U.S. Supreme Court limits home-office deduction. (includes related article)by Sager, Clayton
The U.S. Supreme Court, reversing the 4th Circuit, ruled 8-1 on January 12, 1993, that Nadir Soliman, a physician who managed his medical practice from his home office but treated patients only at hospitals, could not deduct home-office expenses. In Soliman, the first Supreme Court case on the home-office deduction, the Court ruled the taxpayer's home office was not his principal place of business because he did not perform his most important job functions there. Therefore, the home office did not qualify for a deduction under IRC Sec. 280A. While the Court stated it could not offer an objective test to determine the principal place of business, the IRS will undoubtedly rely on Soliman to restrict the home-office deduction in the future. Notice 93-12, issued in February 1993 and discussed later, indicates the direction the IRS is taking.
In 1976, Congress enacted IRC Sec. 280A to prevent taxpayers from converting nondeductible living expenses into deductible business expenses by working a small amount of time in their home office. IRC Sec. 280A allows a deduction for home-office expenses only if the office is used regularly and exclusively as--
1. The principal place of business for any business of the taxpayer, or
2. As a place of business where the taxpayer meets or deals with customers in the normal course of business.
Also, the home-office expenses cannot exceed income derived from the home office. The "principal place of business" issue only arises if the taxpayer's business involves job functions performed at more than one location. IRC Sec. 280A makes no distinction for different types of businesses, e.g. retailing versus manufacturing.
Most of the litigation has focused on the meaning of "principal place of business," which is not defined in the statute. In the first case on Sec. 280A, Baie, the Tax Court interpreted "principal place of business" to mean the "focal point" of the business, which in turn means the place where goods and services are provided to customers and income is thereby generated. This strict test disallows the home-office deduction for most taxpayers who do some work at home, since goods and services are not typically provided in the home. In this case, the court denied the deduction for a taxpayer who cooked food and did administrative chores in her home for her small hot dog stand located one mile away.
The Tax Court retained the focal point test throughout the 1980's. However, in three cases the Court of Appeals reversed the Tax Court. In these cases, the taxpayers spent a majority of their work time performing essential job functions at home and had no other adequate office. In Drucker, the taxpayer was a concert violinist who practiced extensively at home. In Weisman, the taxpayer was a professor. In Meiers, the taxpayer managed a laundromat from her home.
Soliman in the Lower Courts
As described in the original tax court case, Nadir Soliman was an anesthesiologist who provided medical services in hospitals for 30-35 hours per week. For 10-15 hours per week, he managed his medical practice from his home office, performing such functions as phoning patients and surgeons, maintaining billing records, and satisfying continuing education requirements. Since he performed the medical services in hospitals, under the focal point test he could not deduct his home-office expenses.
The Tax Court ruled 11-6 to abandon the focal point test and adopt a test utilizing the following factors:
1. The importance of the work done in the home office;
2. The amount of time spent there doing it; and
3. The lack of an alternate location to do this work.
Finding that Soliman spent substantial time performing essential tasks at his home office and had no other office in which to perform them, the Tax Court allowed the deduction. The Court of Appeals affirmed this decision by a 2-1 vote.
The Supreme Court's Opinion
The Supreme Court completely rejected the lower courts' reasoning. Pointing out that "principal" means "most important, consequential, or influential," the Supreme Court ruled that determining the "principal place of business" requires a comparative analysis of the taxpayer's job functions to determine where the most important functions occur and the time spent doing them. If the most important functions do not occur in the home office, the deduction is denied. The lower courts had failed to undertake this comparative analysis.
The functions of a business can be broken down into marketing (acquisition, transportation, sale, and delivery), production or preparation of goods and services, and administration of the business. While conceding that "in integrated transactions, all steps are essential," the Court held the fact they are essential is of little importance. Instead the Court stressed the need for a comparative analysis of all functions performed at all locations where business is conducted. The two primary considerations required in this analysis are the relative importance of the functions at each location and the amount of time spent at each location.
