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May 1992

Help with the home office deduction and auto expense bonus. (Personal Financial Planning)

by Arrigo, Marie

    Abstract- Section 280A of the Internal Revenue Code provides tax guidelines for business people and professionals who use their homes as their primary place of business. According to this section, expenses incurred from the maintenance of a home office may only be considered deductible if conditions regarding business use, exclusive and regular use, and use as the principal place of business are satisfied. Sec 280A, as interpreted by the courts, allows expenses incurred from commuting between the home office and a secondary place of business to be considered deductible. Sole proprietors are required to submit a report of their home office expenses to the IRS for tax years starting on or after Jan 1, 1991. Likewise, the IRS mandates that home-based professionals file their income tax return together with a new Form 8829.

Business expenses for the costs of maintaining a home office can only be deducted under strictly defined circumstances. Under IRC Sec. 280A, the following requirements must be met in order to qualify:

Business Use. The use of a home office must be connected with a trade or business engaged in by the taxpayer and cannot be used for any other purposes. For instance, if the room is used for investment activities, deductibility of the home office would be negated.

Exclusive and Regular Use. A portion of the taxpayer's residence (or a separate structure) must be used exclusively in connection with the taxpayer's trade or business. As specified in Prop. Reg. Sec. 1. 280A- 2(g)(1) and the Tax Court Case G.H. Weightman, 42 TCM 104, physical separation of the home office from the rest of the residence is not essential.

Anything beyond de minimis personal use violates the exclusive use requirement and causes the deduction to be lost. Walking through the home office enroute to another room would not jeopardize the home office deduction. On the other hand, if a family member watches television in the home office, the deduction is lost (C.D. Hughes Jr., 41 TCM 1153).

Use of the home must be on a regular, on-going basis. Occasional or incidental business use of a portion of the home will not secure the deduction, even if the office is exclusively used for business purposes.

Principal Place of Business. If a taxpayer can meet these tests, the ability to deduct the home office expense will depend upon whether the home office is the taxpayer's principal place of business. Prop. Reg. Sec. 1. 280A-2(b)(3) specifies that if a taxpayer engages in a trade or business at more than one location, all facts and circumstances must be considered. These factors would include 1) the amount of time spent at each location, 2) the amount of income generated at each location, and 3) the facilities available at each location for business purposes.

However, in a series of cases, the Tax Court ignored this premise and instead adopted a "focal point" test. Thus, in order to deduct home office expenses, the home office had to be the place where the goods and services were provided to customers or clients, and where the revenues were generated. It had to be the focal point of the business. While the focal point test may seem reasonable, it actually presented problems for taxpayers who did not provide goods or services at their home offices, but whose home office was essential to their operation. The Court of Appeals for the Second Circuit chipped away at this seemingly concrete premise on the focal point test. In E. Drucker, CA-2, 715 F2d 67, the Court allowed a concert musician to deduct expenses attributable to a practice room maintained in his residence. The employer --an opera company--did not provide a practice room for the musician and the extensive practice was crucial to the business. The court ruled that the focal point of the musician's activities was not the theater where he performed but rather the home practices without which there would be no business activity.

The Second Circuit Case, D.S. Weissman, CA-2, 751 F2d 512, also allowed the home office deduction where part of the services were performed outside such office. There, a college professor spent only 20% of his time teaching on campus and the remainder was spent working in his home office on his research and writing. The professor was not provided with an office on campus to perform any of those functions. The court ruled that since the dominant amount of time was spent in the home office, such expenses should be allowed in accordance with the proposed regulations.

As a result of these appellate decisions, the Tax Court revisited its interpretation of Sec. 280A and the applicability of the focal point test in the case, NE Soliman, 94 TC No. 3. Dr. Soliman is a self- employed anesthesiologist who provided services and generated the revenues for his practice at three hospitals, where he worked 30 to 35 hours each week. Although Dr. Soliman's principal place of business was the hospitals, none of the three provided him with office space. To carry out those duties which were essential to his practice, but which could not be performed at the hospitals, Dr. Soliman converted one of the three bedrooms in his apartment into an office.

Although he could not meet the focal point test, the home office clearly was necessary to Dr. Soliman's business. He furnished the office with a chair, desk, couch, telephone, answering machine, copier, and filing cabinet. He kept patient records, billing records, and insurance and medical materials there. In addition, he used the office to contact surgeons, patients and hospitals, as well as to perform all recordkeeping duties. He also used the office to read medical journals, to prepare for specific patients, to prepare for monthly presentations to nurses at one hospital, and to study continuing education materials. His only "personal" use of the home office was to balance his checkbook, which combined business and personal finances.

These duties were essential to Dr. Soliman's business, and he spent an average of two to three hours each day working in his home office (about 300/0 of his working hours). The IRS would not allow Dr. Soliman to deduct expenses for his home office, however, because he never treated patients there. The IRS claimed that business activities performed at home were ancillary to the primary income-generating services performed at the hospitals. The Tax Court disagreed with the IRS and found that Dr. Soliman's home office met the principal place of business requirement. The court discarded the focal point test and, instead, adopted the new "facts and circumstances" test. This test allows taxpayers to deduct home office expenses whenever management or administrative activities are essential to the trade or business and the only available office space is in the taxpayer's home.

A federal appeals court agreed, noting that the decision is consistent with changes the IRS has already proposed. The proposed regulations indicated that salespersons would be allowed to deduct home office expenses even when they spent most of their time on the road, as long as they spend a substantial amount of time on paperwork at home. However, the IRS has announced that it would not apply the Soliman case to other situations.

Deductible Automobile Expenses

The Soliman decision has created an attractive side benefit. Transportation expenses to and from the home office (which is now considered the principal place of business) and the secondary business location are now deductible rather than being considered nondeductible commuting expenses. This premise has been reinforced in both the Soliman and the L.K. Kahaku (58 TCM 1247) cases. Mr. Kahaku was a professional guitarist who maintained a practice room in his in-law's residence where he lived. The court ruled that automobile expenses for travel between his residence and the restaurant where he performed, music stores, and audition sites were deductible. The court held that since Mr. Kahaku exclusively used the room to practice and perform managerial and recordkeeping functions, the home office was his principal place of business.

Reporting Requirements

For tax years beginning on or after January 1, 1991, sole proprietors must report their home office expenses on Line 30 on their Schedule C. In addition, a new Form 8829 must also be filed with the individual's income tax return. This form provides the details of the home office expense. At the time of the writing of this article, a draft of the new form was not yet available.

The use of "Fact and Circumstance" by the Court to supplement IRC 280 and proposed regulations present opportunity for planning of home premises and work habits that can save taxes.

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