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Home Office Deduction
By Jason Watson, CPA
Posted Saturday, November 4, 2023
Is there a way to have the business reimburse, compensate, or otherwise pay for my home office? Can I still take a home office deduction with an S corporation? Yes, there is a way to claim a home office deduction with an S Corp.
Prior to the IRS making a recommendation to use the Accountable Plan and subsequent reimbursements to the employee (or shareholders), taxpayers would charge their corporation rent and declare the rent as income on Schedule E. Ok, but not elegant.
In the garden variety LLC world, the beauty of this was to take money out of the business as passive income. Since you were changing the color of money from earned income to passive income you were also sidestepping self-employment taxes. In the S corporation world, the beauty of this was to reduce the S Corp’s overall income, and therefore reduce the reasonable salary heuristics or thresholds for shareholders while still taking money out of the business as passive income (again reducing self-employment taxes).
The IRS got sick of this (among other things of course).
The new school way is to use an Accountable Plan and reimburse the employee (you) for expenses associated with the home office. Remember, if you are an S Corp owner, you are both shareholder and employee. Imagine yourself as an employee of Google- the relationship would be arms-length, and you would submit expenses to Google just like you should with your own S corporation. Maintaining an arms-length perspective in your dealings as an employee of your S Corp will help you in the long run.
Your business must have an Accountable Plan to take advantage of this scenario and the basic housekeeping must be satisfied.
Section 280A of the Internal Revenue Code reads in part, “Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.”
So, what are the exceptions?
- Certain business use (typical home office, and discussed more here)
- Certain storage use
- Rental use (tax free… 14-day “Master’s” rule or “Augusta” rule)
- Providing day care services
Section 280A continues by reading-
Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis-
(A) as the principal place of business for any trade or business of the taxpayer, or
(B) as a place of business which is used by patients, clients, or customers in … the normal course of trade or business,
(C) in the case of a separate structure which is not attached to the dwelling unit, in connection with … trade or business.”
We highlighted the buzzwords intentionally. Let’s define these more carefully-
- Exclusive means the identifiable space or room is used only for business purposes (so let’s not have a bed in your home office).
- Regular is a squishier since it is a facts and circumstances evaluation. Spending 4 hours a month selling Etsy stuff online probably won’t win too many arguments.
- Principal place of business was once a hot topic but has been tightened up with this language right out of the tax code- “For purposes of subparagraph (A), the term “principal place of business” includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.”
- Trade or business has been defined in Commissioner v. Groetzinger, 480 U.S. 23, and reads in part, “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement does not qualify.”
Administrative or management activities include a nice list from IRS Publication 587 such as billing customers, clients, or patients, keeping books and records, ordering supplies, setting up appointments, forwarding orders or writing reports (we list more below).
Multiple Work Locations
You can have multiple work locations. The IRS states that if you use a home office as your primary location for substantial administrative activities you are allowed to essentially have two work locations. For example, you own a landscaping business and you have an office in your shop. You perform all your administrative activities such as hiring and firing employees, accounting, balancing your checkbook, talking to your attorney, chatting it up with your Colorado Springs CPAs at WCG etc. in your home office, that office counts as a work location in addition to your office in your shop. Here is the play-by play-blurb from the IRS-
You can have more than one business location, including your home, for a single trade or business. To qualify to deduct the expenses for the business use of your home under the principal place of business test, your home must be your principal place of business for that trade or business. To determine whether your home is your principal place of business, you must consider:
1. The relative importance of the activities performed at each place where you conduct business, and
2. The amount of time spent at each place where you conduct business.
Your home office will qualify as your principal place of business if you meet the following requirements.
1. You use it exclusively and regularly for administrative or management activities of your trade or business.
2. You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.
This also works well for the consultant who works out of his or her home office, but also spends a ton of time on site with the client.
Don’t forget that commuting miles between your residence and your office are not deductible, but if you have a home office suddenly these miles become business miles and therefore deductible. Boom! The use of Boom! is apparently out of fashion. Whatever.
You can read the full IRS Publication 587 (Business Use of your Home) by using the link below-
We will discuss the question, “What is my tax home?” in a few pages.
