively (no personal use,
including storage of personal items) on a regular basis as the principal place
of any business. The exclusive rule will be met only if there is no use of the
business portion of the dwelling unit at any time during the
year other than for qualified business purposes.
Example: Joan,
a real estate agent, also operates an advertising agency from her personal
residence. She may not make real estate
brokerage calls from her advertising agency home office.
Planning tip: Don't take work home. Work from one business (i.e., college professor
correcting student tests) brought home and taken into the office-in-home (that
was the sole office of the professor’s other business of being an actor)
taints the room as a non-exclusive, and therefore a nonbusiness room (A.W.
Hamacher v. Comm, 94 TC 348, No. 21,
Dec. 46, 444).
Operating Two or More Businesses Simultaneously out of
the Same Home Office
The judge in Hamacher
makes clear that two businesses may be exclusively
operated out of the same office-in-home. But each activity must satisfy all the statutory requirements. For
example, real estate brokers or businesspersons with a home office and a second
business as a property manager for managing property owned by themselves or
others may be able to deduct an
office-in-home.
Space Doesn’t Need to Be Marked by Permanent Partition
The mere absence of a wall,
partition, curtain, or the like does not negate this deduction but does raise
the level of inquiry by the IRS agent. Also, the act of walking through the home
office to another room is not a violation of this rule (§1.280A-2(g); Weightman, 42 TCM 104, 1981-301; §1.280A-2(g)(1); C.D.
Hughes, 41 TCM 1153, 1981-140).
Exclusive Use Rule Exceptions: Office-in-home Deduction
for Day Care and for Storage of Inventory and Product Samples
The exclusive use requirement
does not apply when the home is used for qualified day care of children, handicapped or the elderly (discussed later
under Day-Care Facilities), and to wholesale or
retail sellers regularly storing inventory or product samples in the
home (e.g., part-time Mary Kay or
Shaklee salespeople) [§28OA(c)(4); §28OA(c)(2); §1.280A-2(e)].
Rules when storing inventory or product samples: When part of the home is used for the storage of
inventory or product samples, the exclusive use test does not apply. However,
the home worker must meet all the following five tests:
1) The inventory or product
samples is kept for use in a trade or business.
2) The business is the selling
of products at wholesale or retail
3) The home is the only fixed
location of that trade or business.
4) The storage space is used on
a regular basis.
5) The storage space is separately identifiable space suitable for storage (§280A(c)(2)).
The Regular Use Test
Even though no home office case
specifically defines regular use, this test implies that the home office is
being used systematically throughout the year. Occasional or incidental business
use of the home office will not be sufficient even though the room met the
exclusivity requirement.
Trade or Business Use
To qualify under the trade or
business use test, the homeworker must use part of his or her home in connection
with a trade or business. If the home is used home for a profit-seeking activity
that is not a trade or business, a deduction for its business use cannot be
taken.
Warning: No "Passive Business" Offices. These rules makes personal investment activities (e.g.,
reading financial periodicals, clipping bond coupons, etc.) ineligible for
home-office deductions as they don't rise to the level of a "business"
activity (J.A. Moller,
CA-FC 83-2 USTC ¶9698, 721 F2d 810).
Meeting Patients, Clients or Customers at Home.
Even though the homeworker also
carries on business at another location, a deduction for home office will NOT be
denied when a taxpayer:
· in the
normal course of his or her business,
·
physically meets or deals with patients, clients, or customers in his or her home,
and
· their use
of the home is substantial and integral to the conduct of the business,
as long as the space is
used exclusively and regularly for this business activity (PR §1.280A-2(c)).
Comment: This
requirement may be easier to satisfy than the more demanding “principal place
of business” requirement!
The IRS emphasizes that this
“physically meets or deals” exception applies only when the taxpayer is
actually visited by clients or patients, and will not apply to a room where only
phone calls are received and occasional meetings are conducted (§280A(c)(1)(B);
J.W. Green, CA-9, 83-1 USTC ¶9387). Many commentators feel the word “deal” should
allow communicating with patients and clients through computers, e-mail and
faxes without the other parties being physically present in the home.
