|GARY M. FLEISCHMAN, CPA, PhD, CMA, is Holland Assistant
Professor of Taxation at the University of Tennessee,
Chattanooga. His e-mail address is email@example.com.
THOMAS H. PAYNE, PhD, is associate professor of finance and holds the Horace and Sara Dunagan Chair of Excellence in Banking at the University of Tennessee, Martin. His e-mail address is firstname.lastname@example.org.
Starting this year, significant relief is available for the millions of taxpayers self-employed and employees who use some part of their home as a business office. A new law provides a less arbitrary standard for the home office deduction, which should make it possible for more taxpayers to take it. Although most of the provisions of the Taxpayer Relief Act of 1997 became effective in 1998, the home office rule changes did not take effect until January 1, 1999. While congressional committee reports and legislative language clearly indicate the new law does not fully eliminate restrictive prior legislation or judicial precedent, the good news is the law expands the definition of a principal place of business and allows a taxpayer who meets either the old or new standard to take a deduction.
CPAs advising clients on their eligibility for the home office deduction in 1999 and beyond will find it helpful to review the 1997 home office legislation and the related provisions of IRC section 280A as well as previous court rulings and regulatory guidelines that will remain relevant beyond January 1, 1999. In addition, CPAs will benefit from examples of how the new provisions expand the activities that qualify a home office as a principal place of business.
As CPAs begin to deliver completed 1998 tax returns to their clients, this is an ideal time to explain the new home office rules to them. Clients who were previously ineligible may need to begin keeping appropriate expense records and other clients may be eligible for an enhanced deduction that will involve different record-keeping responsibilities.
The primary guidance on the home office deduction comes from section 280A. Because taxpayers frequently abuse that section of the code, the IRS continues to scrutinize such deductions. The more stringent guidelines of this code section were introduced in 1976 to curtail such abuses. Alternative regulations were proposed a few years later but never adopted. Accordingly, case law provides most of the guidance on home office deductions, with occasional refinements from revenue rulings.
Section 280A(c)(1)(A) permits a taxpayer to deduct home office expenses when a specific portion of the home is used exclusively and on a regular basis as the taxpayers principal place of business. The definition of what constitutes a principal place of business is central to determining whether a taxpayer may claim a business deduction for allocated home-related office expenses such as utilities, repairs and depreciation. All taxpayers may claim personal residence mortgage interest and real estate taxes as itemized deductions even if they do not have offices in their homes.
Absent a codified definition, in 1993 the U.S. Supreme Court narrowly construed the principal place of business definition in a landmark case, Commissioner v. Soliman ([1993, S. Ct] 71 AFTR 2d 93-463; 93-1 USTC Par 50014). This caused many taxpayers to lose the home office deductions they previously had been allowed. Fortunately, the new law in effect expands the Courts narrow interpretation by providing additional specific criteria that will permit more taxpayers to meet the principal place of business definition.
THE SOLIMAN CASE
Soliman involved a self-employed anesthesiologist who practiced at several different hospitals but was not provided with an office by any of them. Dr. Soliman used a room in his home two to three hours a day exclusively and on a regular basis for bookkeeping, correspondence, reading medical journals and contacting patients, other doctors and insurance companies. Soliman deducted expenses relating to his home office, claiming the room was his principal place of business under section 280A(c)(1)(A).
The Supreme Court rejected Soliman's deductions, reasoning that his home office was not truly his principal place of business. In so ruling, the Court espoused a two-part test to determine whether a home office is indeed a taxpayer’s principal place of business.
- The relative importance test considers the importance of the activities undertaken at each place of business. The activities are compared to determine which location serves as a base for the most important functions.
- The time test considers the actual time spent at respective business locations. A taxpayer would meet this test if he or she spent more than half of his or her time working in the home office.
Technically, a taxpayer must meet both parts of the test to take a deduction. However, as a practical matter, since the courts give the relative importance test more weight, the time test is consequential only when the relative importance test is inconclusive.
The Court used this test to determine that the administrative and management activities Dr. Soliman performed at his home office were not nearly as important as the functions he undertook at the hospital, activities such as anesthetizing surgical patients and meeting with patients and doctors. Because these medical procedures and activities constituted the essence of Soliman’s business, and since they did not occur at his home office, the Court ruled the home office was not his principal place of business. In addition, the Court denied Soliman’s deductions because he failed to meet the time test, given that he spent the majority of his business day at the hospital rather than his home office.
IMPACT OF SOLIMAN ON SMALL BUSINESS
The Supreme Courts restrictive principal place of business definition in Soliman caused many small businesses to lose their home office deductions. As the following example illustrates, the ruling especially hurt salespeople and other self-employed individuals.
Example. Judy is a self-employed saleswoman for several printing concerns. She has no permanent office where she keeps her books or makes customer calls other than the office she maintains in her home. Most of her business comes from direct contact with her customers. Following Soliman , the relative importance test dictates that the most important activities Judy performs relate to sales that primarily occur at her customers places of business. Thus, Judy’s home office is not considered her principal place of business, causing her to lose the home office deduction. Because Judy spends most of her time on the road going from one customer location to another, she also fails the time test.