Get Reimbursed for the Home Office
The expense report should detail the space used as a home office or storage of business items (inventory, supplies, etc.) as a percentage of overall square footage of the home. This percentage is then applied against rent, mortgage interest, property tax, utilities, HOA dues, insurance and repairs to determine the expense amount to be reimbursed. The reimbursement can be monthly or quarterly or annually- your choice.
Keep in mind that two major expenses associated with a home office are mortgage interest and property taxes. These expenses are already 100% deductible on Schedule A (assuming your state and local taxes (SALT) do not exceed $10,000), so for most taxpayers the home office deduction or reimbursement is relatively small. And you must reduce your mortgage interest and property taxes being deducted on Schedule A by the amounts reimbursed by your business. No double dipping.
Here is quick table on what we mean-
|Total Home Size||2,500|
|Home Office Size||150|
|Home Office %||6.00%|
|Depreciation ($400,000 building)||10,256||615||NA|
|Total Non Sched A||15,556||933|
|Savings @ 22%||205|
|Savings @ 37%||345|
What are we showing here? Good question! The $933 number above represents a reimbursement to you and a deduction to the business that would otherwise not have been deductible except through an Accountable Plan reimbursement. In essence with a home office you are deducting portions of Hazard Insurance, Utilities, HOA Dues and Depreciation.
So, a home office reimbursement as a business deduction might put $200 to $350 in your pocket. Might be worth it based on that alone, but where the home office has a ton of weight is now your commute is from the bedroom to the basement or den, and all travel from your home office is business travel.
Here is another consideration. For those taxpayers who are seeing Schedule A deductions being phased out due to high income, SALT limitations and / or Alternative Minimum Tax (AMT), using the home office reimbursement is a way to ensure these deductions are not reduced.
This can be a huge swing in taxes. This is one of the largest compelling reasons to have WCG (formerly Watson CPA Group) prepare both your corporate and individual tax returns- we can move things around to ensure the maximum deduction is obtained.
There are other examples. A quick example would be where you own an office building 100% through an LLC and the business is operating as a separate LLC or S Corp. The rent must be market rent- we suggest using Zillow or a realtor to periodically update your comparables for market rent analysis. This is outside the home office world (see our chapter on self-rentals).
Home Office Safe Harbor
There is a safe harbor provision for home office deductions where you can deduct $5 per square foot. This would be on Form 8829 for LLCs without an S Corp election. However, for S Corps where you choose to reimburse yourself for the use of the home office, you cannot use the safe harbor method.
According to IRS Revenue Procedure 2013-13 which reads in part-
.02 Reimbursement or other expense allowance arrangement. The safe harbor method provided by this revenue procedure does not apply to an employee with a home office if the employee receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee’s home under a reimbursement or other expense allowance arrangement (as defined in § 1.62-2) with his or her employer.
An expense allowance arrangement is synonymous with an Accountable Plan which we discuss in detail in Chapter 10 (Accountable Plan Expense Reimbursements, page 277). Therefore, you must use actual expenses! This is in stark contrast to the mileage reimbursement since the IRS simply gives you a rate per mile regardless of what you spend.
For disregarded LLCs and sole proprietors, there are some real advantages for using the safe harbor method such as being able to use all mortgage interest on Schedule A instead of a proration. But there are also some limitations that need to be considered. We typically optimize for both methods in these situations.
Home Office Issues with Multiple Owners
We broached this concern in Chapter 2 (Multi-Member LLC That Issues Invoices, page 48) but we’ll tackle it again here. Let’s say you and another person own a business together, and you elect to have the entity taxed as an S Corp. You also create an Accountable Plan to reimburse home office expenses among other things.
As you have learned, you cannot use the simplified method and therefore only actual expenses are reimbursed. No biggie right? Well, perhaps. However, what happens if your home office is smaller as a percentage of your overall home size? In other words, your room is 150 square feet and your house is 3,000 square feet… this is 5%. But your business partner has 180 square feet within a 2,500 square foot house… or about 7.2%.