The Court emphasized that in this comparative analysis, great weight must be given to locations where the taxpayer confers with customers, delivers goods, or renders services. Also, any "facility with unique or special characteristics" must be given special weight. This standard suggests the focal point test of Baie.
The second primary consideration in this comparative analysis is the proportion of time spent at each location. However, the Court did not clarify the precise role of the time factor in determining the principal place of business. One interpretation is that time spent is a factor equal in weight to the importance of the job functions performed at each location. An alternative interpretation is that time spent is only a consideration as a tiebreaker between locations of equal importance. The latter approach is the one taken by the IRS in Notice 93-12 discussed later.
Under the Court's new interpretation, Soliman did not qualify for the deduction. The Court ruled that the treatment of patients was "the most significant event in the professional transaction." In addition, the Court cited the need to deliver these services at a special facility, (the hospital) as further evidence the home office did not qualify as Soliman's principal place of business. Finally, the time he spent in the home office was "insufficient."
The Court also noted that Soliman may prevent taxpayers in "certain trades and professions" from deducting home-office expenses. Presumably taxpayers working in occupations where significant services are provided outside the home could not claim the deduction.
Concert musicians, interior decorators, medical practitioners, auditors, trial attorneys, trades people (electricians, painters, etc.), repair persons, and outside sales people would be among those not eligible. Taxpayers whose only work location is the home office, such as certain writers and people who give advice on the phone or by mail, would still be eligible for the home-office deduction under these rules. For taxpayers who generate income both in their home office and at other locations, the specific facts would determine their eligibility for the home-office deduction.
Finally, the Court made two additional noteworthy points. First, the availability of office space outside the home has no bearing on whether a home office is the taxpayer's principal place of business. Second, the fact there may be situations where there is no principal place of business does not mean that the home office is the principal place of business by default.
Where Do We Go From Here
Soliman focused on the relative importance of the job functions performed and the time spent at each location. The weight given to the delivery of goods and services suggests that the marketing function must be the first consideration in determining relative importance, with added weight given to any special facilities required for marketing or production. While the Court noted the essential nature of the administrative function, it found this function was of little importance in determining the principal place of business. We have constructed the following examples to illustrate our reading of Soliman.
Example 1. An investment advisor works exclusively from a home office. Data is collected from news services, wire services, and mailings, all of which are received at the home. The data is processed in the home office, and the resulting reports are delivered to clients by telephone, fax, and newsletter. Since the three business functions of marketing, production, and administration all occur in the home office, this individual would not be affected by Soliman and the home-office deduction would be allowed.
Example 2. Assume the same facts as Example 1, except the individual must spend one or two days per week outside the home collecting data and processing the information at specialized facilities (a library and a computer lab). Again, the resulting reports are delivered to clients by telephone, fax, and newsletter delivered from the home.
This example illustrates a gray area created by the Soliman decision. The majority of the time spent, as well as all marketing functions, take place in the home. However, the need to employ specialized facilities not available in the home brings a degree of doubt to the deduction.
Example 3. A crafts person uses specialized equipment for production in a home workshop. The finished goods the crafts person produces are picked up by an agent, who sells them elsewhere. In this case, marketing and delivery to the final consumer take place outside of the home. However, the use of an agent transfers the bulk of the marketing functions to a separate entity; therefore, the craft person's involvement in marketing is incidental. In addition, since specialized equipment is used, production is the most important function. This individual would not be affected by Soliman and the home-office deduction would be allowed.
Example 4. Assume the same facts as Example 3, except the taxpayer delivers a significant portion of the goods to the final customers at their homes. This example illustrates another gray area. The special production facilities and the preponderance of time spent in the home support the deduction. On the other hand, the great weight placed by the Court on the delivery function, a significant portion of which occurs outside the home, supports denying the deduction.
Example 5. An individual spends 80% of the time working in a home office preparing educational programs which are then presented at an area technical school. Besides the classroom itself, no specialized facilities are utilized.
The Soliman emphasis on where goods and services are delivered, plus the need to make the presentations in a classroom, would probably result in disallowance of a home-office deduction in this case. Since Soliman is unclear on the importance of both time spent and special facilities in determining the principal place of business, the preponderance of time spent might result in a sympathetic ruling from the Tax Court. However, the IRS would undoubtedly pursue such a case; therefore, it would be risky to claim this deduction.
