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How to Handle Home Office Expenses of a Corporation

How to Handle Home Office Expenses of a Corporation

By Sue Bosevich

Many small business owners find it convenient and cost-effective to operate their business in a room or area of their home. However, if the business operated out of the home is organized as a corporation the expenses of the home office are the corporation’s expenses, not the shareholder-employee’s; consequently, generally not deductible by the shareholder-employee. There are three ways to overcome this problem.

1. Payment of rent. The corporation can pay the shareholder-employee rent to offset home office expenses. The rent would be deductible by the corporation, providing the amount paid is reasonable for the space and services actually provided. The rental income received by the shareholder-employee is reported on Sch E. Unfortunately, with the exception of allocable mortgage interest, property taxes, and casualty losses, the shareholder-employee won’t be able to claim offsetting deductions such as repairs & maintenance and depreciation.

2. Unreimbursed employee expenses. If the convenience of the employer test is satisfied, a shareholder-employee can claim home office deductions as if he were a qualifying employee of an unrelated corporation. There should be a written agreement that states that the shareholder-employee is required to pay for these expenses and confirms that the business use of the home is for the convenience of the employer. Tax Court has held that the convenience of the employer requirement is met if the home business use is required as a condition of employment; necessary for the proper functioning of the business; or, necessary to allow the employee to properly perform his duties. Before going this route, several unattractive consequences should be considered:

• Home office related expense of an employee are deducted on Sch A and only to the extent they exceed 2% of AGI,

• Depreciation deduction opens up the possibility of recognizing gain on the sale of the home in future years, and

• Claiming a home office deduction increases the chances of being audited.

To complicate matters further, a bit of controversy surrounds this strategy. Unlike the other two options, when expenses are unreimbursed, it is the employee rather than the corporation who takes the deduction. Several sources state that upon audit, the IRS often asserts that the shareholder-employee cannot deduct the home office expenses in any event because they relate to corporate business rather than to duties as an employee. The good news is that since the expenditures were made on behalf of the corporation, they should increase the basis of the shareholder’s stock, thus allowing a larger basis to allow a larger pass-though loss deduction.

3. Reimbursed employee expenses. The corporation can reimburse the shareholder-employee for related home office expenses. In order to do so, the employee must have written permission from the corporation and must substantiate the expenses in full (amount, time, place, and business purpose of each expense). The expenses are fully deductible to the corporation and are a tax-free accountable-plan reimbursement to the shareholder-employee. The shareholder-employee can’t, however, deduct the business-related portion of his mortgage interest and property tax if the corporation gives him a tax-free accountable-plan reimbursement for these items. Otherwise, he would be taking a deduction twice – one on Sch. A and the other as a tax-free reimbursement.

Due to related party rules, the reimbursement must actually take place within the tax year in order for the corporation to take the deduction. Accruing the expenses won’t work in many cases. Alternatively, shareholder draws can be reclassified as home office expense reimbursements at year-end, or a shareholder receivable balance can be reduced.

A client letter has been developed to assist in gathering the required year-end information necessary to take the deduction as a reimbursement. It is available as part of the Year-End Resource Packet.

Expenses must qualify to be deductible. Under current law, a home office will be treated as a principal place of business if a portion of the home is used for the administrative or management activities of the trade or business of the taxpayer, but only if there is no other fixed location where the taxpayer conducts substantial activities of that trade or business. Corporate deductions will be allowed for home office-related expenses meeting this test only if the home office is used exclusively and regularly and, in the case of an employee, that exclusive use must be for the convenience of the employer.

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