Perhaps we are splitting hairs… but wait… there’s more! What if your property taxes are substantially lower than your business partner’s? HOA dues? Insurance? Housekeeper? We could go on and on.
You could limit your Accountable Plan expense reimbursements to a certain dollar amount, but doesn’t that hose the other guy? You could reimburse without regard to limits or amounts, but doesn’t that hose the guy with a smaller reimbursement? We’ll find a new word for hose.
Yes, all those things are true except finding a synonym for getting hosed. One solution is to split up into a multi-entity arrangement as shown in Chapter 2 (Multi-Member LLC That Issues Invoices, page 45). Talk to us and we can help!
Home Office With Partnerships
If you are a partner in partnership (member of a multi-member LLC) that is not being taxed as an S corporation, you might be able to reduce partnership income through a tax mechanism called Unreimbursed Partnership Expenses, or UPE for short. UPE is a slamma-jamma version of old school Form 2106 unreimbursed employee expenses, and is a singular line on Schedule E Page 2 reducing partner income.
Here is the blurb from the IRS website on completing Schedule E if you can’t get enough-
You can deduct unreimbursed ordinary and necessary partnership expenses you paid on behalf of the partnership on Schedule E if you were required to pay these expenses under the partnership agreement. You only can deduct unreimbursed expenses on Schedule E that are trade or business expenses under section 162. Don’t report unreimbursed partnership expenses separately if the expenses are from a passive activity and you are required to file Form 8582.
If your partnership agreement or operating agreement allows for it, partners can deduct UPE. However, an Accountable Plan-esque method must be used to create the workpapers and math behind the calculation since it is one big fat number without supporting statements or supplemental forms on your individual tax return (Form 1040).
Home Office Depreciation
Similar to rental properties (among other things), depreciation on a home office is required by the IRS. Here is a Q&A from their website under Sale or Trade of Business, Depreciation, Rentals > Depreciation & Recapture.
Question- I have a home office. Can I deduct expenses like mortgage, utilities, etc., but not deduct depreciation so that when I sell this house the basis won’t be affected?
Answer- No. All allowed or allowable depreciation must be considered at the time of sale. You can generally figure depreciation on the business use portion of your home up to the gross income limitation, over a 39-year recovery period and using the mid-month convention. As long as you determine actual expenses and the correct amount of allowed or allowable depreciation, the depreciation reduces the basis of your home accordingly, whether or not you actually claim it on your tax return.
Note that last phrase, “whether or not you actually claim it on your tax return.” That is the kicker. Truth be known, when a client sells their primary residence most tax professionals do not ask if it was ever used as a home office. Right, wrong or indifferent, it is often overlooked.
Additionally, home office depreciation is tough to track within a tax return. Sure, if you are a disregarded LLC or sole proprietor and reporting your business activities on Schedule C, you will use Form 8829 to generate the home office deduction and that form helps track home office depreciation. Easy.
If you use the simplified method for the home office deduction, you do not have a depreciation recapture problem since you do not have to depreciate your home office. Easy again. But as you know, using an Accountable Plan for reimbursing the S Corp shareholders (recall the two hats- employee and investor) requires actual expenses for home office reimbursement including depreciation.
What makes matters worse is that the depreciation deduction for home office reimbursement is truly done at the business entity level (Form 1120S or 1120). The individual tax return (Form 1040) is not affected, but when the home is sold, depreciation recapture is picked up as income by the individual who was reimbursed.
The tax theory goes like this- if you are reimbursed for depreciation then the cost basis of the asset is reduced by the amount of depreciation. When the asset is sold your reduced cost basis could increase your taxable capital gain (for houses, Yes, for automobiles and other things, probably No).
Sidebar: Having your S corporation reimburse you for business mileage also reduces the cost basis of your automobile by 28 cents per mile (for the 2023 tax year). If you think home office depreciation is often overlooked, the reduction in cost basis for your automobile because of reimbursed mileage is flat-out ignored by most.
WCG CPAs & Advisors tracks home office depreciation within an individual tax return (Form 1040) by creating an out-of-service asset, and updating the historical depreciation each year. Not ideal, but at least it is contained within the owner’s individual tax return for tracking, eventual sale and recapture.
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