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Tax planning aspects of the Section 119 lodging exclusion.

The value of employer-provided lodging, including utilities, is excluded from an employee's gross income if certain conditions are met. Since the lodging expenses are still deductible by the employer, small business owners should try to meet the eligibility requirements. When coupled with a sale of the employee's home to the employer, the tax advantages may be magnified.

Although the typical employer will be a C corporation, the use of an S corporation may provide even greater advantages. The eligibility requirements, choice of legal entity and possible tax benefits are explored below.

When Lodging is Excluded from Gross Income

Under Section 119 and the Regulations thereunder, the value of lodging (including utilities) furnished by an employer to an employee is excluded from the employee's gross income if all three of the following conditions are met:(1)

* The lodging is furnished on the business premises of the employer;

* The lodging is furnished for the convenience of the employer; and

* The employee is required to accept such lodging as a condition of employment.

The employer, on the other hand, is not deprived of any of its deductions with respect to the lodging, e.g., cost recovery, interest and property taxes, utilities, insurance, repairs and maintenance.

All three conditions are capable of being met when a taxpayer incorporates a business run out of taxpayer's home. Consider the following:

* By transferring (renting or selling) the home to the corporation, using the home address as the business address and physically locating the business in the home, the first condition is met. The regulations define the "business premises" as the place of employment of the employee.(2)

* Condition 3 is easy to meet by having a written employment contract with the corporation requiring the shareholder-employee to live on the premises, i.e., to promise not to move out as a condition of employment.

* Condition 2 is not as easily met as 1 and 3 since Section 119(b)(1) states that the existence of an employment contract is not conclusive as to the "convenience of the employer" issue. The regulations require that the lodging must be provided "...to enable the employer properly to perform the duties of his employment."(3)

This condition should be met where all corporate business is transacted on the premises, the shareholder is the only employee and the taxpayer's only phone doubles as the business phone. In fact, living and working on the same premises provide the ultimate convenience for both employer and employee! Furthermore, the employee's convenience does not negate the application of the Section 119 exclusion.

For purposes of Section 119, lodging includes utilities such as heating, air conditioning, water, gas and electricity. Thus, case law has held that the exclusion includes expenses necessary to make the lodging habitable.(4)

In one leading case, the Section 119 exclusion for lodging, including utilities, was allowed to the taxpayer and his family where the taxpayer was the employee of his 100%-owned farm corporation. The facts simply showed that he was required to be available on the premises as a condition of his employment and that this was for the convenience of the employer.(5) Another court that also allowed the exclusion found it compelling that the nature of the work was such as to require the employee to be available at all times.(6)

Section 119 and the "Office At Home" Deduction Compared

The Section 119 lodging exclusion is more advantageous than the Section 280A(c) "office-at-home" deduction for several reasons. For example:

* Unless the taxpayer is self-employed, the home office deduction may only be claimed as an itemized expense. Furthermore, it is a "miscellaneous itemized deduction," subject to the 2% floor under Section 67 and the phase-out of itemized deductions under Section 68.

* The home office deduction is limited to gross income (less adjustments) from its use under Section 280A(c)(5) with a carryover of the excess.

* The home office deduction can only be taken with respect to the portion of the home exclusively used for business purposes while the Section 119 exclusion (and the employer deductions) cover the personal living areas as well.

* No home office deduction is allowable for premises rented by the employee to the employer under Section 280A(c)(6). By contrast, Section 119 is not rendered inapplicable because of an employer/employee rental arrangement.

The two provisions are similar in that they both have a "convenience of the employer" provision and a "business premises" test. The latter is worded as "the principal place of business for any trade or business of the taxpayer" under Section 280A(c)(1)(A) and "the business premises of the employer" under Section 119(a)(2). Of course, these are both one and the same when the business operates out of taxpayer's home.

The bottom line is that Section 119 provides a number of advantages not present under the home office provisions.

