Business tax tip: tax strategies for home offices.

Tax strategies for home offices
By Cora M. Barnhart and Luis I. Ingles III, CPA • Bankrate.com

May 27, 1999 -- Most small business owners recognize that maintaining a qualified home office generates certain tax breaks. They can deduct a portion of certain expenses related to their entire home and all expenses directly related to the maintenance of this office. But there are some additional, less obvious, ways to use this deduction.

Of course, your home-office must meet certain standards before you can reduce your tax liability. This tax tip reviews some specific rules for qualifying a residential area as a home office. It then introduces three tax reduction strategies that may be appropriate once you have a qualified home office. These include converting commuting costs to travel expenses, hiring independent contractors instead of employees, and capitalizing start-up costs.

What is a qualified home office?
If you plan to deduct expenses for your home office, you must meet certain tests established by the IRS. First, the area used for business must be utilized exclusively and regularly for at least one of the following purposes:

As the principal place of business for any trade or business,
As a place to meet or deal with clients in the normal course of the business, or
In connection with the business, if it is a separate structure unattached to the taxpayer's personal residence

The definitions of "exclusively" and "regularly" are critical:

"Exclusively" means for business purposes only. Using part of a home as a business office and also for personal purposes doesn't qualify as exclusive. Two exceptions to this rule are storage of inventory and day-care facilities.

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"Regularly" means on a continuing basis. A part of a home used only occasionally or incidentally doesn't qualify, even if that part of the home isn't used for any personal or other purpose.

Before the 1999 tax year, many taxpayers hadn't been able to deduct their home office because duties performed there were deemed "less important", meaning the office wasn't the principal place of business. The IRS used the relative importance of the activities performed at each business location as the main factor in determining a principal place of business. If the business activities outside the home were more important than the business activities performed within the home, the home didn't qualify as a principal place of business.

The nature of the business determined the importance of activities. For example, the most important activity for a retail business selling goods to the general public is the place where the owner meets his customers. Other required activities like accounting, billing, etc. weren't the most important for this business.

With the new rules in place for tax years 1999 and later, the IRS will consider the home office in the example above as the principal place of business if:

It is used exclusively and regularly for administrative or management activities of trade or business, and
There isn't another fixed location for these administrative or management activities, including billing customers, clients or patients; maintaining records; ordering supplies; organizing appointments, and writing reports.

Other issues affecting Test 1 The new rules regarding the principal place of business haven't eliminated other hurdles your office must avoid to pass the first test. Besides meeting the "exclusively" and "regularly" components of the rule, your home office must also pass three other requirements:

Trade or business use -- If you are claiming a portion of your home as a home office, keep in mind that it must be used in connection with your trade or business. You can't use it for an unrelated profit-seeking activity and take a deduction for its use.
Convenience of the employer -- If you are an employee and want to deduct your home office, you must pass the convenience of the employer test. If your employer provides an office for you, you can't deduct your office unless you are required to work at home.
Deduction limit -- Even if your home office qualifies for this deduction, the amount may be limited if expenses from your home office exceed gross income earned from your home office. Consult IRS Publication 587 for the rules on the deduction limit.

Three categories of control and independence from Chapter Two of IRS Publication 15A
Behavioral control: Does the business provide the worker instructions or training? Instructions -- An employee is generally subject to the business's instructions about when, where, and how to work. Training -- An employee tends to be trained in a particular manner, while independent contractors use their own methods.
Financial control: What is the extent of the worker's unreimbursed business expenses, investment, availability to the relevant market, pay structure and ability to realize a profit and loss? Unreimbursed business expenses -- Independent contractors are more likely to have unreimbursed expenses than employees are. Investment -- An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. Pay structure -- Employees receive payments at designated periods. An independent contractor is usually paid by the job. Ability to realize a profit or loss -- An independent contractor can make a profit or loss.
Type of relationship: Written contracts describing the relationship the parties intended to create. Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay. The permanency of the relationship. The extent to which the worker's activity is a key aspect of the regular business of the company.

Convert commuting costs to travel expenses
Maintaining a qualified home office allows you to deduct home office expenses, and it can provide other types of deductions as well. Let's start with the cost of driving to work. Most people probably realize that expenses from commuting between home and work aren't tax-deductible. However, they may not know that they you can deduct travel between different job locations? A home office transforms your home into a job location. Going back and forth to your home becomes deductible business travel instead of commuting.

Save costs by using independent contractors
Instead of hiring employees, you may want to consider using independent contractors. The benefits are obvious. You avoid the payroll taxes on employees. You may also eliminate insurance and other fringe benefits expenses. However, you need to be cautious about using this particular strategy. Small businesses that classify workers as independent contractors tend to attract the attention of the IRS.

If you are legitimately trying to decide whether to classify someone as an independent contractor or employee, consider his relationship to your business. The IRS considers evidence pertaining to your business' control over that worker. Evidence of the degree of control or independence falls into three categories.

Also, keep in mind that the IRS success rate in reclassifying independent contractors as employees is high. The IRS uses a list of 20 factors to determine a worker's status. For further information in this issue, consult IRS Publication 15A: Employer's Supplemental Tax Guide. Carefully review this list as well as other rules in this area when deciding the worker's correct classification.

Capitalize start-up costs
Start-up costs are expenses you incur while either establishing or investigating the creation or purchase of a trade or business. These costs occur before the trade or business begins operations. These types of expenses must be amortized over 60 months instead of being expensed in full in the year incurred. Only costs incurred in "carrying on" as opposed to "starting up" a trade or business are fully deductible in the year incurred.

Typical start-up costs include market surveys, facility analysis, grand opening advertising, training wages for employees and consulting or other professional fees.

You must elect this 60-month amortization on your original tax return of the year the business begins. You can't elect it on an amended return.

Conclusion:
Qualified home-offices generate well-publicized tax breaks for small business owners. This tax tip addresses a change in this provision allows more home-offices to qualify for this deduction. It also suggests three additional tax reduction strategies that may be appropriate if you maintain a qualified home-office. These include converting commuting costs to travel expenses, hiring independent contractors instead of employees, and capitalizing start-up costs. Understanding the correct use of these strategies minimizes tax liability without risking attention from the IRS.

Luis I. Ingles III is a certified public accountant based in Louisiana

-- Posted May 27, 1999