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Home Office Deduction - Is It Dead?

© by Greta P. Hicks, CPA

On January 13, 1993, the Supreme Court in the case of Nader E. Soliman, made a decision which affects many business people's home office deduction. Immediately after the decision, local IRS persons where heard saying "Just tell them it is not deductible." The National Office of the IRS promptly released Notice 93-12, which if strictly followed, would eliminate many small business person's home office deduction.

The history of the home office deduction is filled with controversy. The Internal Revenue Code (the law) states, in part, that to be deductible the portion of the dwelling unit which is used exclusively and regularly for the following purposes may be considered a deductible business expense, if it is:

  1. An area which is the "principal place of business" for any trade or business of the taxpayer.
  2. A place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business.
  3. A separate structure which is not connected to the dwelling unit, in connection with the taxpayer's trade or business.
  4. A storage area within the dwelling unit which is used on a regular basis as a storage unit for the inventory of the taxpayer held for use in the taxpayer's trade or business of selling products at retail or wholesale, but only if the dwelling unit is the sole fixed location of such trade or business.

Before answering the questions of principal place of business, a place where you meet customers, a separate structure, or a storage area, your home office must first meet three other tests.

Test 1 - The business person must first establish that the activity undertaken in the dwelling constitutes a trade or business. Investment activities do not constitute a trade or business. A hobby or not-for-profit activity is not a trade or business. Managing rental properties is not a trade or business activity.

Test 2 - The area used for business must be used exclusively for business. An area which has a couch, TV, bed, or other personal furnishings is an area which fails to meet the exclusive use test. Some IRS publications go so far as to say that if a personal telephone call is made from the business phone in the office, the office is not exclusively used for business.

Test 3 - The area is to be used regularly for business and be substantial and integral to the conduct of the taxpayer's business. The burden of proof showing regular use of the home office rests with the taxpayer. Does that mean a log is required? No, but how are you going to prove regular use without a record of some kind.

After the home office meets all three tests above, you then determine if it meets the criteria of #2, #3, or #4 of the law. A small business person who regularly meets customers at his home office has an allowable home office. As does the small business person who stores inventory in his home office. Or, if the small business person has constructed a separate structure to be used as his home office, he may have a deductible home office. None of these types of home offices where affected by the Soliman decision. If you have one of these types of "offices" it is as deductible now as it was prior to Soliman.

The decision of the Supreme Court in Soliman affected one type of home office deduction - those business persons whose home office is their "principal place of business." The IRS interpreted "principal place" by using the very strict focal point test. Under this test the office of a business person was held to be the place where they met customers, clients, and patients. For Doctor Soliman, an anesthesiologist, the IRS said that was the hospital. The Tax Courts and Courts of Appeals have used varying criteria to define "principal place." The test used in Soliman was the "facts and circumstances" test. The Tax Court and Court of Appeals stated that to determine whether a home office is the principal place of business all functions performed by the business person should be considered. It gave significant weight to the fact that Dr. Soliman had no other office in which to do his planning, organizing, invoicing, and bookkeeping functions and that these administrative functions are an integral part of his business.

The Supreme Court (SC) held that the focal point test was too narrow and the facts and circumstances test was too broad. Where the business involves multiple points of sale, the court recommended that one of two tests should be met in order to have a deductible home office expense.

SC Test 1 - Relative Importance of the Function Test. The court recognized three stages of a business transaction. Stage 1 is the planning and initial preparation prior to Stage 2, the meeting of clients or delivery of goods. Stage 3, the follow up stage, is the accounting, reporting, and billing after the sale, delivery, or meeting. The Court recommended that a comparative analysis of the various activities in each stage be performed by the business person. The point where the goods and services are delivered must be given greater weight that administrative activities. The controlling factor is where is the remuneration generated and earned. Sounds a lot like the old IRS focal point test.

The question the analysis should answer is: "Is the home office more significant in the taxpayer's business than every other place of business?" If the answer is yes, the home office is deductible. If the answer is no, the home office is not allowed. The Court does not require a log be maintained on the various activities performed by the business person, but how else does the taxpayer prepare the analysis and prove the importance of his office?

SC Test 2 - Time Spent Test. The time spent test is useful when the business person performs income-generating tasks at both his home office and some other location. This test may be used when the importance of the functions performed at various places yields no definitive answer to the principal place of business inquiry.

The Court reached three significant conclusions: There may be no clear principal place of business. The home office does not win (become the principal place of business) by default. It is immaterial whether you have access to an office else where.

In Notice 93-12, the IRS has attempted to interpret the "time spent" test with examples of Joe Smith and Fred Jones. Both are outside salesmen. Joe spends an average of 30 hours a week visiting customers and 12 hours a week working at his home office. Fred's business requires him to make telephone or mail contact with customers primarily from his office, which is in his home. Fred spends 30 hours per week selling to customers from the home office with only 12 hours per week spent visiting customers. The IRS says Joe has no deductible home office and Fred's home office is allowable. This notice is in contradiction to an IRS Proposed Internal Revenue Regulation 1.280A-2(b)(3) which states in part: "If an outside salesperson has no office space except at home and spends a substantial amount of time on paperwork at home, the office in the home may qualify as the salesperson's principal place of business." The IRS has the authority to change this proposed regulation to agree with the Soliman decision and they probably will.

"Is the home office deduction dead?" NO! Any number of small business people meet customers regularly in their home, or store inventory, or have separate structure. There are others such as musicians, lawyers, accountants, consultants, artists, craftsmen, and business men and women who can meet the "time spent" test. And a few will be able to demonstrate that the most important functions of their business are performed in the home rather than at the customers or clients. It is clear that the Soliman decision did not fully clarify a recurring problem of defining "principal place of business" which leaves the door wide open for continued controversy.

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GRETA P. HICKS, CPA and former IRS manager, concentrates in solutions to IRS problems and advises business and tax professional on IRS policies and procedures. Ms Hicks is owner of TAX SOLUTIONS, Inc., a company providing educational materials and programs on solutions to IRS problems and is a nationally known speaker and writer on solutions to IRS problems. To arrange for consultation contact: Greta's web site: http://www.gretahicks.com

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