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Lifting the cloud on home office deductions; a recent Tax Court decision means more taxpayers can deduct home office expenses - maybe.

The tax laws concerning home office deductions have changed significantly over the last two decades. During this time, the Tax Court has failed to provide a consistent interpretation of the law; in particular, the court has grappled with the principal-place-of-business requirement, which allows an individual to deduct home office expenses. With the 1990 Tax Court decision, Soliman v. Commissioner, the court finally has a handle on this complicated issue and has allowed greater leniency in home office deductions.

Taxpayers and practitioners need to be aware of these recent changes. The Tax Court gave a favorable decision in Soliman, in which a doctor took a home office deduction for a room he set aside in his apartment for the administrative duties he could not perform in his place of work; the Internal Revenue Service's response has been to vigorously oppose the opinion. However, taxpayers claiming similar deductions must understand the implications of the case to make optimum use of Soliman. An in-depth study of the legislation and court cases leading up to the Soliman decision follows. Understanding what has happened in the recent past will make it easier to understand the impact of Soliman and what it means for those taxpayers wishing to deduct home office expenses.

LEGISLATION BEFORE 1976

Before the Tax Reform Act of 1976, there was very little structure to the laws concerning home office deductions. Business expenses were allowed as deductions for three types of taxpayers:

* Self-employed individuals who used part of their home for trade or business purposes.

* Employees who maintained an office at home in connection with their duties as an employee.

* Investors who performed investment activities at home.

For these individuals, depreciation, rent, maintenance, utility and insurance expenses were allowed up to the allocable share used for business purposes. A deduction was allowed only if the office was required by the employer as a condition of employment and was regularly used for business. Some courts took a more liberal approach to home office deductions and allowed employees a deduction if maintenance of the office was "appropriate and helpful" to the employees' trade or business.

The appropriate and helpful test was a subjective one; it allowed expenses to be deducted if they helped the taxpayer perform some portion of the business in his or her personal residence. In application, however, this test caused some problems. Taxpayers were able to deduct personal expenses that would ordinarily be nondeductible under Internal Revenue Code section 262.

A 1970 decision, Newi v. Commissioney, sheds some light on the situation prior to the passage of the '76 act. (For a listing of relevant home office deduction cases, including complete citations, see the exhibit on pages 46-47.) Newi sold television time for a TV network. He did his work at night in his den, which was set off by partitions and a door. The network did not require Newi to set aside part of his home for office activities. Also, office space and equipment were available at the network in the evenings.

The Tax Court allowed an ordinary and necessary business expense deduction for a portion of Newi's rent, light and cleaning bills. The deduction was allowed even though the home office was not a requirement of the employer and the portion used for business was also used for personal activities at other times. This is just one case where the court used the "appropriate and helpful" test as a basis for the decision. Rulings such as this one caused much tension between the IRS and the Tax Court. THE TAX REFORM ACT OF 1976 Congress clarified and expanded certain areas of tax law regarding home office deductions by including new rules in the Tax Reform Act of 1976. Congress enacted IRC section 280A to clear up any discrepancies. It concluded the "appropriate and helpful" standard previously used by the courts in evaluating home office deductions was too ambiguous. To correct this, Congress stipulated in IRC section 280A that no income tax deduction be allowed for the business or investment use of a dwelling unit if that unit was also used by the taxpayer as a residence during the taxable year.

The provisions of the 76 act applied not only to individuals but also to trusts, estates, partnerships and S corporations. However, Congress provided several exceptions to IRC section 280A. Under certain circumstances, a taxpayer would be allowed to deduct allocable home office expenses associated with a trade or business where the residence was used

* As the principal place of business activities.

* As a place to meet clients in the normal course of business.

* In connection with a trade or business and a separate structure is added to the home.

A further explanation of certain key words and phrases is necessary to understand the implications of the law and congressional intent. An exception to IRC section 280A stipulates the home office be the principal place of business activities. Congress said the portion of the home set aside for business activities must be used exclusively for such activities to deduct any home office expenses. This differs significantly from previous law. Prior to the'76 act, taxpayers were allowed to use the home office for both business and personal activities; the only limitation was that expenses be allocated appropriately between personal and business use. The change disallowed a deduction for any room used for both business and personal purposes. Further, the IRC also disallowed deductions for a room partially set aside for business use. The room had to be used entirely for business.

