In the last two entries of this series of Legal Log entries, we reviewed how to organize usual expenses to simplify reporting deducible business expenses in a typical balloon-related business. In this entry, we continue this review by reviewing the principles governing a deduction for expenses of maintaining a home office.
To claim deductions for the "Business Use of a Home Office," one must prove that a specific part of the residence is set aside and used exclusively on a regular basis as the principal place of any business, or where one meets with clients or customers. The space does not have to be a separate room while the space is used exclusively and regularly. This deduction is also used on structures apart from the main residence. Certain special uses also qualify, such as storage of inventory for sale. Costs which may be included in computing the deduction include real estate taxes, mortgage interest or rent, operating expenses such as home insurance premiums and utilities, and depreciation. The available depreciation deduction is limited to the net business income generated by the business before deducting taxes, interest and operating expenses of the business.
Under the federal Internal Revenue Code, in order to qualify for the home-office deduction, the home office must be the "principal place of business" where one regularly meets with clients and customers, or a separate free standing structure, such as a detached garage. Before a 1993 Supreme Court decision, most people relied upon the "principal place of business" test, as lower courts had held that the deduction was available so long as it was essential to the taxpayer’s business, there was no alternative available to the taxpayer, and the taxpayer spent a substantial amount of time there.
In a 1993 case, the United States Supreme Court rejected this interpretation in favor of a more stringent view of a principal place of business. According to the Supreme Court, whether a home office qualifies as a principal place of business depends on: (1) where the most important functions of the business take place, and (2) how much time is spent at home compared with the other business locations. Thus, when the most important activity of the business occurs away from the home office, for example, the fact that an anesthesiologist administers anesthesia to patients at hospitals, the home office does not qualify for the deduction. Administrative activities that occur in the business that are not a "core function" and that are performed in the home office are not sufficient by themselves to claim the deduction.
Most persons who might be able to claim the home office deduction, but who perform services outside the home office, even though they do not have any alternative office space available, do not qualify for the home office deduction. However, if a taxpayer can demonstrate that one or more of the important core functions of the business occurs in the home office, and that the taxpayer spends a majority of the time in the home office, the deduction will remain available.
For most balloon-related businesses, especially those businesses only engaged in flight charters, flight instruction, or tether promotions, the home office deduction is not available as these important core functions occur away from the home office, and the time spent away from the home office usually exceeds the time spent in the home office. However, if the ballooning-related business also involves other activities that are important core activities of the business, such as manufacturing or conducting mail order sales of product inventory from the home office, or ground school instruction, the deduction is more likely to be available, especially if the time engaged in the other important core activity in the home office is substantially more than that spent elsewhere.
All expenses attributable to the home office must be claimed on Form 8829 when filing as a proprietor through the individual income tax return. Formerly, taxpayers had to utilize Schedule C in order to report the deduction. The new form now computes the deduction attributable to qualifying home office expenses and the net figure is now shown on the Schedule C.
Part I of Form 8829 is used to compute the percentage of the home used for business. The taxpayer may use either the proportion of square footage or the number of rooms used exclusive for the business activity. Part II of the form is used to compute the allowable deduction, by listing the amounts of the various deductible items, applying the percentage of business use, applying that amount against the available income computed on Schedule C, and if offset in full, computing the carryover of used expenses into next year’s tax return.
The full amount of the various expenses, for the entire residence, must be included in this part of Form 8829. Among the items to be included are casualty losses to the residence, mortgage interest and real estate taxes (or rent), insurance, repairs and maintenance to the residence, depreciation of the residence (as computed in Part III of Part 8829), and utility expenses (such as electricity, gas, water, sewer, and trash pickup). The allowed home office deduction is then reported on Schedule C and the final net profit or no profit or loss is then computed. Under the rules governing the home office deduction, it cannot be used to generate a net loss on Schedule C.
In the concluding installment of this series, we will focus on the elements required for actually keeping the records to prove income and expenses.