Telecommuting employees and the amended home office deduction rules.
One tax aspect to the growing phenomenon of telecommuting employees is the ability to deduct direct and indirect home office expenses. Direct and indirect expenses relating to a home office located in a residence are deductible only if part of the home is used regularly and exclusively as a principal place of business or as a place to meet or deal with customers or clients in the ordinary course of business. Moreover, the gross income test is applicable in all instances. The deductions claimed cannot be greater than the income earned by the business. Employees must meet an additional test--their home office use must be for their employer's convenience (Sec. 280A(c)(1)). The convenience-of-the-employer test will be met if the employer requires the employee to work out of his home. An employee will not meet this test if he asks permission to telecommute from home instead of commuting to the office; in this case, any direct and indirect home office expenses are not deductible.
Telecommuting employees generally will not be using the home office location to meet or deal with customers or clients in the ordinary course of business. Under Sec. 280A, deductions will be available to telecommuters if the home office is used only regularly and exclusively as the employee's principal place of business. A flail-time telecommuter satisfies the principal-place-of-business test, but a part-time telecommuter may fall short of this test. Under prior law, the rules set forth by the Supreme Court in Soliman, 506 US 168 (1993), would determine the principal place of business, whether it be the employer's office location or the home office.
Under the Supreme Court's more restrictive facts-and-circumstances test, the two primary considerations used to determine whether a home office was a taxpayer's principal place of business were the relative importance of the activities performed at each business location and the time spent at each place. The part-time telecommuter (telecommuting some days and commuting to the office on others) would apply this comparative analysis test to determine his principal place of business.
In reaction to the Supreme Court's decision in Soliman, as part of the Taxpayer Relief Act of 1997 (TRA '97), Congress passed legislation redefining a taxpayer's principal place of business. Congressional concern was that the Supreme Court's decision effectively closed the door to legitimate home office deductions for many taxpayers and unfairly penalized small businesses simply because they operated out of a home, rather than from a storefront, office building or industrial park. In addition, public policy concerns relating to economic growth, job creation, energy conservation and working families were also motivation for providing a more flexible principal-place-of-business test.
Beginning in 1999, under amended Sec. 280A(c)(1), a home office could qualify as a principal place of business for purposes of deducting expenses if the taxpayer uses it for the business's administrative or management activities, and no other fixed location exists where the taxpayer conducts these activities. Activities that are administrative or managerial include billing customers, clients or patients; keeping books and records; ordering supplies; setting up appointments; and forwarding orders or writing reports.
Under the new rules, taxpayers who perform administrative or managerial activities for their trade or business at places other than a home office are not automatically prohibited from taking a deduction. The following activities will not disqualify a home office as the taxpayer's principal place of business, even if the taxpayer:
1. Has other people conduct administrative or management activities at locations other than the home office;
2. Conducts administrative or managerial activities at places that are not fixed locations of the business, such as a car or hotel room;
3. Occasionally conducts minimal administrative or management activities at a fixed location outside the home office;
4. Conducts substantial nonadministrative or nonmanagement business activities at a fixed location outside the home; or
5. Has suitable space to conduct administrative or managerial activities outside the home, but chooses to use the home office for those activities instead. (Note: This exception does not apply to employees whose home office use is for their employer's convenience.)
In summary, the home office no longer needs to be the place where the primary income-generating functions of the trade or business are performed (as was earlier required by Soliman). Further, the expanded definition of a principal place of business did not affect the requirements for deductibility of home office expenses. For expenses to be deductible, the home office must be used exclusively and on a regular basis for business purposes. In addition, if a taxpayer is an employee, the use of the home must still be for the employer's convenience.
Example 1: M is a self-employed electrician. He has a home office that is used regularly and exclusively for business purposes. The same administrative and managerial activities were conducted in his home in 1998 and 1999. Most of his time is spent at customers' homes and offices installing and repairing electrical systems. His office is small. He uses it to phone customers, order supplies and keep books. M uses a local bookkeeping service, however, to bill his customers.
For 1998, M's home office did not qualify as his principal place of business; although the administrative and management activities performed there were essential, it was not where he met with customers. M could not claim the home office deduction in 1998.
