My oldest friend (since 5th grade) is also a CPA. At lunch last week, he made a great observation. If you run your business as an S corporation and haven’t been taking the home office deduction? Yeah, you want to rethink that approach.
More specifically, if you qualify for the home office deduction, you ought to take the deduction. But let’s go over the mechanics. This gets a little bit complicated. (Sorry.)
The Usual Rules for Home Office Deduction
As a refresher on home office deductibility, a business owner may be able to deduct home office expenses if she or he uses a home office regularly and exclusively for business and if the home office represents the principal place of business.
The IRS website provides a longer discussion here, but the deduction works pretty simply.
Example 1: How Home Office Deduction Works
Say your sole proprietorship operates out of your house. Further, say the mortgage interest annually runs $10,000, that property taxes run another $5,000, and that utilities and repairs total another $3,000.
All totaled, then, your home operating expenses run $18,000 a year
One needs to consider depreciation, too. But say, to keep things simple, that you also get to include $10,000 a year of depreciation in your calculations.
Total expenses in this example run $28,000 a year once you combine the operating expenses and the depreciation.
If a home office amounts to ten percent of the structure, one could with these costs deduct 10% of $28,000 or $2,800 in home office expenses.
Note: In the case of a sole proprietorship, you show your tax accounting for the home office deduction on a form 8829.
Nothing to Get That Excited About
In spite of the easy math, I was never that big a fan of the home office deduction.
True, as the preceding example 1 shows, you could put a $2,800 deduction on the tax return and thereby save some taxes.
But with a home office deduction, mostly you or your accountant simply moved deductions around.
For example, $1,000 of the $10,000 of mortgage interest moved from Schedule A’s list of itemized deductions to the 8829 form that tallies the home office deduction.
Similarly, $500 of the $5,000 of property taxes moved from Schedule A’s list of itemized deductions to the 8829 form.
You do get $1,000 of depreciation deduction in a situation like that illustrated above… but when you sell the home, you recapture that $1,000 as income.
In the end, then, the only incremental tax savings came from the extra $300 of deduction created by deducting 10% of the utilities and repairs.
That $300 for most taxpayers meant $30 to $50 of income tax savings. Which seems pretty inconsequential.
No, no, I hear you.
Of course, $50 matters. But how much fiddling do you want to go to on your tax return to get an extra $50? And if you’re paying your accountant $200 an hour, you’re not saving money by having him or her do this work.
Note: With a sole proprietorship, just to be accurate, the total tax savings can amount to a bit more. The home office deduction saves not just income taxes but also self-employment taxes.
S Corporation Home Office Deduction Wrinkles
And then here’s the other thing when you look at doing this deduction for an S corporation: The whole S corporation thing complicates the deduction.
Normally, you can’t cleanly take a home office deduction on an S corporation tax return.
Unlike the situation with a sole proprietorship and that 8829 form mentioned a moment ago, no tax form exists for throwing a home office deduction onto an S corporation tax return.
And in fact, tax law sort of prohibits an employer from paying home office expenses to employees. (See Section 280A(c)(6).)
Accordingly, the right way to deduct home office expenses on an S corporation tax return goes like this:
- The S corporation creates a formal reimbursement arrangement (called an “accountable plan”) to pay employees for their business expenses including the expenses of setting up and operating a home office.
- Employees then regularly (say monthly) request reimbursement for business expenses, including home office expenses.
- The S corporation pays those business expenses, carefully applying the rules of the “accountable plan” reimbursement arrangement.
Example 2: Simple S Corporation Home Office Deduction Example
Here’s a simple example of how this reimbursement works…
Mike, a shareholder-employee, works out of a home office for his S corporation, Acme Supplies.
Using its “accountable plan,” Acme Supplies reimburses Mike for the actual business expenses he pays each month, including the actual expenses he incurs for operating a home office.
As long as Mike and Acme Supplies follow the accountable plan’s rules, the reimbursed expenses count as a valid business deduction on the Acme Supplies tax return.
If Mike’s home expenses run $28,000 a year and his home office represents 10% of his home, the above gambit lets Acme Supplies reimburse Mike for and also deduct $2,800 of expenses.
Importantly, the reimbursed expenses don’t count as income to Mike.
You can now really see why the accountants often didn’t get that excited… People (mostly the accountants) may be going to quite a bit of work to save $30 or $50 of taxes a year.
Note: With an S corporation, the home office gambit saves income taxes but not self-employment taxes.
New Deduction Rules Change Home Office Calculus
Nevertheless, as my CPA friend pointed out, things work differently now. And the basic reason is itemized deductions just aren’t worth as much anymore.
First, starting in 2018, most people won’t itemize. Rather, they’ll just take the $12,400 standard deduction for a single person or the $24,800 standard deduction for a married person.
Second, and sort of related, the two largest components of the home expenses—mortgage interest and property taxes—may be limited even if someone does itemize.
