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:
- An area which is the "principal place of business" for
any trade or business of the taxpayer.
- 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
- A separate structure which is not connected to the dwelling unit,
in connection with the taxpayer's trade or business.
- 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
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
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
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