Using a home office for business purposes on a regular basis was another criterion of the principal place-of-business exception. Employees qualified only if the home office was established for the convenience of the employer. To determine whether the office was set up for the convenience of the employer, an analysis of the facts and circumstances in each case was required. Many of these factors still apply today.

To evaluate whether a home office was a principal place of business, certain factors had to be taken into account, including the amount of time spent in the home office, the amount of business activity involved with the home office and the amount of income generated from each location. An analysis of these factors required a comparison between home and business offices. For employees, income was the most important criterion in determining the principal place of business.

The only other relevant exception involved the meeting of clients in the home office. According to IRC section 280A, "the portion of the home for office use must be used exclusively and on a regular basis as a place of business that is used by patients, clients or customers in meeting or dealing with the taxpayer in the normal course of business. " This rule permitted a doctor, lawyer, salesperson, insurance agent, etc., to deduct home office expenses even though the actual business was operated away from the residence. FOCAL POINT APPROACH

While income may be the most important criterion in determining the principal place of business for an employee, there are other factors as well. In 1980, with Baie v. Commissioner, the courts developed a "focal point" approach to help determine home office deductions. Baie was the first in a series of cases that led to the development of this new standard. In Baie, the Tax Court said, "A taxpayer's principal place of business is where goods and services are provided to customers or clients or where income is produced."

Baie and his wife operated a hot dog stand. Because business was good, the Baies decided to expand their operation. Since they leased the stand, expanding its physical dimensions was not an option. They decided to set up a home office to handle administrative functions and to use their kitchen to prepare food. Their deductions were disallowed by the Tax Court. At the time, there was little legislative history for IRC section 280A, and regulations provided little guidance as to what constituted a principal place of business.

The court concluded what Congress had in mind for principal place of business was the focal point of a taxpayer's activities. In the Baies' case, this was the hot dog stand. Since the final packaging and sale took place there, it was the principal place of business.

In 1983, Green v. Commissioner also played a role in developing the focal point approach. Green deducted expenses for a home office because his employer required him to be available outside the office for client phone calls. The court concluded his principal place of business was his workplace and not his home office; however, it ruled for Green because of IRC section 28OA(c)(1)(B), which says deductions are allowed if the home office is used as a "meeting or dealing" place for clients. The IRS appealed the decision. The Court of Appeals interpreted this section to "apply to offices actually visited by taxpayer clients." Green had no way to defend expenses of making his home suitable for business use because clients never physically visited him. The Tax Court's earlier ruling approving the home office deductions was reversed, and the deductions were disallowed. BROADENING THE FOCAL POINT APPROACH

Several court cases broadened the interpretation of home office deductions, casting serious doubt on the strict interpretation of IRC section 280A and the focal point approach. Drucker v. Commissioner (1983) was one such case. Where taxpayers are employed is most often their principal place of business. If this is really the case, the decision in Drucker implies there will seldom be a home-office deduction allowed for an employee of a company. Still, the courts found for the taxpayer in Drucker.

Drucker was a concert violinist, employed by the Metropolitan Opera. The Met did not supply space for him to study or practice. Drucker maintained in his home a practice room used exclusively for musical study and practice. He spent between 30 and 35 hours per week practicing in his home office. The IRS denied his deduction, and the Tax Court supported the IRS decision.

This decision was based on the grounds the Met was Drucker's principal place of business, since this was where he performed his services and received his income. Also, the court believed the home studio was not set up for the convenience of the employer, but for Drucker's convenience because the Met did not require him to have an office. Because of this, the Tax Court said the home office deductions should be disallowed because the office failed the focal point test.