The Supreme Court's decision in Soliman is the final word on the meaning of "principal place of business" unless Congress amends the statute. Clearly this opinion has the effect of greatly restricting the home- office deduction. Although the Court emphasized that Soliman does not give taxpayers "an objective formula that yields a clear answer in every case," the Court did not elaborate on the limitations or exceptions to their opinion. Nevertheless, practitioners may discover some flexibility in applying Soliman. Only future court cases will clarify its limits.
Taxpayers who claimed the home-office deduction in reliance on either of the lower court opinions in Soliman will want to examine their facts and circumstances in relation to the Supreme Court's decision.
IRS Reaction to Supreme Court Decision
In a display of goodwill, the IRS in Notice 93-12 dated February 22, 1993, announced that it would not challenge deductions taken on prior years' returns as long as taxpayers "reasonably followed" the previous guidance as set forth in IRS Publication 587, Business Use of Your Home. This guidance, which is also contained in proposed regulation 1.280A- 2(b), cited three factors in determining the principal place of business: time, facilities, and income. The notice pointed out that the 1992 edition of Publication 587 will be modified to reflect the Supreme Court's decision by replacing the three factor test for principal place of business with a two factor test as follows:
1. The relative importance of the activities performed at each business location; and
2. The amount of time spent at each location.
Based upon the discussion in the notice, the two factors are not to be treated equally. The IRS has taken the position that the time spent becomes a tie breaker only where the most important activity or activities are performed both at home and away from home.
Notice 93-12 also indicates that the modification of Publication 587 will replace the example under the "Principal Place of Business" discussion with three new examples. The first example will disallow the home-office deduction using facts similar to those in the Soliman case as decided by the Supreme Court. The second and third cases describe two salespersons who operate from their homes. The first regularly meets with customers outside the home to discuss products available for sale and take orders. He spends 30 hours a week visiting customers and 12 hours working at home making appointments and writing orders and sales reports. The second sales person performs the same duties at home as the first, but makes most of his sales by phone or mail from his home office. His time is spent in a reverse fashion--30 hours per week in the home office and 12 hours per week visiting prospective customers. According to Notice 93-12, the first sales person cannot deduct the expenses for the business use of the home; whereas the second can.
Not All the Problems Are Solved
Notice 93-12 removes some of the ambiguity from the Supreme Court decision by its two factor test of "principal place of business." Unlike the Supreme Court, the Notice does not mention the effect of required use of special facilities on determining the principal place of business. Therefore, it is not clear whether upon examination the IRS will raise this issue as a factor in evaluating a home-office deduction. As a result, the ambiguity of the kind described by the authors in Examples 2 and 4 remain. Taxpayers are advised to evaluate their facts and circumstances not only in relation to Publication 587, but also to the discussions in the Supreme Court's Soliman decision itself.
ALL IS NOT LOST
As explained in the 1991 edition of IRS Publication 587 Business Use of Your Home, a taxpayer may take a depreciation or IRC Sec. 179 (immediate expense up to $10,000) deduction for furniture and equipment used in the home for business, including work as employee. This deduction may be taken even if the taxpayer does not qualify to deduct expenses for the business use of the home.
There are special rules for the deduction of home computers. If the computer is used more than 50% of the time for business, the taxpayer may take a MACRS depreciation deduction and an IRC Sec. 179 deduction. Otherwise, the taxpayer may not take an IRC Sec. 179 deduction and must compute depreciation using the straight line method.
The time used on the computer for investments does not count in computing the 50% test for business use. However, the combined business and investment time may be used to compute the applicable depreciation deduction.
For an employee to be treated as using a computer for business purposes, it must be placed in the home for the convenience of the employer as a condition of employment.
Peter Barton, JD, CPA, Associate Professor of Accounting, and Clayton Sager, PhD, Assistant Professor of Accounting, are at the University of Wisconsin-Whitewater.
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