Home-Based Business Deductions Are Not Always Legal

By Leonard G. Weld and Kaye F. McClung

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Many ideas on how to reduce taxes are simply overlooked deductions that may be brought to mind by a newspaper or magazine article. Other times, the ideas are promoted by tax scam artists. Many erroneous beliefs have been used as justification to avoid federal income taxation; for example, the tax system is voluntary.

A less radical idea is that a home-based business can save tax dollars. If a legitimate business based in the taxpayer’s home incurs an operating loss, then there is a tax savings. Unfortunately, tax scam promoters promise deductions for expenditures that are not legitimately deductible.

Hobby Deductions

An activity may be classified by the IRS as a hobby regardless of what the taxpayer calls it. The distinction between a business and a hobby is vitally important. A business may incur an operating loss during a tax year. This loss can offset income from other sources if the taxpayer or the taxpayer’s spouse works in the business more than 500 hours during the year or works substantially all of the hours required to operate the business. According to the Individual Income Tax Returns Preliminary Data in 2001, taxpayers filed approximately 17.6 million returns that included business or professional activity, and 24% of those returns reported a deductible operating loss.

A loss from a hobby activity, on the other hand, is not deductible and cannot offset other sources of income. The full amount of hobby revenue is included in a taxpayer’s gross income. If a taxpayer chooses to itemize deductions on Schedule A, then hobby expenses may be deductible, but only up to the amount of hobby revenue. Therefore, a taxpayer can never have a hobby loss. Taxpayers must offset hobby revenue with hobby expenses in this specific order: 1) mortgage interest and property taxes attributable to the hobby, 2) normal business expenses (e.g., salaries, office supplies, advertising), and 3) depreciation.

Allowable hobby expenses are combined with other miscellaneous deductions, such as unreimbursed employee business expenses, tax preparation expenses, and investment expenses (other than investment interest expense). The total of these miscellaneous deductions is then reduced by 2% of the taxpayer’s adjusted gross income (AGI). Any excess deductions over 2% of AGI are added to other itemized deductions. If a taxpayer uses the standard deduction rather than itemizing on Schedule A, then hobby expenses are not deductible.

Is It a Business?

Given that the distinction between a business and a hobby is critical to taxpayers, it is essential to understand the factors the IRS uses to make a determination. Treasury Regulations section 1.183-2 identifies nine relevant factors to distinguish between a business and a hobby:

  • The manner in which the taxpayer carries on the activity, e.g., maintaining accurate books and records;
  • The expertise of the taxpayer or the taxpayer’s advisors;
  • The time and effort expended by the taxpayer in operating the activity;
  • The expectation that assets used in the activity may appreciate in value;
  • The history of success of the taxpayer in other activities;
  • The history of income and losses in this activity;
  • The amount of occasional profits, if any, that are earned;
  • The financial status of the taxpayer—that is, if this activity is the taxpayer’s only source of income, the IRS is more inclined to consider the activity a business—and
  • The elements of personal pleasure or recreation involved.

In the regulations, none of these factors is given more weight than another and there is no formula to ensure classification as a business. Taxpayers and the IRS often disagree about the proper classification of an activity. There are a plethora of court cases on this issue. Relying on just one decision would be ill advised. The facts of each case are distinct and usually give the reader only an indication of how the IRS might rule under very specific circumstances.

Home-Based Business

Assuming that a taxpayer’s activity is classified as a business and that the business has an office in the taxpayer’s home, additional criteria must be met before any deductions are allowed for the office.

A home office must be used exclusively and on a regular basis as the principal place of business by the taxpayer. If the area is used eight hours a day for business but children come in at night and play video games on the computer, the office fails the exclusive use test.

There are two exceptions to the exclusive use test. If the taxpayer is in the business of selling products, the area of the home that is used to store inventory does not have to meet the exclusive use test. The storage space must, however, be a specific, identifiable area.

The other exception applies when the home is used regularly to provide day-care services to children, handicapped persons, or the elderly. A formula based on the number of hours of business use and total use is applied to the allowable business deductions.

