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April 2010
The New Entrepreneur: Home-based business tax considerations
By John Blair

     In the wake of the current recession and its massive layoffs, the rate of unemployment has risen to a level not experienced in this country for more than 30 years. Even more distressing, unemployed individuals are faced with an economy that continues to lose more jobs than it creates.

     In many cases, unemployed individuals have chosen to operate on their own, offering the same services they performed as an employee to several different companies under negotiated terms as an independent contractor. Others have used unemployment as an opportunity to explore an area of personal interest, completely unrelated to their prior employment.

     In either case, the individual’s business is usually being operated out of their home as a matter of economy or necessity. Significant financial advantages of conducting a business out of the home include the bvious: zero cost for office space, zero time spent in commuting (opportunity cost).

      However, the income tax benefits are less clear. One reason for this is Section 280A(a) of the Internal Revenue Code which states, “Except as otherwise provided in this section, in the case of a taxpayer who is an individual…, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.”

     Interpretation: No tax deduction is allowed for the cost to maintain or live in your home except for those allowable under the Internal Revenue Code.

     Costs that are allowable can be categorized as (i) those deductible regardless of whether your business is based in the home, and (ii) those deductible because it is, called home office expenses. Let’s explore the latter.

 

Home Office Expenses

     Satisfy the strict rules that govern home office deductions and you can deduct the “direct expenses” of the home office—e.g., the costs of painting or repairing the home office, depreciation deductions for furniture and fixtures used in the home office, and the “indirect expenses” of maintaining the home office—e.g., the properly allocable share of utility costs, depreciation, insurance, etc., for your home, as well as an allocable share of mortgage interest, real estate taxes, and casualty losses.

     In effect, the home office expense provision converts what would otherwise be non-deductible personal expenses to deductible business expenses.

     The properly allocable share of the indirect expenses of your home is determined by the portion of your home that qualifies as a home office. So if 10 percent of your home qualifies as a home office, 10 percent of the indirect expenses are deductible.

     Home office expenses are not permitted, however, to conduct a hobby in your home. A hobby is an activity you pursue because it primarily gives you pleasure and not because it is profitable. The presumption is that if an activity makes a profit in 3 out of 5 years, it is a business. If it continuously losses money, it is a hobby.

     If you use your home office, exclusively and on a regular basis, as your principal place of business, that use qualifies for the home office deduction. It is your principal place of business if it satisfies either a “management or administrative activities” test, or a “relative importance” test.

     The management or administrative activities test is satisfied if you use your home office for administrative or management activities, and you meet certain other requirements.

     You meet the relative importance test if your home office is the most important place where you conduct your business, in comparison with all the other locations where you conduct that business.

     A scenario which also entitles you to deduct home office expenses is using your home office, exclusively and on a regular basis, to meet or deal with patients, clients or customers who are physically present in your home office.

     Additionally, a separate unattached structure on the same property as your home—for example, an unattached garage, artist’s studio or workshop, used exclusively and on a regular basis for business, qualifies as a home office.

     Finally, if you’re in the business of selling products at retail or wholesale, and if your home is your sole fixed business location, you can deduct home expenses allocable to space that you use regularly (but not necessarily exclusively) to store inventory or product samples.

     While your home office deductions are subject to limitations based on the income attributable to your use of the home office, any home office expenses that can’t be deducted because of these limitations may be carried over and deducted in later years.

     So for some, a home-based business brought about by unemployment may have real advantages financially—and may even open new avenues of work and/or new ways of working!

     Content provided by Blair, Bohlé & Whitsitt, PLLC, a CPA firm that provides accounting, assurance, tax compliance and planning services in addition to strategic planning and tax minimization strategies to privately held businesses. For more information, contact managing partner John D. Blair Sr. at 704-841-9800 or visit www.bbwpllc.com.

John D. Blair Sr. is a managing partner at Blair, Bohle & Whitsitt, PLLC.
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