Transportation expenses. Failing the principal place of business test caused many taxpayers like Judy to lose more than just the home office deduction. Judy’s transportation costs for travel to and from her home office to client offices would be deductible if the home office qualified as her principal place of business. However, travel between home and the first business stop is treated as a nondeductible commute for taxpayers who fail the two-part test. The same is true for the drive home from the last business stop in the evening.
Home computer. Classification of a home computer as a business expense generally is subject to the restrictive listed property rules of section 280F. Those rules contain detailed record-keeping requirements that busy entrepreneurs find especially bothersome. The home office deduction rules, however, eliminate listed property status if the taxpayer uses the home computer exclusively in a home office that meets the principal place of business definition. Once again, business use of a home office that fails to satisfy the two tests forces taxpayers such as Judy to comply with the cumbersome listed property requirements.
Many CPAs and tax policymakers viewed the Soliman two-part test as anti-small business. After all, why should a large business that leases offices be allowed a deduction that a small business, allocating time and essential business activities across multiple locations, is precluded from taking? The confining principal place of business definition also was viewed as antifamily and wasteful with respect to energy consumption and resource allocation. The law did not consider cultural and technological changes that have allowed home-based businesses to become catalysts for economic growth and job creation. Fortunately, tax policymakers recognized that fundamental change was needed in the definition of a principal place of business and the related deductibility of home-based business expenses.
NEW LAW BRINGS EXPANDED ALLOWANCES
The 1997 law expanded the principal place of business definition to permit home offices to qualify for deductions starting in 1999 if
The taxpayer uses the home office to conduct administrative
or management activities of his or her trade or business. It is
important to note that if the home office cannot qualify as the
principal place of business under this new administrative or
management activity test, taxpayers still may take deductions by
qualifying under the old relative importance and time tests.
- The trade or business has no other fixed location where the
taxpayer conducts substantial administrative or management
activities. As the examples which follow show, however, the good
news for many taxpayers is that insubstantial administrative or
management activities that take place outside the home office will
not necessarily preclude the taxpayer from taking a deduction.
- The taxpayer uses the home office exclusively and on a regular
basis for business activity.
- The home office is in place for the convenience of the employer if the taxpayer is an employee.
Requirements 3 and 4 carry over from the old law. A taxpayer must meet these requirements at all times, whether he or she is using the new law or the old Soliman test to qualify his or her home office as a principal place of business.
EXAMPLES AND APPLICATIONS
The House committee offered four examples to clarify the business definition and deduction standard. It said a taxpayer in any one of these situations will be allowed a home office deduction starting this year.
Example 1. Taxpayers may take a home office deduction if they do not conduct substantial administrative or management activities at a fixed location other than the home office, even when those activities (such as billing) are performed by other people at other locations. Any insubstantial administrative or management activities may be performed at fixed locations other than the home office. As a result, Judy may contract out her customer billing without losing her deduction.
Example 2. Taxpayers performing administrative and management activities at sites that are not fixed locations of the business (such as cars or hotel rooms) in addition to performing the activities in a home office may still secure the deduction. This means Judy does not have to perform all her administrative and management services at home to qualify for a deduction.
Example 3. Taxpayers who conduct an insubstantial amount of administrative and management activity at a fixed location other than the home office (occasionally doing minimal paperwork at another fixed location) may still take the deduction. This stipulation recognizes that, as a practical matter, businesspeople often perform minimal paperwork at other locations. For example, a medical doctor may do a limited amount of paperwork at a hospital or clinic, or Judy may write up an order at a customer’s office.
Example 4. Taxpayers conducting substantial nonadministrative or nonmanagement business activities at fixed locations other than their home offices will not be prevented from taking the deduction. For example, meeting with customers, clients or patients at another fixed location will no longer preclude the deduction.
Example 4 directly relates to the effective repeal of Soliman as the only definition of a principal place of business. Thus a home office will be deemed the principal place of business if the taxpayer uses it for administrative or management activities of any trade or business and there is no other fixed location where the taxpayer conducts a substantive portion of these activities. This ignores the importance of other nonadministrative and nonmanagement activities the taxpayer may engage in outside the home office. Therefore, example 4 clarifies that Dr. Soliman, Judy or any consultant, doctor, salesperson or house painter, for example, who meets the new definition can take a home office deduction starting this year.
Under the new law, Dr. Soliman would meet the revised definition in 1999 because he performs administrative and management activities in his home office and has no other fixed location at which to do so. The fact that he spent the majority of his time and performed the most important business activities away from the home office no longer would preclude him from deducting home office expenses. Unfortunately for Dr. Soliman, these changes are not retroactive.
