So, your number has come up and you've been tagged for an Internal Revenue Service field audit. You are gripped by anxiety as you wait for the auditor to arrive at your home, knowing full well that a field audit entails a far more searching inquiry than the standard audit in IRS offices.
You ask yourself why this fate has befallen you, and then you remember that seemingly innocuous question you answered affirmatively on Schedule C: "Are you deducting expenses for an office in your home?"
Perhaps what you have done, says Richard J. Stricof, tax partner at the New York office of the accounting firm of Seidman & Seidman, "is to wave one of the biggest red flags you possibly can." This is more true than ever on your 1987 tax return as a result of changes that substantially limit home office deductions for both employees and the self-employed.
If you qualify, the deduction can be worth a lot of money. For homeowners, a percentage of depreciation, utilities and other operating expenses can be written off. One free-lance writer in Los Angeles even got away with deducting the cost of tuning the piano that he said was part of his office furniture. Renters can deduct a percentage of their rent.
As you anticipate the auditor's arrival, you may take comfort in the fact that your home office seems to meet at least one of the traditional IRS tests: It is a dedicated space used "regularly and exclusively" for business. A room, of course, is best, but a separate area walled off by shelves will do.
"Your kitchen table won't qualify, but a desk in your living room might be acceptable," says one accountant.
Armed with this knowledge, you gaze proudly at your IBM PC or Apple Macintosh in its own separate room--proof, you figure, that this is indeed a home office. Wrong. For both employees and the self-employed, there are other major hurdles.
An employee's deduction of a home computer is allowable only if he can pass two tough tests. The first test is that the machine must be there for "the convenience of the employer"--rather than for the convenience of the employee. The second is that having the machine is required as "a condition of employment." That means your employer requires you to have it.
"The IRS takes a very hard line on these questions," says Sidney Weinman, a senior editor at the Research Institute of America, which publishes tax law information for lawyers, accountants and other professionals.
If, for example, the employer provides access to a computer at the employee's office, the employee will most likely strike out if he tries to claim deductions for a home PC. "If you are an engineer at General Dynamics," Weinman says, "it is not enough to say that you use the PC to finish up at night and on weekends work that you started in the office."
The IRS reasoning: The employee could have stayed late or gone into work on the weekend.
Even if you have passed these rigorous tests, the Tax Reform Act of 1986 makes it tougher for an employee to take deductions for home offices and home computers. That's because such expenses must be lumped in with other miscellaneous expenses. Once aggregated, only those miscellaneous expenses that exceed 2% of the taxpayer's income can be deducted.
The Tax Reform Act also slams shut a clever loophole that was opened by an enterprising accountant in Phoenix a few years ago. Failing the standard tests, he entered into an arrangement with his employer under which he leased a portion of his home to the accounting firm.
He reported the rent as rental income--but he was more than compensated by taking large deductions for rental expenses, including depreciation, insurance and utilities. This deduction has been abolished.
The new tax law also places tough new limits on home office deductions for the self-employed. The law essentially states that self-employed people may not use home office deductions to create a tax loss.
Seidman & Seidman's Stricof explains: "Let's assume we have a woman named Dolly Decorator, a part-time interior designer. She works, but she isn't going at it full tilt. She also has a good time, entertaining potential clients, taking them out to dinner or whatever.
"Now let's assume that she has $5,000 in income and $5,000 in expenses--before considering the home office. Under the old law, she could have taken a deduction for a home office and created a loss to offset other income or even her husband's income. Under the new law, she cannot."
The law was changed after the IRS became concerned that people were abusing the home office deduction to create tax losses. An Amway salesman once claimed that the family pet was a "guard dog" for his home office and took a (quickly disallowed) deduction for the pooch's food and veterinary expenses.
The other big test for the self-employed is that the home office must be the "principal place of business." That usually rules out employees but gives breathing room to free-lancers or others who operate a "sideline business" from their home.
Still, there are other hurdles. For a sideline to be a true business in the eyes of the IRS, it must have made money in three of the last five years--compared to two of the previous five before tax reform. Otherwise, the sideline is a hobby and not eligible for tax deductions.
One last word: You can only claim that percentage of the cost of a personal computer that applies to your income-generating activity. Accountants advise clients to maintain logs to back up their claims.
So if you've claimed 100% of the computer's cost as a business or employee expense and an IRS auditor is on the way, "make sure to hide Flight Simulator and any games your kids might play," Stricof deadpans.