The Evolution of a Key Internal Revenue Code Section: The Home Office Deduction

By Banatte, Jean-Marie; Damtew, Desta | Entrepreneurial Executive, Annual 2008 | Go to article overview

The Evolution of a Key Internal Revenue Code Section: The Home Office Deduction


Banatte, Jean-Marie, Damtew, Desta, Entrepreneurial Executive


INTRODUCTION

Under the Internal Revenue Code (IRC), taxpayers have traditionally been able to deduct all of the "ordinary and necessary" expenses of conducting a trade or business from the revenue generated by such business (Internal Revenue Code [section] 162). For those not engaged in a regular "trade or business but who nevertheless derive some income from a certain activity, their expenses related to the production of that income are also deductible (Internal Revenue Code [section] 212). Thus, many taxpayers have in the past been deducting the cost of maintaining an office at home where they conduct either a regular business or some income producing activities. Examples would cover lawyers, doctors, salesmen using an office at home to prepare legal briefs, consult with patients or perform other administrative tasks related to their income generating work. Given the technological advances making telecommuting more prevalent, and more advantageous for both employees (flexibility, reduced commuting costs,) and employers (cost savings of not having to provide office space), the use of home office has vastly increased in our economy, going from an estimated 1.5 million taxpayers in 1991 to a far larger segment of the work force (Hoffman et al. Individual Income Taxes, 2006 ed. West Federal Taxation, Thompson, South-Western).

Until the middle part of the seventies, it was fairly easy for taxpayers to receive these deductions. So long as they could substantiate, by their records and receipts, their expenses in generating the income or in conducting the trade or business, they were virtually assured of the deductions for such items as a portion of the mortgage or rent payments, of the utilities, of the cost of furnishing and generally maintaining that portion of their home used as the "home-office". In the event of an audit by the Internal Revenue Service, they usually prevailed as long as they could show that the expenses involved were "appropriate and helpful" and "reasonable" in the trade or business.

The restrictions of Code Section 280A

In search of additional revenues to reduce the large federal deficits, in 1976 Congress enacted IRC section 280A, thereby imposing much stricter rules for those deductions. The new requirements were:

1. Taxpayer had to use the home office "exclusively" and "regularly" for business purposes.

2. That home office had to be taxpayer's principal place of business.

3. It had to be a place of business used to consult with clients or patients.

The Internal Revenue Service (IRS) enforced the first requirement to the letter, meaning that the home office had to be a location separated by some wall, partition, curtain or other physical demarcation. The United States Tax Court disagreed, saying that it found no such requirement in the legislation. That Court even ruled that a large walk-in closet would qualify as a home office (Tax Court Memo 1981-140). The second part of the first requirement still had to be met, that is the space had to be used regularly, not intermittently, for the business or income producing activity.

The second requirement generated even more controversy. What was to be considered the taxpayer's principal place of business? To help in the interpretation, the courts employed a new concept, "the focal point test". In the case of an employee, the principal place of business, that is, the focal point of his activities was deemed to be the business premises of his employer. This became almost an insurmountable obstacle for most employees. In one case, an expert violinist was hired by the opera at a large metropolitan area. During the performing season, he spent about 26 hours per week rehearsing at the opera center. But since the employer did not provide him with any private office facilities, he set up a studio at home to perfect his skills. Despite his unchallenged testimony at the trial, that usually he would spend 30 hours per week rehearsing in the home studio, the Tax Court denied him the deduction, using the reasoning of "the focal point test". …

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