The bad news. Under section 280A(c)(1) of the new rules, if the taxpayer is an employee, all of the above requirements must be satisfied and the business use of the home must be for the convenience of the employer. CPAs need to consider specific facts and circumstances when making this determination for their clients. IRS Publication 587, Business Use of Your Home , says use of the home by an employee that is merely appropriate and helpful to the employer is not sufficient to meet the convenience test. Similarly, use of the home for the employees convenience or because the employee can get more work done at home also will not suffice.
SUBSEQUENT SALE OF THE RESIDENCE
Special rules apply when selling a residence containing a home office. Home office depreciation deductions have a direct impact on the ultimate tax consequences. The portion of the home claimed as a home office is not considered part of the principal residence but, instead, is considered business property. If the residence is later sold at a gain, part of the gain must be allocated to the home office. The business portion of the gain likely will be relatively larger because of home office depreciation deductions. The gain allocation issue is especially important now that the new law provides for a $250,000 exclusion of gain ($500,000 if married and filing jointly) relating to the personal (nonbusiness) portion of the residence. Unfortunately, the new gain exclusion rules do not apply to the business portion of the gain associated with the home office, so taxpayers may be surprised by a tax liability.
Even if the home office is converted back to personal use before the year of the sale, IRC section 121(d)(6) says the gain exclusion still does not apply. This causes gain recognition to the extent of any depreciation allowable with respect to the home office after May 6, 1997. Losses on the sale of a residence generally are not deductible. However, the portion of the loss associated with the home office will be deductible as an ordinary business loss. Once again, depreciation reduces the home office adjusted basis, limiting the taxpayer’s deduction.
1999 TAX PLANNING TIPS
The new home office rules were effective January 1. The tax planning ideas described here can help CPAs advise their clients about potential home office deductions.
Starting this year, taxpayers who meet the expanded definition of principal place of business will be able to deduct mileage between home and customer offices. In addition, taxpayers using computers exclusively in the home office no longer are subject to the listed property rules of section 280F. However, it is still important for taxpayers to keep proper records to document the required regular and exclusive business use of the home office. Taxpayers should keep a daily log of meetings with clients or customers at the home office. They should also make videotapes or photographs to show there are no personal items in that part of the home. Taxpayers should document office expenses with canceled checks and receipts. They also need to ensure that no personal or family activities occur in the home office.
CPAs should be aware that the new law expands but does not displace the Soliman two-part test for determining a principal place of business. The new law provides that a home office used for administrative and management activities also will qualify as a principal place of business if the previously specified requirements are met. For a flowchart on meeting the new home office deduction requirements, see the exhibit.
An employee who has available a fixed location other than the home office can expect a challenge from the IRS when asserting he or she is conducting home office activities for the convenience of the employer. However, the taxpayer in Mulne (TCM 1996-320) was able to secure a home office deduction because her employer required her to prepare reports after business hours. For security reasons, her downtown Los Angeles office building was closed during the nighttime hours she needed to work. These circumstances might also meet the new convenience of employer requirement, since the taxpayer did not have an employer office available to her at the times she needed to run the reports.
Employees who telecommute or whose employers require them to use the Internet during off-peak hours when it may be more efficiently accessed might also be able to secure a home office deduction. This would be particularly plausible if the employers building or computer equipment was inaccessible beyond regular office hours. In the absence of any cases to cite as precedent, CPAs should carefully scrutinize the specific circumstances used to support the assertion that the home office exists for the employer’s convenience. It also would be helpful if the employer had a written policy explaining this practice. Finally, employees may deduct the cost of computer equipment as a business expense without being subject to the listed property rules described earlier as long as the employees home office qualifies as the principal place of business for the convenience of the employer.
Employees who work at home but are unable to claim a home office deduction should consider seeking reimbursement from their employers. Many companies now reimburse employees for such expenses or offer incentives to encourage employees to work at home. If an employer has an accountable plan, amounts reimbursed to the employee are not included in income, since they merely offset related expenses. In any event, employees must properly substantiate all expenses.
EXPANDED DEFINITION, EXPANDED DEDUCTIONS
Although the new home office rules are generally more beneficial, CPAs and their clients should not take them lightly. Deducting home office expenses will still increase the probability of an IRS audit. Further, the rules remain quite exacting and complex, which is one reason why only about 10% of the estimated 14 million full-time self-employed taxpayers take a home office deduction. Taxpayers also still need to take into account nontax considerations in maintaining a home office, including local government zoning restrictions, the possible intrusion by family members on client meetings and limits on homeowners insurance coverage.
The expanded definition of principal place of business will restore the home office deduction to thousands of taxpayers this year, many of them small business owners. And because many small businesses meet the new principal place of business definition, their owners now will be able to deduct the cost of traveling between home and client offices. CPAs should alert clients to these changes immediately so they begin to keep the proper records. Although the new rules seem more straightforward, it is the courts that will ultimately decide how they are applied. The rules for deducting home office expenses can be expected to come under even greater scrutiny in the future as pressure arising from the need for child care, energy conservation and pollution abatement causes even more taxpayers to work out of their homes, either for themselves or their employers.