Renting a Home Office To An Employer

A client asked about the home office deduction last week.

This deduction has lost much of its punch with the Tax Cuts and Jobs Act of 2017. The reason is that employee home office deductions are a miscellaneous itemized deduction, and most miscellaneous itemized deductions have been banned for the next two-plus years. 

The deduction still exists for self-employeds, however, including partners in a partnership or members in an LLC. Technically there is one more hoop for partners and members, but let’s skip that for now.

Say you are working from home. You have a home office, and it seems to pass all the bells-and-whistles required for a tax deduction. Can you deduct it?

Depends. On what? On how you are compensated.

(1) If you are a W-2 employee, then you have no deduction.

(2) If you receive a 1099 (think gig worker), then you have a deduction.

Seems unfair.

Can we shift those deductions to the W-2 employer? Would charging rent be enough to transform the issue from being an employee to being a landlord?

There was a Tax Court case back in the 1980s involving the tax director of a public accounting firm in Phoenix (Feldman). His position involved considerable administrative work, a responsibility difficult to square with being accessible to staff at work while also maintaining confidentiality on private firm matters.

Feldman built a house, including a dedicated office.  He worked out an above-market lease with his firm. He then deducted an allocable share of everything he could against that rent, including maid service.

No surprise, Feldman and the IRS went to Tax Court.

Let’s look at the Code section under dispute:

Sec 280A Disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc.

(a)  General rule.

Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, 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.

Thanks for the warm-up, said Feldman., but let’s continue reading:

      Sec 280A(c)(3) Rental use.

Subsection (a) shall not apply to any item which is attributable to the rental of the dwelling unit or portion thereof (determined after the application of subsection (e).

I am renting space to the firm, he argued. Why are we even debating this?

The lease is bogus, said the IRS (the “respondent”).

Respondent does not deny that under section 280A a taxpayer may offset income attributable to the rental of a portion of his home with the costs of producing that rental income. He contends, however, that the rental arrangement here is an artifice arranged to disguise compensation as rental income in order to enable petitioner to avoid the strict requirements of section 280A(c)(1) for deducting home office expenses. Because there was no actual rental of a portion of the home, argues respondent, petitioner must qualify under section 280A(c)(1) before he may deduct the home office expenses.

Notice that the IRS conceded that Feldman was reading the Code correctly. They instead were arguing that he was violating the spirit of the law, and they insisted the Court should observe the spirit and not the text.

The IRS was concerned that the above-market rent was disguised compensation (which it was BTW). Much of tax practice is follow-the-leader, so green-lighting this arrangement could encourage other employers and employees to shift a portion of their salaries to rent. This would in turn free-up additional tax deductions to the employee - at no additional cost to the employer but at a cost to the fisc.

The IRS had a point. As a tax practitioner, I would use this technique - once blessed by the Court – whenever I could.

The Court adjusted for certain issues – such as the excess rent – but decided the case mostly in Feldman’s favor.

The win for practitioners was short-lived. In response Congress added the following to the Code:

      (6)  Treatment of rental to employer.

Paragraphs (1) and (3) shall not apply to any item which is attributable to the rental of the dwelling unit (or any portion thereof) by the taxpayer to his employer during any period in which the taxpayer uses the dwelling unit (or portion) in performing services as an employee of the employer.

An employer can pay rent for an employee’s office in home, said Congress, but we are disallowing deductions against that rental income.

Our case this time was Feldman v Commissioner, 84 T.C. 1 (U.S.T.C. 1985).

 

Tax Court And Delivery Services

 We sent a petition to the Tax Court on Friday. It needs to arrive by Monday.

Technically, the petition does not have to arrive Monday, as long as it is in the care of an “approved” delivery service. I do not like to count on that extra day(s), however, so I treat the final day of the 90-day letter as an absolute deadline. In truth, I do not like waiting this late into the 90 days, but there was, you know, tax season and all.