Only $10,000 of state property and income or sales taxes are deductible, for example.
And interest on a large mortgage (over $750,000) may be limited too. (See our new mortgage interest deduction blog post for details.)
Given this, someone who adds a home office deduction to their tax return starting in 2018 may not be simply moving deductions from one page of a tax return to another page.
Rather, a taxpayer may be dramatically increasing deductions. And in some cases, the taxpayer may be sidestepping around mortgage interest and state tax limitations.
Example 3: The New Home Office Deduction Economics
Here’s an example of what I mean.
Continuing with the first example introduced, assume an S corporation operates out of the shareholder-employee’s house. Again assume the mortgage interest annually runs $10,000, property taxes run another $5,000, and utilities and repairs run another $3,000… and that the depreciation comes to $10,000 a year.
Home operating expenses and depreciation in this simple example total $28,000.
If a home office takes ten percent of the home, voila, $2,800 in home office expenses.
Assume, however, that the homeowner isn’t itemizing. Assume he takes the standard $24,800 deduction because he’s married.
In this case, the taxpayer loses nothing by moving $2,800 of home office deductions onto the business tax return.
No other schedule of deductions—like Schedule A’s list of itemized deductions—gets plundered for the deductions. The home office deduction is all gravy.
A small business owner in this situation may be looking at $300 to $700 in true annual additional tax savings because the return’s total deductions have grown by nearly $3,000.
You see what my CPA friend is talking about right?
Structuring the Reimbursement Arrangement
An “accountable plan” reimbursement arrangement like the one vaguely described above creates all sorts of opportunity for taxpayer tom-foolery.
Accordingly, predictably, the Internal Revenue Service says the reimbursement arrangement needs to operate in a very business-like and common-sensed manner.
Specifically, you and I need to apply the Section 1.62-2(d)(1) regulations. Those regulations say the employer needs to reimburse an employee or shareholder-employee for appropriately substantiated expenses tightly connected to the business. The employer needs to quickly reimburse employees. Employees need to return over-payments.
You probably want to read the regulation if you’re going to do this. (Or review the rules with your accountant.)
And do do a good job on the paperwork and with your record-keeping. (One website suggests using the 8829 home office deduction form to make the calculations and help document the deduction even for an S corporation. And that seems like a pretty good idea.)
Example Accountable Plan
Here’s an example accountable plan document. Note that you can copy and paste the italicized text below into another document and then replace every occurrence of Acme Supplies with your firm name.
Acme Supplies IRC Sec. 62(c) Accountable Plan
Acme Supplies hereby establishes a IRC Section 62(c) accountable plan that implements and fully complies with Regulation Section 1.62-2.
Refer to Regulation Section 1.62-2 for detailed requirements—since Regulation Section 1.62-2 by this reference describes and controls the operation of the Acme Supplies accountable plan—but to generalize Acme Supplies will reimburse employees for ordinary and necessary business expenses of Acme Supplies that employees and shareholders directly pay as long as employees or shareholders fully substantiate these expenses by providing receipts and any additional documentation required by Acme Supplies.
Note that for travel related expenses, employees must provide not only the receipts but also substantiate the time, location and business purpose of the expense as per IRC Section 274(d) and its related regulations.
Employees may receive advances such as for upcoming travel up to 30 days in advance.
Employees must account for expenses paid or incurred within 60 days.
If Acme Supplies overpays employees, employees much refund overpayments or unsubstantiated amounts with 120 days.
A Final Warning and a Clarification
Let me close with a warning and then also a clarification.
First, the warning. This accountable plan stuff matters for more than just an S corporation home office deduction. If you don’t operate an accountable plan, you by definition operate a nonaccountable plan. And that’s bad news. With a nonaccountable plan, tax law requires the employer to add reimbursements to wages. So reimbursements become taxable income to employees.
Note: The new tax law eliminates the miscellaneous itemized deduction, which in past included employee business expenses.
Second, a clarification: If you rent your home and your home includes a valid home office and you operate your business as a sole proprietorship, your situation works differently than what I describe here. You also save more money with the home office deduction because the deduction shelters your income both from income taxes and self-employment taxes.
Other Resources You Might Find Useful
Somewhere on this page, you will see an advertisement for your “Setting Low Salaries for S Corporations” monograph.
If you have questions about how to optimize your S corporation shareholder-employee salaries, you might look into that resource. We wrote the monograph for tax practitioners, but many veteran S corporations find it a useful resource.
Earlier in this post, we mentioned another related blog post connected to the new tax law: New Mortgage Interest Deduction Rules. If you plan to deduct your mortgage interest or home equity loan interest, you may find that post useful.
The rules for deducting meals and entertainment expenses have changed for 2018 and later years. All business owners want to make sure they understand the new rules. Here’s a blog post that describes this: Meals and Entertainment Deductions 2018 and Beyond.