Separate Structures
This exception applies to the
freestanding structure apart from the taxpayer’s residence if such structure
is used exclusively and regularly in the taxpayer’s trade or business. To
qualify for the exception, it is not necessary that the taxpayer establish that
the structure is his or her principal place of business or that it is a place
where he or she meets patients, clients, or customers (§280A(c)(1)(C)).
Principal Place of Business
Prior to 1997, neither the
Internal Revenue Code nor congressional committee reports explained what was
meant by principal place of business and left it to the administrative and judicial branches
to define "principal place of business," which they did, much to
taxpayers chagrin in Commissioner v. Soliman, 113 S.Ct. 701 (1993); IRS Notice 93-12; and Rev. Rul.
94-24.
Applying the Principal Place of Business Test When the
Taxpayer Has Only One "Regular" Business Location
If a taxpayer has only one
place of business, this is considered the taxpayer's "regular" place
of business, a location deemed superior to a principal place of business.
IRS example: An author. Danny is a self-employed author who uses a home office to
write.
He spends 30 to 35 hours of his
work time per week writing in his home office. Danny also
spends another 10 to 15 hours
of his work time per week at other locations conducting research,
meeting with his publishers and
attending promotional events.
The essence of Danny's
trade or business as an author is writing. Danny's research, meetings with
publishers and attendance at promotional events, although essential, are less
important and take less time than his writing. Therefore, Danny's office in the
home is his principal place of business, and he can deduct expenses for the
business use of the home (Rev. Rul. 94-24; IRB 1994-15,5).
Home Office Definition Expanded
Applying the principal place of business test when
the taxpayer engages in business at multiple locations: To reverse the Soliman decision, Congress created a simple, two-step, test to
determine if the home office is the taxpayer’s principal place of business.
Starting in 1999, a home
office qualifies as the taxpayer’s “principal place of business”
if:
1.
Inside
Test: The home office is used by the taxpayer for the
administrative or management activities of any trade or business of the
taxpayer, and
2.
Outside
Test: There is no other fixed location of the trade or business
where the taxpayer
conducts substantial administrative or management activities of the trade
or business (new §280A(c)(1) flush language and effective for tax years after
December 31, 1998).
Tax planning: Many
taxpayers who have a second business conducted out of their home will be able to
deduct their traveling to and from their “home office” to their main office
(previously considered nondeductible commuting mileage) under this expanded
definition. This topic is discussed later in this appendix.
Caution - the regular, exclusive requirements still
valid. Of course, the home office
deduction is only allowed if the office is also exclusively used on a regular
basis as a place of business by the taxpayer (§280A(c)(1)).
Congressional examples are extraordinarily liberal. The House Committee Report provides the following
examples of the type of taxpayers who will be able to use this new expanded
definition of principal place of business. The home office is the “principal
place of business” if:
1.
the
administrative or management (A/M) activities performed by the taxpayer outside
the home is not substantial, even if some A/M activities are performed at an
outside fixed location and even if A/M activities (e.g., billing activities) are
performed by other people at other locations;
2.
substantial
non-administrative or nonmanagement activities is performed outside the home office by the taxpayer (e.g., taxpayer meets
with, or provides services to customers, clients, or patients at a fixed
location of the business away from the home office, such as outside
salespeople);
3.
substantial
administrative or management activities is not performed anywhere by
the taxpayer, as long as the home office is used for any A/M
activities regularly; even if:
4 Administrative or management
activities are performed at non-permanent locations by the taxpayer (e.g., in a
car or hotel room), in addition to performing those same activities in the home
office, or
5.
Some
administrative or management activities are performed outside the home at other
fixed location by the taxpayer, so long as the outside A/M are not substantial
(e.g., the taxpayer occasionally does minimal paperwork at another fixed
location of the business) [see Chairman’s Mark, Revenue Reconciliation Bill of
1997].
