Incorporating Could Doom a Home-Office Deduction
Deducting home-office expenses is a much-appreciated tax benefit of the many people with small businesses or sideline self-employment income. But taking this popular deduction gets a lot trickier once you incorporate.
In fact, even under the best of circumstances, forming a corporation can mean losing at least some of the tax benefit of a qualifying work at home office. Let me explain.
Straightforward for sole proprietors
First off, a refresher: Most commonly, people with small businesses are able to take home-office deductions because the home office is used regularly and exclusively for business purposes and the home office is the primary place of business. (For more on the rules of home-office deductions, check out this previous column.)
That’s relatively straightforward if you’re the sole proprietor of an unincorporated business. The water gets murkier when you incorporate your business and are simultaneously a business owner, employee and homeowner.
Taking an employee deduction
One possibility for taking a home-office deduction after you incorporate is to claim the deduction as an employee of your business. You would have to show that you, as the employee, are required to have the home office for the convenience of the employer.
If you qualify for a deduction under these circumstances, you would take the expenses as miscellaneous itemized deductions on Schedule A of your tax return. A major negative to that: Miscellaneous itemized deductions are allowed only to the extent that they exceed 2% of your adjusted gross income (AGI). So if your AGI on your tax return was $70,000, you would get a tax benefit only on the miscellaneous deductions in excess of $1,400. “That’s not worth bothering with for most people,” says Ed Zollars, a partner in the Phoenix-based CPA firm of Henricks, Martin, Thomas & Zollars.
Getting corporate reimbursement
Another possibility is to have the corporation reimburse you for office expenses.
“Once the need for the home office has been documented, the corporation could reimburse you for expenses related to the operation of the home office, such as utilities, insurance and repairs,” says Terrance Eckert, a CPA with Candy & Schonwald in Dallas.
The result is that the corporation reimburses you for those office expenses and deducts the expenses on its own tax return, but you do not have to declare the expenses as income.
Documentation is crucial if you’re going to try this. Tax professionals such as Eckert recommend that all information about the transactions, including an explanation of the need for the office space and reimbursement, be documented in the corporation’s minutes and that the expenses be paid under what is known as an “accountable reimbursement plan.” In a worst-case scenario, the IRS could decide that the reimbursements are taxable to the individual and the expenses are not deductible by the corporation. As Eckert understates, “Compliant documentation is extremely necessary.”
Renting to your business: a no-no
Some small-business owners have the corporation pay rent on the home office, with the owner reporting that rent as income on his personal returns and claiming a prorated portion of utilities, maintenance and insurance as expenses of the rental space.
But that’s a recipe for trouble. “You can really shoot yourself in the foot by renting your home property to your business,” Zollars says.
“There’s a specific prohibition in Section 280A of the Internal Revenue Code that basically says that if you are an employee of a business, you cannot take any deductions for renting space in your home to your employer,” he says. “So what would otherwise make sense — renting the space to your business and taking the deductions — no longer applies.”
In fact, what you would wind up with in this situation would be a rental deduction by the corporation, but equal rental income — with no additional deductions — by the employee.
‘Change in form can be consequential’
I went to the ultimate source on matters like this: the IRS. Agents there confirmed that if the employee and the business owner are one and the same, then while the corporation could deduct any reasonable rent it paid, that rent would have to be reported as income by the employee with no expense deductions allowed.
“There is no question that employees working out of their home are treated more rigorously [under the tax code] than someone who is a sole proprietor,” says one IRS employee. “If you’ve got someone who is working out of his home office as a sole proprietor and suddenly that individual incorporates and is the sole shareholder and sole employee, I would certainly agree that in a metaphysical sense not very much has changed. But I think this is an instance where the change in form can be consequential.”
Get professional help
Home-office deductions for corporate owners are so tricky that the topic often comes up in educational seminars for tax pros. Even two IRS employees interviewed for this column had different opinions on some aspects of the rules.
Be sure to consult with a pro who is familiar with the rules before trying to take these deductions on your own — or your corporation’s — returns.