The Optional Legal Choice of "Employer"

The ideal choice of employer to achieve the maximum benefit from Section 119 is the S corporation. This may be made clear when alternative legal forms of business are surveyed:

Proprietorships. As a proprietor, the taxpayer has no employer and is not an employee but an independent contractor (self-employed) and Section 119 has no application. Furthermore, a proprietorship is not a separate legal person so no transfer of a home can be made to "it."

Partnerships. Although a partnership is a separate legal flow-through entity, several disadvantages exist. First, there must be at least two partners. Secondly, partners are self-employed, not employees. However, one court has conceded that it is possible to be a partner and an employee for Section 119 purposes simultaneously.(7)

Limited Liability Companies. These have emerged as an alternative to partnerships and S corporations as they are treated as corporations under state law and typically as partnerships for Federal tax purposes. However, if treated as partnerships they suffer from the disadvantages of partnerships and if treated as C corporations they suffer from the corporate disadvantages.

C Corporations. A corporation is a separate legal entity so that a shareholder may transfer property to it and receive tax-free cash. Also, there is no legal barrier to being a shareholder-employee eligible for the Section 119 exclusion. However, C corporations and their shareholders are subject to double taxation if there is income, while losses are trapped in the corporation as opposed to flowing through to the shareholder-employee. The C corporation is a strong candidate as a Section 119 vehicle if it has limited taxable income or loss in the long run, since Section 119 enriches the shareholder-employee tax-free while providing deductible corporate expenses.

S Corporations. An S corporation offers the advantages of a C corporation with respect to Section 119 but is a pass-through entity. Thus, there is no double taxation and losses flow through to the shareholder-employee.

In cases where the Section 119 exclusion is not available, the office-at-home deduction may be allowable and provide an important if lesser benefit.

Fringe Benefits of S Corporations

Under Section 1372, an S corporation is to be treated as a partnership and its more-than-2% shareholders as partners for purposes of employee fringe benefits. However, a good case can be made that this general rule does not apply to the Section 119 lodging exclusion. At least two different arguments can be made to that effect:

* The lodging exclusion is not a fringe benefit since it is predicated on the employer's convenience and is a condition of employment.

* A shareholder (or partner) may also be an employee at the same time. Even a partner may be considered an employee under Armstrong v. Phinney. An S corporation shareholder who works for the corporation is an employee not only under local law but under Federal law, most notably for social security purposes. Paying the shareholder/employee a fixed salary will further bolster this argument.

At the time of writing no cases or administrative pronouncements contradict these arguments.

Section 119 Planning with an S Corporation

Assuming that the Section 119 lodging exclusion is available in an S corporation setting, the ideal situation for its use involves the sale of an over-age-55 shareholder-employee's home to the corporation at a gain, then meeting the Section 119 requirements.

Example: Brenda, age 55, owns her own home free and clear, with an adjusted basis of $75,000, a fair market value of $200,000 and with a fair rental value or $1,000 a month. Before she starts a mail order business that will occupy 60% of the floor space for office and storage facilities, she does the following:

* She forms a corporation under local law with a minimum capital of $1,000. The corporation's address is given as that of her home.

* She makes an "S" corporation election.

* She sells her home to the corporation for a note in the amount of $200,000, secured by a mortgage on the property.

* She signs an employment contract with the corporation requiring her to live on the premises.

* She pays the corporation no rent, not even the fair market value of the residential portion.

* She takes a fair salary for services rendered.

The tax consequences are as follows:

* Brenda may exclude her $125,000 gain on the sale of a principal residence by making the Section 121 election on Form 2119.

* The corporation's original basis in the property is $200,000, the purchase price.

* Brenda's basis in the S corporation is $201,000: $1,000 of stock basis and $200,000 of debt basis under Section 1367(b)(2)(A).

* The corporation will cost recover the building over 31.5 years as "nonresidential real property." Under Section 168(c), 100% of the $200,000 not allocable to land is cost recovery property but is not eligible for a 28.5 year recovery period. This is because "residential rental property" is defined as "... any building or structure if 80% or more of the gross rental income ... is rental income from dwelling units." Here no rent is charged because 100% of the property is used for the corporate owner's business purposes.

