Will Your Home Office Deduction Pass the Muster in an IRS Audit or Raise Red Flags?

With more people working from home, one has to wonder if the home-office deductions on tax returns are out of control or warranted. Will the IRS be scrutinizing home office deductions and what do they look for. In short, will your home office deduction pass in an IRS audit or will it raise red flags? If you are self-employed your home office deduction will depend on how your business is structured. Are you an employee of your own company? Are you, as your company, reimbursing yourself, as your employee, for use of the office? Are you, as your employee, submitting expense reports for use of the office?  So many things to consider that we definitely recommend working with a tax reduction expert like Ken Mar Tax to make sure your tax returns are not raising red flags and that how you file will hold up in an audit.

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Writing Off the Home Office as a Corporation

Do you operate your business as a corporation? If yes, are you an employee of the corporation? If yes, would you like to deduct an office in your home? If yes, know this: Your route to the deduction follows a strict path that requires

1. you to use the office in your home for the convenience of your employer-corporation,
2. you to pass the tax code rules for deducting a home office, and
3. your corporation to reimburse the home-office deduction to you as an employee business expense.

Why So Strict for Home-Office Deduction?

The Tax Cuts and Jobs Act eliminated “employee business expenses” as itemized deductions for the years 2018 through 2025. Thus, you may not currently obtain the home-office deduction as an employee.

However, by following this strict path, your work-around is to have the corporation claim the deduction. It does this by reimbursing you, the corporate employee, for your home-office expenses.

Renting the Office to Your Corporation Does Not Work

The IRS audit manual, in its boilerplate language for denying the home-office deduction, addresses the rent-as-expense issue as follows: “If you rent all or part of your residence to your employer and use the rented portion when performing services for the employer, you cannot deduct home-office expenses.”

Convenience of Employer.  To qualify as a tax-deductible expense, your use of your home office must be for the convenience of your employer (your corporation).

Office in the Home Is the Only Office. If your corporation has no office outside your office in the home, your home office is obviously for the convenience of your employer corporation. In this case, you don’t need any special documentation as to the need for the office.  To deduct the office, the corporation reimburses you for its expenses and claims the deduction as office space on the corporate tax return.  You must provide the corporation with proof of your expenses and that you used the home office regularly and exclusively for the corporate business.  If the office in your home is the only office of the corporation, it is a tax-law-defined principal office. More on the benefits of this later.

More Than One Office. When you have more than one office—say, an office in your home and a downtown office—you want the IRS to consider the office in your home a tax-law-defined “principal office.” Why?  Because the principal office in the home turns the vehicle mileage from your home to your downtown office into business mileage. It eliminates commuting mileage.

Example. Glen drives 21 miles from his principal office in his home to his downtown office and back home. The 42 miles round trip are all business miles.

Because the home office eliminates Glen’s commuting miles, his business use of his corporate vehicle is 93 percent. Without the home office, he would have only 29 percent business use. On his $60,000 vehicle, that’s a difference of $38,400 in vehicle depreciation deductions alone.

Glen is not done. He adds 93 percent of his operating cost deductions. Those could equal the depreciation deductions. You can see that this principal office can produce big deductions.

Creating the Principal Office If you have both an office in the home and a downtown office, you need to meet all of the following rules to make the office in your home a principal office:

• Use the office in your home for your corporate administrative or management activities.
• Have no other fixed place such as the downtown office where you conduct substantial administrative or management activities.
• Use the office in the home exclusively and regularly as a place of business.
• Use the office in the home for the convenience of your employer corporation.

Convenience of Employer. Neither the law nor the IRS has given guidance on what is an office in the home that’s for the convenience of the employer. One recent court case states: “A home office is not for the employer’s convenience if it is maintained for the employee’s personal convenience, comfort, or economic benefit.”  Here’s another rule to know. It’s from the legislative history of the convenience test: In the case of an employee, the question whether an employee chose not to use suitable space made available by the employer for administrative activities is relevant to determining whether the present-law “convenience of the employer” test is satisfied.

Documentation Is Key. Once you establish that you meet the basic rules of administrative use, regular use, and exclusive use, you need to spend some time documenting how and why you meet the convenience-of-the-employer test. Once you have that figured out, have the corporation write you a letter requiring you to do your administrative or management activities at home for the corporation’s convenience.

