A self-employed taxpayer may be able to claim deductions for the business use of his or her home. These deductions include mortgage interest, real estate taxes, maintenance, insurance, utilities, and depreciation. However, certain conditions must be met, sand the IRS closely scrutinizes home office deductions because of perceived abuses in this area. To deduct home office expenses, a self-employed taxpayer must use the home office space exclusively and regularly:
1. As a principal place of business;
2. As a place to meet or deal with clients and customers in the normal course of business; or
3. In connection with the business if the space is a separate structure from the residence (Sec. 280A(c)(1)).
Note: While employees may also claim home office deductions, the home’s business use must be for the convenience of the employer, and the space must be used exclusively and reg-ularly for job-related activities. As a practical matter, these are insurmountable hurdles for many employees.
The “principal place of business” test is often the one that taxpayers try to meet. In Soliman, 506 US 168 (1993), the Supreme Court identified two primary factors for determining whether a home office qualifies as the taxpayer’s principal place of business: (1) the relative importance of the activities performed at each business location and (2) the time spent at each place.
The relative importance test is analyzed first; if no definitive answer is reached, the time test is considered. In analyzing the relative importance of the activities performed at each location, the place where clients are met or goods and services are delivered is given great weight (Strohmaier, 113 TC 106 (1999)). Whether the functions performed at home are essential to the business, while relevant, is not controlling, and the availability of alternative office space is irrelevant.
However, in Popov, 246 F3d 1190 (9th Cir. 2001), the Ninth Circuit over-turned a Tax Court decision on a musician’s business use of the home. The de-livery of services analysis, which is part of the relative importance test, was not an appropriate framework for determining whether a home office deduction was appropriate for the musician, who practiced at home four to five hours a day. The appeals court decision stated, “It is possible, of course, to wrench musical performance into a ‘delivery of services’ framework, but we see little value in such a wooden and unblinking application of the tax laws.” Therefore, the court moved to the test of time spent at each place. Since the musician spent substantially more time practicing at home than performing away from home, the home office deduction was allowed.
In Rev. Rul. 94-24, the IRS provided several examples illustrating how these tests will be applied. In addition, it reiterated the Supreme Court’s finding in Soliman that, in some cases, application of the relative importance and the time tests may result in a determination that a taxpayer has no principal place of business for home office de-duction purposes.
Administrative and Management Activities
The definition of principal place of business includes a place that is:
1. Used exclusively and regularly by the taxpayer to conduct administrative or management activities of a trade or business; and
2. The only fixed location where the taxpayer conducts substantial administrative or management activities of that trade or business (Sec. 280A(c)(1)).
This effectively allows more taxpayers to meet the principal place of business definition. However, this does not change the regular and exclusive use requirements for the taxpayer to deduct home office expenses. Also, the principles set forth in Soliman would still apply in situations not covered by these rules for administrative and management activities.
Example 1: T is a self-employed contractor who builds single-family homes. She maintains an office at home, where she spends a significant amount of time working on building plans, ordering materials, calling subcontractors, doing payroll, keeping books, paying bills, and conducting other administrative and managerial duties. The room is used for no other pur-pose. She can claim a deduction for having an office in her home because she uses the space exclusively and regularly to conduct administrative or management activities of her trade or business, and no significant administrative or management activities are conducted elsewhere.
Office Outside the Home
The taxpayer can have another office away from the residence and still claim the home office deduction if the criteria are met. The correct test to apply is where the administrative or management work is actually done—not where it could be done. Therefore, even though there is another office away from home that can be used for administrative and managerial work, the taxpayer can still claim the home office deduction if he or she chooses to do that work at home.
Example 2: Assume the same facts as in Example 1, except that T also has an office in a high-rise building where she meets with clients, works on building plans, orders materials, meets subcontractors, and performs other tasks directly related to the business of building houses. She continues to work at home doing payroll, keeping books, paying bills, and conducting other administrative and managerial duties. T can claim a home office deduction because she uses the home office ex-clusively and regularly to conduct administrative or management activities, and there is no other fixed location where she conducts substantial administrative or management activities.
Planning tip: Taxpayers with out-side work locations may want to shift substantial administrative and management activities to their personal residence to qualify for the home office deduction.
IRS Publication 587, Business Use of Your Home, notes that administrative or managerial activities include (1) billing customers, clients, or patients; (2) keeping books and records; (3) ordering supplies; (4) setting up appointments; and (5) forwarding orders or writing reports. It also gives several ex-amples of activities that will not disqualify a taxpayer’s home office from being a principal place of business based on the administrative or management activities performed there.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 8th Edition, by Anthony J. DeChellis and Patrick L. Young, published by Thomson Tax & Accounting, Ft. Worth, TX, 2007 ((800) 323-8724; ppc.thomson.com).