The corporation's expenses related to the property all flow through to Brenda, who has ample stock and debt basis to absorb them. They include:

* Cost recovery deductions on the whole building;

* All utilities--such as heating, air conditioning, water, electricity--as well as insurance, repairs, maintenance, cleaning, etc.;

* All property taxes and mortgage interest;

* All expenses directly incurred for business, such as business phone calls, office equipment, computers, postage, supplies, etc.

Since Brenda lives on her employer's premises for the employer's convenience and as a condition of her employment, the conditions of Section 119 are fulfilled. Thus, neither the rental value nor the corporate-paid utilities are included in Brenda's gross income. This is so even if her dependents also live on the premises.

Brenda will, of course, report interest income as a mortgage when the corporation pays it, but this simply results in a "wash" since the corporation's interest expense deduction flows through to her.

Since Brenda has ample stock and debt basis and "materially participates" in the business, any tax loss generated would be deductible currently.

Section 119 Planning with a C Corporation

One traditional way to get money out of a closely held C corporation without paying dividends is to engage in a sale and lease-back of a shareholder-employee's home. The selling shareholder recognizes no gain if the selling price does not exceed the adjusted basis of the home or if the realized gain is excluded from gross income because of the Section 121 election. If the purchase price is payable in installments, the corporation will incur deductible interest expense while the shareholder reports interest income. However, rent must be paid which is taxable to the corporate lessor and nondeductible to the shareholder-lessee.

By qualifying for the Section 119 lodging exclusion after the sale, the corporation is still eligible to deduct all expenses associated with the home, including cost recovery, without charging rent, while the shareholder employee saves the nondeductible rental payment without having to report the rental value as gross income. A minor disadvantage of the Section 119 approach is that the home would be considered commercial property with a tax life of 31.5 years rather than residential property eligible for the 28.5 cost recovery period.

Ideally, a C corporation's taxable income is brought down to $50,000 or below so as to be subject to only 15% Federal income taxation pursuant to Section 11(b)(1)(A). Qualifying for the Section 119 exclusion makes this more likely since the employer is allowed all the expenses of carrying and maintaining the residence without having to report rental income. A 15% tax may be viewed as the price paid for the indefinite deferral of the second tax on ultimate shareholder distributions.

Example: Alex sells his house with an adjusted basis of $100,000 to his wholly owned C corporation for $100,000 in cash. He continues to live in the house and qualifies for the Section 119 exclusion. The following advantages ensue:

* Alex receives $100,000 tax-free.

* He continues to live in the house tax-free (including utilities) and without paying rent.

* The corporation deducts cost recovery, straight-line over 31.5 years based on $100,000, less a reasonable allocation to the land. Also deductible are utilities, insurance, maintenance, repairs and property taxes.

Conclusion

Taxpayers who operate a business out of their houses should make every effort to qualify for the Section 119 lodging exclusion. By selling the home to a closely held corporate employer, personal living expenses may, in effect, be converted to corporate business deductions, cost recovery becomes available and tax-free funds may be received. If an S corporation is utilized, the tax benefits may be even greater. Section 119 represents an under-utilized "home-made" tax shelter overlooked by many small business owners.

Rolf Auster, PhD, LLM, CPA, is professor of taxation in the school of accounting at Florida International University in Miami.

Footnotes

1 Reg. 1.119-1(b).

2 Reg. 1.119-1(c)(1).

3 Reg. 1.119-1(b).

4 See, for example, Turner v. Comm., 68 TC 48 (1977) and Benninghoff v. Comm., 614 F.2d 398 (CA-5, 1980).

5 J. Grant Farms, Inc., 49 TCM 1197 (1985).

6 Caraton v. Comm., 442 F.2d 606 (CA-9, 1971).

7 Armstrong v. Phinney, 394 F.2d 661 (CA-5, 1968).
COPYRIGHT 1994 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Auster, Rolf
Publication:The National Public Accountant
Date:Apr 1, 1994
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