COMMENT: Yes, the individual filing deadline was moved to May 17, but we made a concerted effort to prepare as many individual returns as possible by April 15. The majority of us here at Galactic Command do not like or appreciate a Dunning-Kruger Congress requiring us to again reschedule our personal lives.  

You may remember the old days when people used to go to the post office on April 15^th and mail their returns, especially if there was money due. Clearly there is no way that the return could make it to the IRS on the 15^th if one mailed it on the 15^th. The reason this worked (and still works, although it is much less of an issue with electronic filing) is Code Section 7502.

            § 7502 Timely mailing treated as timely filing and paying.

(a)  General rule.

(1)  Date of delivery.

If any return, claim, statement, or other document required to be filed, or any payment required to be made, within a prescribed period or on or before a prescribed date under authority of any provision of the internal revenue laws is, after such period or such date, delivered by United States mail to the agency, officer, or office with which such return, claim, statement, or other document is required to be filed, or to which such payment is required to be made, the date of the United States postmark stamped on the cover in which such return, claim, statement, or other document, or payment, is mailed shall be deemed to be the date of delivery or the date of payment, as the case may be.

This Section means that putting the return in the mail timely equals the IRS receiving it timely.

Mail service in our corner of the fruited plain has been … substandard recently. We have an accountant who no longer uses mail delivery for repetitive time-sensitive filings, such as sales and payroll taxes. She has too many experiences of mail taking a week to go crosstown that she has given up on regular mail for certain returns.

It is easier nowadays to avoid the post office, of course, with Fed Ex and UPS and other delivery services available.

We sent our petition via Fed Ex.

I am looking at a case that deals with “approved” delivery services.

What makes this an issue is that a delivery service is not approved until the IRS says it is. Granted, a lot of services have been approved, but every now and then one blows up. Use CTG Galactic Delivery, for example, have a hiccup – or just cut it too close – and you may not like the result.

A law firm sent a Tax Court petition the day before it was due. The admin person shipped it with Fed Ex using “First Overnight” delivery.

OK.

Something weird happened, and the package got relabeled. Why? Who knows. The result however is the petition got to the Tax Court late.

In general, one would consider Fed Ex to be a safe bet and Fed Ex to be squarely within the list of approved delivery services. The problem is that the IRS does not look at Fed Ex overall as “approved.” It instead looks at the delivery options of Fed Ex as individually approved or not. When the law firm sent their petition, the following services were approved:

·      Fed Ex Priority Overnight

·      Fed Ex Standard Overnight

·      Fed Ex 2 Day

·      Fed Ex International Priority

·      Fed Ex International First

You know what service is not on the list?

Fed Ex First Overnight, the one the law firm used.

Now, Fed Ex Overnight eventually got added to the list, but not in time to save the law firm and this specific filing.

Are their options left if one blows the Tax Court filing?

Yes, but the options are less appealing. One could litigate in District Court, for example, but that would require one to pay the assessed tax in full and then sue for refund.

There is also audit reconsideration, but I shudder to take that option with IRS COVID 2020/2021. The IRS has the option of accepting or rejecting a reconsideration request. I can barely get the IRS to do what it HAS to do, so the idea of giving it the option to blow me off is unappealing.

For the home gamers, our case this time was Organic Cannabis Foundation LLC et al v Commissioner.

IRS Notices And Waiting To The Last Minute

We have been fighting a penalty with the IRS for a while.

What set it up was quite bland.

We have a client. The business had cash flow issues, so both the owner and his wife took withdrawals from their 401(k) to put into the business.

They each took the same amount – say $100,000 for discussion purposes.

OK.

They did this twice.

Folks, if you want to confuse your tax preparer, this is a good way to do it.

At least they clued us that the second trip was the same as the first.

They told us nothing.

The preparer thought the forms had been issued in duplicate. It happens; I’ve seen it. Unfortunately, the partner thought the same.

Oh oh.

Eventually came the IRS notices.

