Redefining the home-office deduction

Nation's Business, Sept, 1997 by Gloria Gibbs Marullo

The home-office deduction has been around for more than 20 years, but home-based-business owners and the Internal Revenue Service have yet to see eye to eye on what constitutes a tax-deductible home office. Little wonder. It's more complicated than it initially appears.

It is not just one deduction but actually several deductions added together. They include a portion of items such as mortgage interest or rent, depreciation of the space used as the office, utility bills, insurance costs, and repairs.

"The home-office deduction is a clash of conflicting principles," says Karen F. Brown, a CPA in Manassas, Va., who specializes in small businesses. "Family and personal living expenses are not deductible. Business expenses are. It's inevitable that the rules will collide."

Despite such collisions, about 1.6 million people claim the home-office deduction each year, according to the IRS. To qualify, you must show that you use your office exclusively and regularly in a trade or business.

In addition, owners must meet at least one of the following three tests:

* The home office is the taxpayer's principal place of business.

* The home office is a place where the taxpayer meets or deals with patients, clients, or customers in the normal course of business.

* The home office is a separate structure, not attached to the residence, used in connection with the taxpayer's trade or business.

The High Court's Opinion

Determining whether an office meets the principal-place-of-business test has sparked hot debate and one landmark Supreme Court case. In 1993, the high court interpreted the principal-place rule very narrowly in Soliman vs. Commissioner of Internal Revenue. The decision eliminated the home-office deduction for many taxpayers.

The Soliman case involved a self-employed anesthesiologist who worked at three hospitals but maintained a home office to do his scheduling, patient reports, insurance filing, and billing. Soliman claimed a tax deduction for depreciation of the office portion of his home, but the IRS denied it after an audit of his tax return.

Soliman appealed all the way to the Supreme Court, which upheld the IRS. The high court ruled that the doctor's principal place of business consisted of the hospitals where he spent 30 to 35 hours a week with patients.

In 1994, the IRS issued a set of regulations designed to explain by example what the Supreme Court ruling meant. One example involves a plumber who works from home and employs one full-time worker to answer phones and do bookkeeping. The plumber actually uses his home office 10 hours a week and is at customers' homes 40 hours a week. The IRS says he is not entitled to deduct depreciation because his home office is not his principal place of business.

Nonetheless, he may deduct all ordinary business expenses, including the employee's salary.

Dissatisfaction over the Supreme Court's restrictive interpretation prompted small-business advocates on Capitol Hill to propose overturning the Soliman ruling. Congress did just that in the tax bill passed in late July, by redefining a principal place of business as an office that meets both of the following descriptions:

* It is used for conducting administrative or management activities of a trade business.

* It is the only place where the business owner conducts substantial administrative or management activities for the trade or business.

Thus, business owners who perform services or deliver goods outside the home, such as sales representatives and real-estate sales agents, will be able to qualify for the home-office deduction.

But not right away. The change doesn't become effective until Jan. 1, 1999.

Rep. James Talent, R-Mo., the chairman of the House Small Business Committee, says the change will benefit several million lawyers with home offices.

Home Work That Passes

By contrast, businesses that generate their income within the home office have no problem meeting the current IRS regulations. For example, Traci DeGroat of KTDID Marketing & Promotions in Manassas works from a home office that qualifies as a principal place of business. DeGroat, who has three small children, is a former corporate promotions manager who started her business in 1990 to better manage family and career.

"I'm very happy at home with my computer," says Degroat. "Ninety-five percent of my business comes through contacts I've made serving on chamber of commerce committees, but I do all of the work at home." Her children, she adds, "spend 10 hours a week at day care. This is a serious business."

Similarly, anyone using a detached structure regularly and exclusively for a home-based business should have no problem claiming the home-office deduction. Many physicians and lawyers easily pass the test of meeting clients or patients in their offices.

Areas Of Less Certainty

Although some types of home business present a clear case for a tax deduction, there are other occupations that, by their nature, can pose harder questions about deductibility. Accountant Brown cites the example of computer consultants who work on some projects exclusively in their home offices while other contracts require them to be at a client's place of business in an office provided for them.