In an appeal, a higher court disagreed with the Tax Court decision. The Tax Court had based its ruling on the belief Drucker was in the business of being a "Met employee." The court of appeals felt this was where the Tax Court erred; Drucker's principal place of business was not the Met, but his practice studio. The court found in this rare situation that "both in time and importance, home practice was the focal point' of the appellant musician's employmentrelated activities." The amount of time the taxpayer spent in his home studio versus his office decided his principal place of business. Since Drucker's performance at the Met was related to the amount of rehearsal time, "the place was immaterial so long as the musicians were prepared." Most of this preparation occurred in his home. Therefore, the deduction was allowed. Drucker cast serious doubt on the focal point approach.

In 1984, Weissman v. Commissioner further undermined the focal point test. For Weissman to maintain his teaching position at the City University of New York, he was required to do research and publish in his field. Because Weissman shared an office at the university, he set up an office in his home, where he spent 80% of his time researching and writing.

Originally, the Tax Court denied a home office deduction; Weissman had failed the focal point test. The appeals court, however, said the focal point approach shifted too much attention to "the place where a taxpayer's work is more visible, instead of where the dominant portion of his work is accomplished." Since the university office Weissman shared was considered unsafe to keep research materials and no other office space was available, Weissman was allowed to maintain a home office. That he spent 80% of his time in the home office was the final and most important fact. The court said a major consideration in determining principal place of business should be "the length of time the taxpayer spends in the home office as opposed to other locations." Weissman's home office was his principal place of business.

Increasingly, a length-of-activity approach was used in connection with the focal point test. In 1986, the courts relied on this criterion in Meiers v. Commissioner. John and Sally Meiers were sole shareholders of the Appleton Laundry Corporation, which operated a selfservice Laundromat. Mrs. Meiers spent most of her time performing administrative functions in her home office. Again, the Tax Court denied any home office deductions. Relying on the legislative history of IRC section 280A and Weissman, the appeals court overturned the Tax Court's ruling. As evidenced in Weissman, there was more to consider in determining principal place of business than where goods and services were provided or income generated. Weissman used a comparison of the amount of time spent in each office as the principal test. While this was important, it was not the only consideration.

In Meiers, the appeals court looked at the "importance of the business functions performed by the taxpayer in the home office." Mrs. Meiers spent more time in her home office than she did at the Laundromat. Furthermore, her most important activities, including keeping the books and scheduling, were performed at home. Therefore, deductions were granted. A NEW STANDARD

By 1990, the courts were looking for a new standard on which to base the principal place of business exception. The focal point test looked only at where services were performed. In Soliman v. Commissioner (1990), the courts established such a standard, which has become known as the Soliman approach. In this case, the Tax Court was asked to analyze "all the facts and circumstances to determine taxpayer's principal place of business." The principles established by the Soliman decision continue to be useful to practitioners until replaced or modified by a more recent decision.

THE SQLIMAN APPROACH

Nader E. Soliman was a self-employed anesthesiologist who incorporated his practice in September 1983. He worked for two hospitals, where he spent from 30 to 35 hours per week. Since he was not provided an office at either of these locations, he spent two to three hours a day working in his home office. He used a room in his apartment exclusively to manage his medical practice. The activities he performed at home, billing patients and scheduling surgery, were essential to his practice, although not necessarily directly related to his primary income-generating services as an anesthesiologist.

IRC section 28OA(c)(1)(A), enacted as part of the'76 act, permits a deduction for home office expenses if the portion of the home is exclusively used on a regular basis as a principal place of business for any trade or business. The Tax Court agreed Soliman used the home office exclusively and on a regular basis; however, the question arose whether the home office was his principal place of business. The court applied the "focal point" test but said under the circumstances the test was insufficient to determine deductibility of the home office expenses.

The Tax Court believed the focal point test should be evaluated along with the IRC section to determine whether both should be applied to Soliman, in which administrative activities of the taxpayer's business were essential and no office was available outside his home. The problem with the focal point test alone was it looks only to where services are performed and income generated. According to this requirement, Soliman obviously failed the test, because he did not generate income working at home.

In Soliman, the Tax Court held that where "a taxpayer's occupation requires essential organizational and management activities distinct from those activities that generate income, the place where the business is managed can be the principal place of business." The court said the previously used focal point test merged the "principal place of business" exception with the "meeting of clients" exception. However, these two exceptions do not necessarily go hand in hand. By merging them, the court said, the principal place of business exception seems not to apply.