I got it. The client owes tax. And interest.

And a big old penalty.

Here at CTG galactic command, yours truly seems to be the dropbox for almost all penalty notices we receive as a firm. In a way it is vote of confidence. In another way it is a pain.

I talked to the client, as I wanted to hear the story.

It is a common story: I do not know what all those forms mean. You guys know; that is why I use you.

Got it. However, we are not talking about forms; we are talking about events – like tapping into retirement accounts four times for the exact amount each time. Perhaps a heads up would have been in order.

But yeah, we should have asked why we had so many 1099s.

So now I am battling the penalty.

Far as I am concerned there is reasonable cause to abate. Perhaps that reasonable cause reflects poorly on us, but so be it. I have been at this for over three decades. Guess what? CPA firms make mistakes. Really. This profession can be an odd stew of technicality, endurance and mindreading.

However, the IRS likes to use the Boyle decision as a magic wand to refuse penalty abatement for taxpayer reliance on a tax professional.

Boyle is a Supreme Court case that differentiated reliance on a tax professional into two categories: crazy stuff, like whether a forward contract with an offshore disregarded entity holding Huffenpuffian cryptocurrency will trigger Subpart F income recognition; and more prosaic stuff, like extending the return on April 15th.

Boyle said the crazy stuff is eligible for abatement but the routine stuff is not. The Court reasoned that even a dummy could “check up” on the routine stuff if he/she wanted to.

Talk about a Rodney Dangerfield moment. No respect from that direction.

So I distinguish the client from Boyle. My argument? The client relied on us for … crazy stuff. Withdrawals can be rolled within 60 days. Loans are available from 401(k)s. Brokerages sometimes issue enough copies of Form 1099 to wallpaper a home office.

I was taking the issue through IRS penalty appeal.

The IRS interrupted the party by sending a statutory notice of deficiency, also known as the 90-day letter.

Class act, IRS.

And we have to act within 90 days, as the otherwise the presently proposed penalty becomes very much assessed. That means the IRS can shift the file over to Collections. Trust me, Collections is not going to abate anything. I would have to pull the case back to Appeals or Examination, and my options for pulling off that bright shiny dwindle mightily.

You have to file with the Tax Court within 90 days. Make it 91 and you are out of luck.

I am looking at a case where someone used a private postage label from Endicia.com when filing with the Tax Court. She responded on the last day, which is to say on the 90^th day. Then she dropped the envelope off at the post office, which date stamped it the following day.

I get it.

That envelope has an Endicia.com postmark. Then it has a U.S. Postal Service postmark dated the following day.

Then there is another USPS postmark 13 days later.

And the envelope does not get delivered until 20 days after the date on the Endicia.com label.

Who knows what happened here.

But there are rules with the Tax Court. One is allowed to use a delivery service or a postmark other than the U.S. Post Office. If the mail has both, however, the USPS postmark trumps.

In this case, the USPS postmark was dated on the 91^st day. 

You are allowed 90.

She never got to Tax Court. Her petition was not timely mailed.

Sheeeessshhh.

BTW always use certified mail when dealing with time-sensitive issues like this. In fact, it is not a bad idea to use certified mail for any communication with the IRS.

And - please - never wait to the last day.

Self-Renting a Big Green Egg

Sometimes tax law requires you to witness the torture of the language. Other times it herds you through a sequence of “except for” clauses, almost assuring that some future Court will address which except is taking exception.

And then you have the laughers.

I came across an article titled: Corporation’s self-leasing rental expense deduction denied.”

I was curious. We tax nerds have an exceptionally low threshold for curiosity.

Before reading the article, I anticipated that:

(1)  Something was being deducted

(2)  That something was rent expense

(3)  Something was being self-leased, whatever that means, and

(4)  Whatever it means, the deduction was denied.

Let us spend a little time on (3).

