Bill Clinton may not have decided whether to raise taxes. But in an 8-1 decision limiting home office deductions, the Supreme Court on Jan. 12 in effect did part of the job for him. Hundreds of thousands of people will be affected by the ruling, which allows deductions only if a home office is the principal place of business. Some 1.6 million taxpayers claimed home office deductions last year, saving an estimated $8 billion. No one knows precisely how many taxpayers will be affected, but one New York accountant says it could be upward of 50% of those who claimed the deduction.
The new litmus test uses two criteria. The business' most important functions--where services are provided--must take place in the home office. And the amount of work time spent in the home office should be greater than the amount spent outside of it. "That means if you silk-screen T-shirts in your basement and sell them on the street corner, your primary place of business would be the street corner," says William G. Brennan, editor of Ernst & Young's Financial Planning Reporter.
Accountants say it doesn't matter whether the at-home business is your only livelihood or a sideline to a full-time job. As long as you do all or most of the work for the home-based enterprise in a separate space designated for that purpose, it will continue to qualify for special tax treatment. Thus, a graphic artist who does regular freelance work at home would still be eligible. So would a phone company employee who sells Amway products in his spare time from a basement office.
But there's a caveat: "The business must be a continual activity, not just a once-a-year thing," says Tom Ochsenschlager, a partner in the Washington (D. C.) office of accounting firm Grant Thornton. "If a guy takes photos on the weekends and sells a few at a county fair, the IRS might say it's just an extension of his hobby and not a business."
Also on shaky ground in taking the deduction are self-employed people, such as computer consultants and lawyers, who spend much of their time meeting with clients and working outside their homes. However, a gray area exists that still allows them to argue for deductibility. Take a management consultant who spends a lot of time doing research at home. But he frequently meets at clients' offices to discuss projects and present reports. "There, you've got an argument that the most important function of your business is the work you do at home," says Paul Laughlin, a partner in individual tax services in Arthur Andersen & Co.'s Chicago office.
The Supreme Court decision was made in the case of Nader Soliman, a self-employed anesthesiologist who used his McClean (Va.) home office to keep records and make phone calls for his work at three local hospitals. Justice Anthony M. Kennedy wrote the majority opinion, arguing that since Soliman took care of patients at the hospitals, that was his primary workplace. And since he only spent 10-15 hours a week in his home office, he could not deduct it, even though he had no other office. In doing so, the court upheld a statute that's long been in the tax code, but has been interpreted in recent years to mean a place where work is done that is essential to your business.
QUICK ACTION. Tax experts say the ruling is retroactive, and they have little doubt that the IRS will get the audit machinery rolling. Last year, the agency made it easier to identify taxpayers who claim home office deductions by introducing a separate form--8829--for itemizing expenses. The IRS can now punch up these forms on the computer in minutes, says Laughlin of Arthur Andersen. He advises people who are disallowed under the new law to file amended returns promptly. That's to stop the interest meter from ticking, not to avoid a penalty. "They should not be subject to penalty because the authority at the time did permit the deduction," Ochsenschlager says.
Those who think they still have a good case to make for their past home-office deductions, should wait. First, the IRS isn't going to audit everyone, so the issue may not come up. And even if it does, then they can argue the merits at that time.
In the meantime, taxpayers will grow even more gun-shy of the home office deduction. Only a fraction of the millions of people entitled to the deduction use it, because they're afraid they'll be audited, says Bernadette Grey, editor of Home Office Computing. The Supreme Court has just raised those odds substantially.
HOME OFFICE DEDUCTIONS: BIG BUCKS Taxpayers taking deduction 1.6 million Average claim $5,000 TOTAL $8 billion DATA: INTERNAL REVENUE SERVICE; BW ESTIMATE