Prior to 1976, deductions for home office expenses were allowed if its use was appropriate or helpful" in the taxpayer's business. In enacting Sec. 280A, Congress established the principal place of business rule. Taxpayers were not allowed a deduction for expenses of an office in the home unless a portion of the home was used exclusively and regularly as either:

1. The principal place of business for any trade or business of the taxpayer.

2. A place of business used by clients, patients, customers, etc.

The Treasury issued proposed regulations defining the "principal place of business" as well as interpreting the exclusive and regular" use rule. However, the Tax Court basically ignored the proposed regulations defining the "principal place of business" and instituted a "focal point" test. The "focal point" test has generally been interpreted to place primary emphasis on the location where goods and services are provided to customers and revenues are generated. Such an interpretation almost always prohibited a deduction for home office expenses to a taxpayer whose earnings could be traced to goods or services provided away from the home. The fact that a home office was necessary and was used exclusively for business did not change the results.

The Soliman Case

In recent months, the Tax Court has moved away from its "focal point test." In Soliman the Tax Court held that the "focal point" test for determining principal place of business for allowing a home office deduction will not apply when all of the following conditions are present:

1. The home office is essential to the taxpayer's business.

2. The taxpayer spends substantial time working at the home office.

3. There is no other location to perform the office functions of the business.

The decision represents a significant loosening of the principal place of business requirement because the "focal point" test had required the home office be the place where the taxpayer performed services or generated income by dealing with customers. The decision should make the home office deduction available to more taxpayers.

In an unusual press release, the IRS stated it would not follow the opinion in Soliman. Further, they filed a motion for reconsideration of the opinion and, if it is not withdrawn, they will recommend appeal. The motion is based on the contention that the decision is contrary to the legislative history of Sec. 280A. In the meantime, the IRs cautioned taxpayers not to rely upon the opinion. No doubt recent magazine and newspaper articles about the "looser" Soliman test, which suggested that taxpayers file amended returns and take the home office deduction on their current returns, had something to do with the issuance of the press release.

Regardless of the IRS's opinion, the Soliman test is still good law. The remainder of this article discusses how the taxpayer in Soliman met the three conditions to avoid the "focal point" test and how subsequent court decisions have applied the Soliman test.

The Facts of Soliman

Nader Soliman was a self-employed anesthesiologist who spent 30 to 35 hours a week performing services at three hospitals. None of the hospitals provided him with office space. He used one bedroom in his three bedroom apartment exclusively as an office for his practice to:

1. Contact surgeons and patients;

2. Arrange hospital admissions;

3. Maintain billing records and patient logs;

4. Correspond with his billing service;

5. Record billing collection information;

6. Read medical books and journals;

7. Prepare for patient interviews;

8. Satisfy and prepare for his continuing education requirements; and

9. Prepare for monthly presentations to post-anesthesia care nurses.

Although, he spent two to three hours a day in his office, he never treated patients there. In addition, his home office contained the following equipment and records: chair, desk, couch, telephone, answering machine, copier, filing cabinet, patient records, billing records, correspondence with patients, names of surgeons and insurance companies, medical journals, medical texts, collection agency records and insurance code books. Also, it is important to note that his only "personal" use of the home office was to balance his checkbook that combined his business and personal affairs.

Office Was Essential

The Court noted that Soliman engaged in a business that required the performance of two distinct activities--medical services and practice management. The Court concluded that the practice management activity was essential to his business and that the home office was suitable for the activity performed there. Another aspect the Court examined was the appropriateness of the furnishings in the home office. It concluded that the items in the office were appropriate to and essential for the conduct of his home office activities.

Use Was Substantial

Because Soliman's business required him to perform two distinct activities, a comparison of the number of hours spent at each location was not used to determine substantial use. Instead the Court had to determine whether Soliman spent a substantial amount of time working in his home office. The Court concluded that the two to three hours each day he spent in the home office was substantial use.

It is important to compare the substantial use conclusion in Soliman to the previous decision in Pomerantz. In the latter, the Court concluded that three to five hours per week use of a home office was not substantial. The two decisions do not provide specific guidelines but do show what works and what does not.

No Other Place

The Court stated that the lack of other available space weighed heavily in Soliman's favor and was a significant factor influencing the decision. The lack of alternative office space merited a great deal of consideration by the Court and was not outweighed by a mechanical comparison of the number of hours spent at each location.

Sons of Soliman

The Tax Court recently followed its new Soliman test. In Kabaku, the taxpayer was a self-employed professional guitarist who averaged eight to 12 hours per week performing at a restaurant in Honolulu. The taxpayer maintained a practice studio (home office) in his father-in- law's house and practiced there approximately 30 hours a week. He also used the studio to maintain business records.

Because he did not pay rent to his father-in-law he did not incur any home office expenses, but he did deduct transportation expenses from the studio to the restaurant. If the studio did not qualify as a home office, then the transportation expenses would not be deductible. Using the Soliman test, the Court concluded the studio qualified as a home office and allowed the transportation expenses as a deduction.

The Kahaku decision has been appealed to the Ninth Circuit. The Ninth Circuit has yet to reverse the Tax Court in the use of the "focal point" test. Thus, the appellate court may overturn the decision based on a "focal point" argument, or uphold based on the Soliman test.