Self-lease (or self-rental) means that you are renting something to yourself or, more likely, to an entity that you own. It took on greater tax significance in 1986 when Congress, frustrated for years with tax shelters, created the passive activity (PAL) rules. The idea was to separate business activities between actually working (active/material participation) and living the Kennedy (passive activity).

It is not a big deal if all the activities are profitable.

It can be a big deal if some of the activities are unprofitable.

Let’s go back to the classic tax shelter. A high-incomer wants to shelter high income with a deductible tax loss.

Our high-incomer buys a partnership interest in a horse farm or oil pipeline or Starbucks. The high-incomer does not work at the farm/pipeline/Starbucks, of course. He or she is an investor.

In the lingo, he/she is passive in the activity.

Contrast that with whatever activity generates the high income. Odds are that he/she works there. We would refer to that as active or material participation.

The 1986 tax act greatly restricted the ability of the high-incomer to use passive losses to offset active/material participation income.

Every now and then, however, standard tax planning is flipped on its head. There are cases where the high-incomer wants more passive income.

In the name of all that is holy, why?

Has to do with passive losses. Let’s say that you had $10,000 in passive losses in 2015. You could not use them to offset other income, so the $10,000 carried over to 2016. Then to 2017. They are gathering dust.

If we could create passive income, we could use those passive losses.

How to create passive income?

Well, let’s say that you own a company.

You rent something to the company.

Let’s rent your car, your office-in-home or your Big Green EGG XXL.

Rent is passive income, right? The tax on our passive income will be zero, as the losses will mop up every dollar of income.

That is the “self-rental” the tax Code is after.

But it also triggers one of those “except for” rules: if the self-rental results in income, the income will not qualify as passive income.

All your effort was for naught. Thank you for playing.

Back to the article I was reading.

There is a doctor. He is the only owner of a medical practice. He used the second story of his house solely for the medical practice. Fair be fair, he had the practice pay him rent for that second floor.

I have no problem with that.

The Tax Court disallowed the corporation a rent deduction.

Whaaat? That makes no sense.

The purpose of the passive/active/material participation rules is not to deny a deduction altogether. The purpose is to delay the use of losses until the right type of income comes around.

What was the Tax Court thinking?

Easy. The doctor never reported the rental income on his personal return.

This case has nothing to do with self-rental rules. The Court simply was not permitting the corporation a deduction for rent that its shareholder failed to report as income.

The case for the home gamers is Christopher C.L. Ng M.D. Inc.

Saying Goodbye To Employee Business Expenses

Let’s talk about miscellaneous itemized deductions - likely for the last time.

These are the deductions at the bottom of the form when you itemize, and you probably itemize if you own a house and have a mortgage. Common miscellaneous deductions include investment management fees (if someone, such as Simply Money, manages your savings) and employee business expenses.

These are the “bad” expenses that are deductible only to the extent they exceed 2% of your income (AGI), because … well, because the government wants more of your money.

I am reading a case concerning a bodyguard and his employee business expenses.

His name is Rick Colbert and he retired after 30 years from the Long Beach, California Police Department. He gigged-up with Screen International Security Service Ltd (SISS) in Beverly Hills. They assigned him celebrities. He chauffeured them, deflected paparazzi, installed and monitored security devices, patrolled their estates, performed access point control and responded to distress calls.

SISS had a reimbursement policy. It did not cover everything, but it did cover a lot. Colbert did not seek any reimbursement.

He filed his 2013 tax return and reported SISS income of $25,546.

He then deducted employee business expenses of $23,965.

COMMENT: One can tell he is not in it for the money.

Those numbers are out-of-whack, and the IRS audited him. Like the IRS we know and love, they bounced all of his employee business expenses, arguing that he had not substantiated anything.

On to Tax Court they went.

The Court went through the list of expenses:

(1) $211,154 for a pistol and target practice.

Looks legit, said the Court.

(2) $86 for earbuds

To avoid annoying celebrities.

The Court grinned. OK.

(3) $1,711 for clothing and dry cleaning

Nope said the Court.