IRS Makes Accounting for Home Office Expenses Difficult
For the self-employed: The self-employed homeworker, when filing Schedule C
(Form 1040), must complete Line 30 titled "Expenses for Business Use of
Your Home (Attach Form 8829)."
Audit Point: The Form 8829 allows the IRS to identify taxpayers who
claim the home office deduction. Congress believes taxpayers are abusing the
office-in-home deduction and asked the IRS to analyze the potential misuse. The
IRS wants to determine if the taxpayer is complying with the home office
limitations and if the calculation is being done correctly.
Calculating the allowable home office expenses. Two types of expenses, direct and indirect, are deducted
on Form 8829 when the home is used for business purposes. Any other expenses,
such as salaries, supplies and business telephone expenses, are deductible
elsewhere on Schedule C and should not be entered on Form 8829.
Direct expenses. These expenses benefit only the actual office itself,
such as painting or repairs made to the specific area or room used for business.
All of these expenses (100 percent) are entered on the appropriate expense line
in column (a) of Form 8829.
Indirect expenses. These expenses are for keeping up and running the
entire home. They benefit both the business and personal parts of the home, such
as interest, taxes, roof repairs and utilities. Generally, 100 percent of these
expenses are entered on the appropriate expense line in column (b) of Form 8829,
totaled and deductible only to the extent of the business percentage.
Exception. If
the business percentage of an indirect expense is more accurately determined
separately, it is to be included as a direct expense. For example, if the
electricity of the home office is on a separate meter, or the taxes are itemized
between business personal property and home personal property, these normally
indirect expenses should be considered direct expenses.
Calculation of business percentage. Previously, the business percentage was determined either
by dividing the square footage of the office-in-home by the total square footage
of the home (e.g. 200 square foot office ÷ 3000 square foot home = 6.67
percent) or by dividing the office
room by the number of rooms in the house (e.g., 1 room ÷ 10 rooms = 10 percent)
and using the percentage most advantageous to the taxpayer. No more!
Office Occupying 59% of Home Found Implausible (Karan M. Hintze v. Comm., T.C.
Memo 2001-70)
Karan Hintze, a cosmetologist
and paramedical aesthetician, developed a new line of business in the field of
micropigmentation, which involves changing of human body colors through the use
of certain injected dyes (a.k.a. permanent makeup and cosmetics).
Exclusive test flunked! Karan lived in an 850 square foot one-bedroom,
one-bathroom condominium in Sun Valley, ID, where she designated 500 square feet
as being used for business purposes, including her entire living room and dining
room, her entire bathroom, and the portion of the kitchen containing the sink.
The court found that any claim for exclusive business use implausible, and
denied the home office deduction.
A Home-office Deduction Is Not Allowed to the Extent That
it Creates or Increases a Net Loss of a Business
If the gross income from the
business use of the home equals or exceeds the total business expenses
(including depreciation), all the business expenses, including the
office-in-home expenses, can be deducted. But
if the gross income from that use is less than the total business expenses, the
deduction for certain expenses for the business use of a home is limited.
Carryover of unallowed expenses.
Home
workers can carry over to the next tax year deductions over the current year's
limit whether or not the dwelling unit is used as a residence during the tax
year. These deductions are subject to the gross income limit from the business
use of the home for the next tax year. Any unused carryover amounts are lost if
the business closes.
Commuting From a Home Office
A deductible home office often converts commuting mileage
to business mileage! If a
taxpayer has a home office that is the principal place of business, each of that
taxpayer’s business trips from home is considered a deductible transportation
expense as he or she is traveling between different business locations. Because
this may amount to a substantial annual tax deduction, it may pay to have an
office-in-home. However, if the principal office is at another location (e.g., a
real estate office located downtown), the mileage from the home to the first business
location is a nondeductible commuting trip (Rev. Rul. 190; Rev. Rul. 55-109).
Tax planning: The
liberalized definition of a principal place of business allows many more
taxpayers to deduct their “commuting” costs. Financially, this is a much
larger deduction for most taxpayers than the office-in-home deduction.