“Regular” use means that a specific area is used on a continuous basis. Occasional or incidental use does not meet the threshold, even if the area is not used for any other purpose. Neither the courts nor the IRS has specifically stated how many hours per day (or per week) the office must be used for business purposes. The time element depends on the facts and circumstances of each individual case.

An office in the home is used as a principal place of business if it is a place used by patients, clients, or customers to meet with the taxpayer in the normal course of the taxpayer’s business. This use must be for the convenience of the employer, not the employee, if the taxpayer is employed outside the home.

Although a taxpayer may not regularly meet with customers or clients in the home, or perhaps the business consists mainly of selling or providing services outside the home, Congress recognized that almost every business needs a location where a business owner can store records, complete paperwork, and take care of other administrative tasks. Accordingly, the Taxpayer Relief Act of 1997 expanded the definition of the term “principal place of business” such that a deduction can be taken if the home office is used to conduct administrative or management activities, and the taxpayer has no other fixed location in which to do so. A deduction is allowed for business expenses associated with the regular use of a separate structure that is not attached to the taxpayer’s home, such as an artist’s studio, a florist’s greenhouse, and a carpenter’s workshop.

Business Versus Personal Expenses

IRC section 162 allows “a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” It continues by giving several examples:

  • A reasonable allowance for salaries or other compensation for personal services actually rendered;
  • Traveling expenses (including amounts expended for meals and lodging that are not lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and
  • Rental payments for equipment or real estate.

An “ordinary” expense generally is one that is normal, customary, or usual for a business under the facts and circumstances of its situation. An expense can be ordinary even if it only occurs once in the life of the business (for example, legal expenses for defending against a patent infringement).

A “necessary” expense is one that is appropriate and helpful for the trade or business. This requirement helps distinguish between business and personal expenditures. A necessary expenditure need not be vital, but it may be appropriate for that line of business and helpful to the operation of the business. For example, property insurance may not be necessary in order to operate a business, but it is appropriate.

A final requirement is that the expense be “reasonable” in amount. This is an issue that arises often in family-owned businesses. Salaries paid to family members must be appropriate for the amount and complexity of their work. Other expenses, such as travel and entertainment, may be disallowed by the IRS if the expenses are judged to be unreasonable for the circumstances, or personal in nature.

Personal and family living expenses are not deductible unless specifically authorized by the IRC. Examples of deductible personal expenditures include the following:

  • Prescription medicine and most medical expenses;
  • State and local taxes;
  • Home mortgage interest and property taxes;
  • Charitable contributions; and
  • Many investment expenses.

Other expenditures that might seem to be deductible business expenses are actually nondeductible personal expenditures. For example, the costs of commuting to and from work and the cost of business attire are nondeductible personal expenditures.

Home-Based Business Schemes

According to the IRS, home-based businesses and tax avoidance scams have gained in popularity over the last few years. In a consumer alert, the IRS warned that no matter how convincing the claims in the marketing materials for these bogus business schemes may appear, nondeductible personal living expenses cannot be transformed into deductible business expenses.

According to the IRS, the following are nondeductible personal expenses that are commonly claimed as business expenses in home-based business schemes:

  • Deducting the cost and operation of a personal residence;
    n Paying children a salary for services, such as answering telephones, washing cars, or other tasks, and then deducting these costs;
  • Deducting education expenses from the salary wrongfully paid to children as employees;
  • Deducting excessive car and truck expenses when the vehicle has been used for both business and personal use;
  • Deducting personal furniture, home entertainment equipment, children’s toys, and other household items; and
  • Deducting personal travel, meals, and entertainment under the guise that “everyone is a potential client.”

IRS Commissioner Charles O. Rossotti has said, “Each year, taxpayers reasonably search for deductions that will reduce the amount they owe. But they should resist the temptation of quick and easy schemes. Creating a bogus home business or other schemes crosses the line and puts the taxpayer on a path that will result in paying interest and penalties on top of the taxes they owe.”


Leonard G. Weld, PhD, is a professor of accounting and head of the accounting and finance department at Valdosta State University, Valdosta, Ga.
Kaye F. McClung, DBA, CPA, is an associate professor of accounting and head of the accounting and finance department at the University of Tennessee at Chattanooga.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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