Because of the amendment of Sec. 280A, for the 1999 tax year, M's home office will qualify as his principal place of business; he will be able to deduct expenses for its use. M uses the home office for the administrative and managerial activities of his electrical business, and has no other fixed location where he conducts these activities. The fact that his billing is done by another company does not affect the principal place of business.
Example 2: B is a teacher who is required to teach and meet with students at his school and to grade papers and tests. The school provides him with a small office where he can work on lesson plans, grade papers and tests and meet with parents and students. The school does not require B to work at home. He prefers to use the office he has set up at home, and not the office the school provided.
For 1998, B's home office does not qualify as his principal place of business, because the administrative activities are less important than his actual teaching duties at the school. B cannot take a home office deduction. Because B's home office is not his principal place of business, it is not necessary to determine whether he maintained the office for the convenience of his employer.
For the 1999 tax year, B will still have to meet the convenience-of-the-employer test, even if his home office qualifies as his principal place of business. Because B's employer provides him with an office and does not require him to work at home, B does not meet the convenience-of-the-employer test and cannot claim a deduction for the business use of his home.
The Soliman comparative analysis test still applies when the statutory test does not settle the principal-place-of-business issue.
Beginning in 1999, the more flexible facts-and-circumstances test of amended Sec. 280A(c)(1) will allow many more home office workers to deduct their expenses. The deduction will no longer be limited to those who generate income directly from their homes, but will also be available to those who deliver goods and services outside 'their homes and who use their home offices to conduct substantial administrative and management activities.
Now that the home office rules have been more liberalized, taxpayers who have been using their homes as home offices (or renting part of their homes for business purposes) will be wise to keep related tax ramifications in mind if they intend to sell their homes. For joint taxpayers, the TRA '97 fundamentally changed the treatment of gain on the sale of a residence. The TRA '97 replaced the provision allowing rollover of gain (repealing former Sec. 1034) and the one-time exclusion of $125,000 of gain for taxpayers over age 55 (former Sec. 121), with a relatively simple $250,000/$500,000 gain exclusion (Sec. 121). For taxpayers to claim the exclusion, they must satisfy the ownership-and-use test. Simply, an individual must have owned and occupied the residence as a principal residence for an aggregate of at least two of the five years before the sale or exchange. The required two years of ownership and use need not be continuous. Property used partly as a home and partly for business or rental should be considered as two sales transactions when the entire property is sold. Gain is excluded only on the part used as a home; the portion that applies to rental or business use is reported on Form 4797, Sales of Business Property.
Example 3: In 1993, T bought a house. He used three-quarters of the house as his main home and a quarter for business purposes. On Oct. 31, 1998, T retired and started using the entire house as his main home. On Dec. 1, 1999, he sold the house at a gain. During the five-year period ending on the date of sale, T met the two-year use test only for three-quarters of the house. Only gain from that part of the house qualifies for the exclusion, unless he sold the house due to a change in health (or place of employment).
If a taxpayer were entitled to a depreciation deduction because the home was used for business purposes or as rental property, he could not exclude the part of his gain equal to any depreciation allowed as a deduction for periods after May 6, 1997. If he could demonstrate by adequate records or other evidence that the depreciation deduction allowed was less than the amount allowable, the amount not excludible is the lower figure.
Example 4: In 1998, D sold his main home at a $40,000 gain. He meets the use-and-ownership tests to exclude the gain from his income. However, he used part of the home for business from July through December 1997, and claimed $600 depreciation. He can exclude $39,400 ($40,000 - $600) of his gain and has a $600 taxable gain.
Today, the new workplace is interactive video, the Internet and digital documents. Telecommuting is now common and provides an improvement to an individual's quality of life, as well as a savings in travel costs and time. Employees who work from home have both more flexible work schedules and more time to spend with their families. Restoration of the home office deduction should foster continued economic growth and encourage Americans to start their own business ventures.
MARINA L. FERRONE, CPA, NEW YORK, NY
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|Author:||Ferrone, Marina L.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2000|
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