Did Not Pass the Test

In Shore, the Tax Court disallowed any part of a basement rental as a home office deduction. The taxpayer failed to offer any evidence to show that maintenance of the basement area was essential to his business, that he spent substantial time working there or that he had no other location available to perform the office functions of the business. The taxpayer did not pass the Soliman test.

Another Deductible Home Office

Even the Soliman test will not allow a home office deduction if the taxpayer has another place outside the home where the primary functions of that business can be performed. But a recent Tax Court decision shows that a home office deduction will be allowed if the business that the taxpayer operates outside the home is a different business than the one operated inside of the home. In Hoye, the taxpayer conducted a medical practice, specializing in cancer patients, from an office outside his home. In his home, he had a laboratory from which he conducted an aspiration cytology biopsy practice. The Tax Court found the two activities to be closely related. In fact, 50% of the laboratory patients came from the medical practice. However, the Tax Court held that a separate business exists if a substantial difference exists in the task and activities. The laboratory work involved a different task from seeing patients: therefore, it was a different business. After determining a separate business existed, the Tax Court applied the Soliman test and held that the principal place of the laboratory business was the home office. The home office deduction was allowed.

Planning Considerations from the Cases

Soliman payes the way for the increased availability of home office deductions. Taxpayers who think they are entitled to home office deductions udder the Soliman test can file amended returns for open years. The returns will be treated as claims for refunds. The IRS has stated that the claims will be suspended until the appeal is finally resolved. The press release was designed, in part, to discourage the filing of amended returns.

Taxpayers who think they are entitled to home office deductions under the Soliman test can use the deductions on a current return. Of course, the taxpayer would be subject to possible audit on the home office deduction. However, the important issue in this situation is the manner in which the deduction must be reported. First, a taxpayer claiming a home office deduction under the Soliman test should not have to meet the disclosure standard necessary to nullify the negligence component of Sec. 6662 penalty. Second, if the home office deductions (including transportation) are so large that they could result in a substantial understatement under Sec. 6662(b)(2), the taxpayer should not have to make the disclosure described in Reg. Sec. 1.6661-4. Both these penalties should be avoided because of the presence of "substantial authority" in Soliman.

The Shore decision shows that taxpayers must be able to demonstrate that they pass the Soliman test. Documentation or other evidence must be provided concerning all of the following:

1. Demonstrate that the functions performed in the home office are essential to the business. Activities such as billing, accounts receivable collection, scheduling, and continuing professional education should qualify as essential business functions.

2. Demonstrate the home office furnishings are appropriate to the business functions performed there.

3. Demonstrate that the functions performed in the home office are not the same functions performed outside the home office.

4. Demonstrate that a substantial amount of time is spent working in the home office. Detailed records, i.e., dairies, daily logs, time slips, etc., of the home office use must be maintained.

5. Demonstrate the lack of alternative office space or that other available office space is inadequate for performing necessary business functions.

Finally, the Hoye decision shows another possibility for a home office deduction. By maintaining two businesses separately, taxpayers should be able to qualify for deductible home office expenses even though they have an office outside the home. If the activities are different, they should be given separate status. Thus, it is possible that a CPA, who does writing and speaking for profit, could treat that activity as different from the accounting practice.

What to Deduct

Expenses associated with your home office are divided into two categories--direct and indirect. The rules for deducting the expenses are different for each category.

Direct expenses are expenses that benefit only the business part of your home. Examples are painting or repairs made to the specific area or room that is used for business. Taxpayers may deduct all expenses directly related to the business use of their homes.

Indirect expenses are expenses that benefit both the business and personal part of the home. Examples of indirect expenses are: real estate taxes, deductible mortgage interest, casualty losses, rent, utilities, insurance, repairs, security systems, and depreciation.

The business portion of indirect expenses are deductible if they are related in some way to the part of the home used for business. For most expenses, the business portion is figured by dividing the area used for the home office by the total area of the home. The area can be measured in square feet, or if the rooms are about the same size, the indirect expense may be allocated by number of rooms. Unrelated expenses that benefit only the personal part of the home are not deductible. These would include lawn care, landscaping, etc.

It should be noted that the deduction for home office expenses is limited to the gross income from the business less all other business expenses. Also, those expenses that would be allowable as itemized deductions (if no home office existed, i.e., mortgage interest and real estate taxes) must be deducted first. In spite of this limitation, home office expenses have the potential of reducing gross income from that business to zero.

An Additional Deduction Arises from the Home Office

The Kahaku decision shows the attractive side benefit available from a deductible home office. If the taxpayer has a home office, then transportation expenses from that office to see clients, patients, customers or to conduct other activities of that business would be deductible as business transportation. The taxpayer must remember to maintain the appropriate records and documentation to substantiate the transportation deduction. It is possible the deductible transportation expense could be as significant as the deductible home office expenses because there is no dollar limitation on their deductibility. Therefore, taxpayers should consider the additional deduction of business transportation when considering the establishment of a home office.

The Soliman test is a significant change in the method of analyzing home office expense deductions. The Tax Court's decisions since Soliman indicate their willingness to use the test, despite the IRS's opposition. The decision provides significant tax saving opportunities for taxpayers who can qualify for a home office under the more liberal Soliman test.