Everyone seems to fear the home office deduction. And there is good reason for this if you are a W2 employee. However, for S Corp employee-owners this can be a great deduction without increasing your audit risk at all.
Home Office Determination
You've probably heard about this deduction and how it is an audit red flag. Basically, you can deduct from your gross the percentage use of your home office. This is a personal deduction, not a business expense, although it can be structured as a business expense (which is my preferred method, see below).
As a contractor I'll likely work at my client's facilities the most. This doesn't rule out the Home office deduction however. Your HO is your pincipal place of business if you use it exclusively and regularly for administrative or management activities of the business and you have no other fixed location to do these functions. So, if you have a dedicated space in your home for your business that you use to file taxes, prepare your payroll, do research, dial in remotely to your client, etc, you should be OK.
You can deduct a portion of the total expenses you incur in the operation of your home. Divide the sq footage of your office by the sq ft of your home. You can deduct:
- cleaning supplies
- hazard ins
- repairs to the entire house (the same percentage you calculated earlier since a repair to another part of the house indirectly affects your HO).
- mortgage interest
An Alternate Method to Structure Your Home Office Expenses
If you organize your entity as an S Corp instead of a sole proprietorship or partnership you don't need to file Form 8829 (Expenses for Business Use of Your Home) that shows that you are taking the home office deduction and how you are calculating it. Form 8829 is the audit red flag, but notice how it can be easily avoided. Conceptually this is simple. You create an "accountable plan" where the cost of the home office is a reimbursable employee business expense. IRS Pub 587 gives even more detail on other options you can use, including you personally renting the office space to your company. The problem here is you now have taxable real estate income. This flowchart from Pub 587 shows the various methods that can be used for home office expenses.
Why are Office Space Expenses Better than the Home Office Deduction?
If you take the HO deduction it's just a deduction so it's not really a dollar for dollar decrease in tax. BUT, if I go back and expense the LLC then the LLC gets a dollar for dollar decrease in earnings so less income tax flowing through via distributions.
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