For example, your corporation might require that your administrative or management work be carried out at home

• to protect the confidentiality of the payroll and accounting records;
• to ensure that your work at the office focuses on sales (patient care, production);
• because the office has inadequate space to accommodate the payables records, invoices, receipts, and so on; or
• to facilitate uninterrupted attention to business plans and budgets.

This list is by no means exhaustive, but it should help trigger some viable reasons for your administration or management at home.

More Possible Reasons. The convenience-of-the-employer test is a facts-and-circumstances test. To pass this test, you want the office in the home to be a condition of your employment with the corporation, because you need this office to ensure the functioning of the corporation’s business or to allow you, the employee, to perform the duties required by your position.

With these thoughts in mind, consider the following as possible reasons why you absolutely must do your administration in your home office rather than your regular office:

• Your business requires that you work after hours and on weekends, but the landlord eliminates air conditioning and heating once business hours are over.
• Although the neighborhood is perfectly safe during the day, it is not safe after hours, as evidenced by crime in the area (which you can prove).
• You have drugs in the office. Accordingly, your corporation has a policy that no person is to be in the office alone.

The key factor is that the use of a home office needs to be for the convenience of the employer, not the convenience or preference of the employee. These scenarios could all potentially qualify, but they depend heavily on the facts and circumstances that constitute convenience for the corporation.

In Hamacher, the court noted that the convenience-of-the-employer test was satisfied in the following circumstances:

• The employee had to maintain a home office as a condition of employment.
• The employee’s home office was necessary for the function of the employer’s business.
• The home office was necessary for the employee to perform his duties properly.

Eight More Possible Reasons Your Corporation Could Require a Home Office

1. Generate more work output. With a home office, an owner-employee can work at any time without being restricted to office hours. This could be useful for handling international business, urgent work that comes up outside normal office hours, or simply allowing the employee to work more hours.
2. Cost efficiency. If the employee is also an owner and can work from home, the corporation might be able to downsize its physical office space and save on rental costs.
3. Business continuity. If there’s an emergency, disaster, or situation that makes the downtown office inaccessible or unsafe (such as a pandemic, natural disaster, etc.), having a home office allows work to continue uninterrupted.
4. Reducing commuting time. By allowing owner-employees to work from home, the corporation reduces the time and stress involved in commuting, which can enhance productivity.
5. Backup technology. In some cases, having a home office might provide a backup location with different technological resources. For example, if the internet connection goes down in the downtown office, work can continue at the home office.
6. Client convenience. Depending on the nature of the business, a home office could offer a more convenient or comfortable location for some clients.
7. Health reasons. Depending on the individual’s health condition, having a home office could be a necessity.
8. Childcare or eldercare responsibilities. For owner-employees with significant childcare or eldercare responsibilities, having a home office allows them to work more hours and meet personal responsibilities.

Documentation for Home-Office Deduction: Create the Letter

You want your corporation to create a letter requiring you, the employee, to maintain a home office for the convenience of the employer. Keep the letter in your corporate tax file—the permanent file.  Sure, we know, you are likely writing the letter as the president of the corporation to you, the employee. Seems silly. But do it. Documentation is key here.  You don’t need a big long letter, but you do need reasons why this is for the benefit of the corporation and not for your personal benefit or convenience. Try to create as many good reasons as possible. Write the letter on corporate letterhead. It’s also a good idea to incorporate the letter into the corporate minutes from, say, the annual meeting.

Summary:

When you operate your business as a corporation, you and your corporation can benefit if you, as the employee, can qualify for a home-office deduction that’s classified by the tax code as a principal office and for which the corporation reimburses your office to you as an employee business expense. Here are the benefits:

• You receive the employee business expense reimbursement as a tax-free fringe benefit.
• Your corporation deducts the reimbursement as a business expense for office space.
• The home office’s principal-office classification eliminates personal-use commuting mileage, creating more business use and business deductions on the business vehicle (yours or the corporation’s).
• The home office creates corporate business deductions from the business percentage of your personal home expenses.
• If the office in your home that you use regularly and exclusively for the corporate business is the only office of the corporation, it automatically is a principal office under the tax law.
• If you have an office in your home and a corporate office outside the home, you could have two principal offices. Sure, that’s not logical, but it’s true—after all, this is tax law. To qualify the office in the home as a principal office, you need to
  • use it exclusively and regularly for the corporate business,
  • use it for the convenience of the corporation, and
  • use it for substantially all your personal corporate administrative or management tasks. (Don’t consider the employees here—this is about you only.)