We have talked about this before. If you can wear the clothing about town and day-to-day, there is no deduction. It is just another personal expense, unless our protagonist wanted to dress up like “Macho Man" Randy Savage.

(4) $1,609 for a gym membership, weight loss pills and other stuff.

Uhh, no, said the Court, as these are the very definition of “personal, living, or family expenses.”

(5) Office in Home

This would have been nice, be he did not use space “exclusively” for the office, which is a requirement. This would hurt a send time when the Court got to his …

(6) iPad and printer

Computers are like cars when it comes to a tax deduction: you have to keep records to document business use. The reason you never hear about this requirement is because of a significant exception – if you keep the computer in an office you can skip the records requirement.

When Colbert lost his office-in-home, he picked-up a record-keeping requirement. He lost a deduction for his iPad, printer and supplies.

(7) $5,003 for his cellphone

It did not help that his internet and television were buried in the bill.

The Court disallowed his cellphone, which amazes me. Seems to me he could have gone through his bills and highlighted what was business-related.

He won some (primarily his mileage) but lost most.

And his case is now among the last of its kind.

Why?

The new tax bill does away with employee business expenses, beginning in 2018. There is NO DEDUCTION this year.

If you have significant employee business expenses, you really, really need to arrange a reimbursement plan with your employer. Your employer can deduct them, even though you cannot. Why the difference?

Because, to your employer, they are just “business expenses.” 

A Condo Association, Dogs Running Wild and An Office In Home

This time we are talking about an office-in-home. Many of us have one, but few of us can actually claim a tax deduction for it.

The office-in-home deduction has five main rules, two of which are highly specialized. The remaining three require one to:

1. Use the office exclusively and regularly as a principal place of business
2. Use the office exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of business
3. Use the office in connection with a trade or business – but only if the office is a separate structure

If you are an employee, then you are in the trade or business of being an employee. If your office is in a separate structure, you are home-free under test (3). 

OBSERVATION: I suppose a converted, oversized shed could meet this test.   

I have a CPA friend who practices out of her basement. She would qualify under test (2), as she regularly meets with her clients there. I however almost always meet clients either at their office or mine, so I would not qualify.

That leaves us with test (1), which is an almost impossible standard to meet if one has an office elsewhere. Fortunately there was a Supreme Court decision a number of years ago (Soliman), which allowed one to consider administrative or management duties for purposes of this test.  

Soliman was an anesthesiologist, and the three hospitals where he worked did not provide him with an office. He used a spare bedroom for work-related activities, such as contacting patients and billing. The IRS had previously taken a very hard line with test (1) and denied the deduction. The IRS reasoned that Soliman’s job was to put people to sleep, and he did that job at the hospital. This meant that the hospital was his “principal” place of business.  The IRS was not going to be persuaded otherwise, at least until the Supreme Court told them to knock it off and allow Soliman his deduction.

Great. So I can do administrative work at home – such as scheduling or billing – and have my office qualify for a deduction, right?

Not so fast.

There are two more tests if one is an employee. The one that concerns us is the requirement that the office be for the convenience of the employer.

Those words sound innocuous, but they are not.

For most of us, having an office at home is for our convenience. In fact, the IRS takes this farther, arguing that – if your employer provides you with an office – then it is virtually impossible for the home office to be for the employer’s convenience.  The IRS reasons that the employer would not care if you showed up, as it had an office waiting. There are some exceptions, such as telecommuting or requiring work hours when the office is closed, but you get the idea. For the vast majority of employees, one cannot get past that convenience-of-employer test.

What if one is self-employed? Forget the convenience test. There is no employer.

Let’s look at McMillan v Commissioner. There will be a quiz at the end.

Denise McMillan had a couple of things going on, but what we are interested in is her home office. She was self-employed.

