Update on the allowability of the home office deduction.

When are the expenses associated with a home office deductible? After the Supreme Court's 1993 decision in Soliman, 113 Sup. Ct. 701, rev'g 935 F2d 52 (4th Cir. 1991), aff'g 94 TC 20 (1990), the answer is "rarely." Soliman defined the "principal place of business" test so narrowly that even individuals who perform essential business activities in the home office will be denied deductions for utilities, depreciation, insurance, repairs, etc., for that office.

The Tax Reform Act of 1976 added Sec. 280A(c)(1), which provides that the "portion of the dwelling unit which is exclusively used on a regular basis ... [as] the principal place of business ... of the taxpayer" is exempted from the general rule that prohibits a business expense deduction for a portion of the cost of a personal residence. Judicial action has imposed severe restrictions on the ability of individuals to make use of this provision.

In Soliman, the Supreme Court established new guidelines for a home office to qualify as a "principal place of business." Currently, it is not sufficient to show that the activities performed in the home office are essential to the business; rather, it must be established that the functions performed in the home are the most significant events relative to the business in question.

Individuals must consider the relative importance of activities performed at each business location and focus on whether revenue is generated or services are performed in their home offices. The Court further held that individuals should compare the amount of time spent at home with time spent at other places where business activities occur. The Court noted that this comparative analysis may reveal no principal place of business analysis does not demonstrate that the principal place of business is the individual's home, the individual is not entitled to a deduction for the home office.

The Court decided that the actual treatment of patients by Soliman, who was an anesthesiologist, was the most significant event in his professional transactions. The Court also noted that the doctor spent 10 to 15 hours of essential administrative and preparation time in his home office, as compared to 30 to 35 hours performing services in three hospitals. The Court found that if the nature of the business "requires the taxpayer to meet or conference with a client ... or to deliver goods or services to a customer, the place where that contact occurs is often an important indicator of the principal place of business." Many employees cannot demonstrate that they are entitled to deduct the cost of their home offices under this standard; they rarely (or never) generate revenue or service customers there.

The IRS has issued Rev. Rul. 94-24 to help individuals interpret Soliman's "relative importance" and "time" tests. It provides four situations illustrating when a home office will (or will not) be deductible. The plumber and the school teacher who used their homes for administrative functions and performed services outside the home were not permitted to deduct their home office expenses. The writer's home office was his principal place of business even though he also attended promotional events and meetings outside the home. The jeweler who worked out of his home but also spent significant time at craft shows and consignment shops must look to the "time" test to determine whether his home office was his principal place of business. Because he spent almost twice the time working out of his home as he did in other locations, his home office expenses were deductible.

This ruling illustrates that Soliman allows the nature of the individual's business to dictate whether the home office is deductible. Some types of businesses clearly have principal places of business; others do not. If the individual is a dentist who uses the home office to treat patients, the home office is deductible. If the individual is a consultant who performs services at the customer's job site, the use of the home office (and equipment therein) for essential management and planning functions is not deductible.

The home office deduction has relevance beyond the small business run out of a home or the independent consultant, e.g., for employees whose employers maintain no local business office and who maintain a business office in their homes for essential business activities.

Also, if a home office is the individual's principal place of business, daily transportation expenses incurred in traveling between the taxpayer's residence and other work sites will be deductible. if the office fails the test, only mileage beyond that to the first call and prior to the last call of the day is deductible.

Legislation currently pending in Congress could ameliorate the result of the Soliman case. As part of the Contract With America, Congress will consider the job Creation and Wage Enhancement Act (H.R. 9), which would allow a home office to qualify for a deduction as the "principal place of business" if it is where the individual regularly and systematically conducts essential administrative and management activities, and the individual has no other location to perform these activities for the business. The provision retains the requirement under current law that the office be exclusively for business use and for the employer's convenience.