Soliman had two separate activities. He was required to render medical services at two hospitals and to oversee the administrative activities of his own business. The first function did not require the use of an office; therefore, he was not given one by either hospital. However, the second activity did require an office. Consequently, Soliman used his home for this purpose and deducted the expenses appropriately. Congress did not intend IRC section 280A to compel taxpayers to set up business offices outside their homes in order to be able to deduct the cost of maintaining such necessary facilities.

The court relied on some of the factors mentioned above in considering home office deductibility, including the amount of time spent in each place of business, as well as whether the functions performed at home were essential to the business. Another consideration was whether the home office was suitable for the functions performed there. A comparison of the number of hours spent at each location was misleading. The court said the activities involved were very different. Comparing unrelated activities such as administrative duties and medical services is impossible. Therefore, it proposed a new test be considered-a substantial amount-of-time test. Soliman spent 30% of his time at his home office. The Tax Court considered this to be substantial. In evaluating what constitutes a substantial-amount-of-time, the Soliman court established that 30% is substantial enough to qualify for a home office deduction. But, is 5% or 10% substantial? In looking at previous cases, the court relied on the 1986 decision in Pomarantz v. Commissioner to provide taxpayers with some insight into what is not considered "substantial."

In Pomarantz, the courts ruled against the taxpayer because the amount of time spent in the home office was not substantial. Pomarantz was a physician who worked as an independent contractor. He was not provided an office by the hospital. Pomarantz spent only two to three hours per week in his home office. The amount of time was considered insubstantial. While 30% is substantial, two to three hours a week are not.

REACTION TO SOLIMAN

The IRS wasted no time reacting to Soliman. It opposed the decision and is asking the Tax Court to reconsider. If the court stands firm, the IRS plans to appeal the ruling. To some experts, the substantial amount-of-time requirement seems too vague. This is one reason the IRS has taken such a firm view against Soliman. But, Soliman also offers a guideline concerning what might be "substantial." Clearly, 30% is substantial.

The Tax Court's analysis of Soliman says the time Soliman spent in his office could not alone be used as a basis for deciding the principal place of business. The court decided the principal place of business was his home because his activities at home and at the hospital were unrelated. It advised no longer looking to Drucker. Instead, the court suggested granting home office deductions in cases where a taxpayer's home office is essential to his business, he spends substantial time there and no other location is available to perform essential office functions.

The Soliman approach is important because it keeps the two exceptions-principal place of business and meeting of clients separate. In the focal point test, these two ideas had been merged. The courts realized this and have been trying to get away from this position. Essentially, the focal point approach eliminated the principal-place-of-business requirement. The principal place of business is not necessarily where goods and services are transferred to customers, but it is quite often the administrative headquarters of a business. Taxpayers can thus be permitted to take home office deductions if they spend a substantial amount of time working in this administrative headquarters. CONSEQUENCES OF SQLIMAN

It appears taxpayers can rely on Soliman to substantiate home office deductions. Yet, the IRS is making it very difficult to use Soliman as an authority. It has been years since a press release was issued by the IRS regarding its position on a particular court case. A press release was, however, issued regarding Soliman in which the IRS cautioned taxpayers not to rely on the decision. However, until the dispute between the IRS and the Tax Court is settled, Soliman is still a valid authority.

Taxpayers who believe they can deduct home office expenses for prior years using Soliman as support can file amended returns for those years. These returns will be treated as claims for refunds; the IRS has stated it will suspend such claims until the issue is settled. Taxpayers unwilling to wait for settlement can file refund suits against the IRS six months after their amended returns are filed. For those who wish to take a deduction currently, the IRS is forced to refund any tax overpayments unless it wishes to pay interest on the overpayment.

The Soliman decision reflects the changing view of the Tax Court and attempts to accurately interpret IRC section 280A. The court had hoped its Soliman decision would clear up this controversial issue and offer a rational guideline for taxpayers and practitioners. It seems likely, however, the issue will not be fully resolved until the courts issue a decision with which the IRS agrees.

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Author:Cuciniello, Victor
Publication:Journal of Accountancy
Date:Jul 1, 1991
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