She claimed an office-in-home deduction on her 2009 return. I am not certain of her housing situation, but her office was 50% of her home. I cannot easily visualize how this is possible, especially given the requirement that the office space not be used for any other purpose. That is a lot of space that she is not using for another purpose – like living there.

She lived in a condo. She had gotten into it with the homeowners association over construction defects related to mold and noise, dogs running wild, dogs barking incessantly and leaving dog memorabilia as dogs will when running wild and barking nonstop.

The condo association would do nothing, so she sued them.

The condo association – highlighting the quality of its Board – sued her back.

Wow, send me a flyer so I can consider buying at this bus station to paradise.

All in all, she was out over $26 thousand in legal fees and expenses.

And she deducted 50% of them through her office-in-home deduction.

QUIZ: Is this a valid tax deduction?

She sued because of events which were interfering with her use and enjoyment of her property.  Had this property been exclusively her residence, the conversation would be over. But one-half of it was being used for business purposes.

She next had to show that the litigation also had an effect on her business activity.

 QUESTION: Have you decided yet?

The Court observed that she was suing over noise, animal waste and similar issues. She argued that they were affecting her ability to work. Makes sense to me.

The IRS did not challenge her argument. 

NOTE: My hunch is that the IRS was relying upon an origin-of-claim doctrine. The lawsuit originated from a personal asset – her residence – so the tax consequences therefrom should remain personal. In this case, personal means nondeductible.

Since the IRS did not challenge, the Court could not – or would not - conclude that there was no effect on her ability to work.

The IRS had not challenged the 50% percentage either.

So the Court decided that she was entitled to a tax deduction for 50% of her legal expenses.

By the way, how did you answer?

Change in Office-In-Home Rules (Starting Next Year)

The IRS surprised me yesterday.

Do you ever work from home? Let me phrase it differently: do you have an office-in-home, as the IRS defines the term?

I have an office at home and I work from home occasionally (I try to keep my workload at the office). I do not however have an office-in-home for tax purposes. Why? My office would have to meet one of three criteria to rise to a tax deduction:

 

(1)   My office–in-home is the principal place of my trade or business

·        I will not meet this test as I have an office in Cincinnati.

(2)   A place where I meet with clients, patients or customers in the normal course of my business

·        Granted, I do a lot of my work on a computer or over a cell phone, but I primarily meet with clients at my office in Cincinnati.

(3)   I work from home for the convenience of my employer

·        The IRS has interpreted this test to mean that the employer does not provide the employee with an office, so the employee – needing a place to work – has one in his/her home. If the employer does provide an office, one will have an almost insurmountable challenge in meeting this test. There may be some latitude in a hoteling situation, but you get the idea. I will likely fail this test.

Let’s say that you meet one of the three tests. Perhaps you freelance as a second job. That freelancing may qualify you for the office-in-home deduction. We meet for preparation of your taxes. We discuss expenses related to your office-in-home: the interest, taxes, utilities, insurance, security and etc. We calculate the depreciation. We then have to prorate between the personal use of your home and the business use. All the while, I am remembering that just putting this deduction on your return increases your odds of audit selection.

So the IRS came out yesterday and provided a simplified rule for an office-in-home. They will spot you $5 per square foot – up to 300 square feet - for your office. No depreciation. No proration of expenses. There is a downside: you will not be able to carryover excess office-in-home deductions under this method. There is an upside: you can elect annually which method you want to use. Obviously if you have more than 300 square feet, or your expenses run more than $5 per square foot, you will probably elect to use actual expenses.

• NOTE: The simplified election starts with tax year 2013. We cannot use this election when preparing your 2012 individual tax return, unfortunately.

By the way, let me clarify what the IRS means by office-in-home. Any direct expenses you have – say a camera or film for a photographer or payroll for an employee – are not considered office-in-home expenses. An alternate phrasing is that these expenses would be avoidable if you did not engage in the business activity. The office-in-home expenses are indirect and unavoidable. That is, you would still have the mortgage, taxes, and insurance whether you freelanced or not.