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Archive for Home Office

Is a Home Office Worth Having? It is If You Want to Save on Taxes for Your S Corporation!

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Operating your single-owner business as an S corporation has a variety of tax advantages. One way to ensure your tax advantages is to have your company reimburse you for the costs of keeping a home office. This tax savings strategy enables you to:

  • Convert the mileage from your commute into business mileage, thus increasing your vehicle deductions;
  • Consider a portion of your home expenses to be business expenses; and
  • Avoid home office audit risks on your tax return.

And, here’s even more good news when you employ this strategy—you never pay back those tax savings, even when you sell your house. Of course, in order to reap these benefits, you will have to make sure you follow the proper procedures (including documentation) regarding the office in your home. Many of these apply even if you operate your business under an entity structure other than S corporation.

Getting Reimbursed for Your Office

By tax law, S corporation owners are able to make deductions on home office expenses, and there’s more than one way you can go about doing so. However, the best way is to have your corporation reimburse you for the employee-business expenses you incur from having an office at your home.[1]

Let’s just look at the basics for a moment. When you create an office in your home, you have switched a portion of your house to business use from personal use. So, on your taxes, part of your home is considered a business asset. If, as an example, you used 1/3 of your house for office space, then 1/3 would be a business asset and 2/3 would be a personal asset.

Office Location Makes a Difference

Did you know that where you locate the office in your home can make a big difference on your tax savings? In fact, in the right location, your office is eligible for a $250,000/$500,000 home profit exclusion from taxes. This exclusion applies when you eventually sell your home. That’s right—how you locate your office now can affect tax savings at the time of sale. Specifically, you get a break on taxes for up to $250,000 (filing singly) or $500,000 (filing jointly) of profits on the sale of your personal residence.[2]

What does the business portion of your home have to do with this? Well, you generally have two possible scenarios:[3]

  1. The office is inside the walls of your home. If this is the case, you’re in a good position because the home sale profit exclusion applies to both the business and personal portions of your residence. The only exception to this is depreciation recapture (which will be further explained).
  2. The office is outside the walls of your home. An example of this would be an office located in a detached garage, guest house, or some other separate structure. In this situation, you’ll need to do a little more planning in order to get the best possible result. The tax exclusion will only apply to the residential part of your property. The sale of the business part will generate taxable business gains, as well as recapture on depreciation. However, as you’ll see discussed below, you can use a Section 1031 exchange to get out of those taxes.

Anytime you sell a house, you have a recapture tax for the depreciation you claimed. Regardless of the location of your home office, the home sale profit exclusion does not get rid of the recapture.[4] Before you start to feel gloomy about this, know that depreciation still gives you an advantage, even with the recapture tax, and here’s why:

  • You defer this payment until the year of sale, and
  • It’s possible for your depreciation deduction to be greater than (up to 36.9 percent rates) your recapture tax rate (up to 25 percent).[5]

Of course, it would be even better to just get rid of that recapture tax all together, wouldn’t it? Well, you can.

Making a 1031 Exchange

For any business gain you have left that is not covered by the profit exclusion you can make a like-kind, Section 1031 exchange. In fact, the IRS has provided guidance specifically on how to combine the home sale profit exclusion with the 1031 exchange for selling a house with an office.[6] Section 1031 will not dispose of your tax. What it does instead is defers it. But, here’s the really nifty bit, you can keep on making 1031 exchanges with every home sale and deferring that payment for the rest of your life. Then, the home goes up to fair market value and your taxable gains disappear.

The most important thing you need to know about making the 1031 exchange is that you must hire a professional intermediary to handle the monetary exchange. Don’t worry—you’ll spend less on an intermediary than what you would have paid in taxes, and a professional will ensure that you go through the process correctly.

Here’s how Section 1031 works when your office is inside your home (this example comes from the IRS):[7]

  1. You bought your home for $210,000 and split it into 1/3 business use and 2/3 personal use.
  2. Because you split the basis between business and personal, you have a business use basis of $70,000 and a personal use basis of $140,000.
  3. With a $30,000 depreciation for your office, that leaves a business use basis of $40,000 (reduced from $70,000).
  4. When you sell your home, it will split into a business portion and a personal portion. So, if you sell the house for $360,000, then you have sale prices of $120,000 for the business part and $240,000 for the personal part.
  5. You qualify for the full $250,000 Section 121 exclusion (single filing).
  6. Determine the gain on both parts of the home. In this example it’s $80,000 for business ($120,000 – $40,000) and $100,000 for personal ($240,000 – $140,000).
  7. Apply the profit exclusion to both parts (personal first). Don’t include recapture. Applying the $250,000 exclusion to your $100,000 personal gain gives you zero taxable gains, and you are left with $150,000 of profit exclusion. This remainder is applied to the business portion, except for your $30,000 of depreciation recapture.
  8. Finally, you defer the $30,000 using a Section 1031 exchange to acquire a new house with a new home office and watch the taxes disappear!

And, what about when your office is in a structure outside of the main residence? The example above changes a little bit. Here’s how it all works out:

  1. Determine the gain on both parts of the home. This is done in exactly the same way as it’s calculated in steps 1-6 above.
  2. Apply the profit exclusion to both parts of your residence. This step, however, is different from above. In this case, the exclusion does not apply to the business portion, which is located outside the walls of your home. You still get $0 in personal gain, but business gains will come to $50,000 capital gains and $30,000 depreciation recapture (determined by the $80,000 in business gains calculated above).
  3. Here’s the good news. You can still use a 1031 exchange to defer both the $50,000 in capital gains and the $30,000 in depreciation recapture.

It’s pretty clear that converting part of your home into an office for your S corporation makes good financial sense. If you don’t have an appropriate space inside your home, you can make an office in a detached structure. The math works out a bit differently, but you can still save big on taxes when you plan correctly.

  1. Reg. Section 1.62-2(d)(1). ↑
  2. IRC Section 121. ↑
  3. Reg. Sections 1.121-1(e)(1) and 1.121-1(e)(4) example 5. ↑
  4. IRC Section 121(d)(6). ↑
  5. IRC Section 1(h)(1)(E). ↑
  6. Rev. Proc. 2005-14. ↑
  7. Example 3 from Rev. Proc. 2005-14. ↑
Categories : Business Expenses, Home Office, Tax Planning

Qualifying for Your Home Office Deduction—Simplified

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

You may know which expenses qualify for home office deductions, but are you savvy about the requirements for your office qualifying to take these deductions in the first place? In order to make home office deductions, your office must pass the “regular use” test. It’s just what it sounds like—a determination of whether you regularly do business from the office in your home.

What the IRS Says

The IRS states in its audit manual, “Regular use means that you use the exclusive business area on a continuing basis. The occasional or incidental business use of an area in your home does not meet the regular use test even if that part of your home is used for no other purpose.”[1] Obviously, setting up an area exclusive to your business, filling it with files, and never going in there will not cut it, but this definition does little to pinpoint exactly what does count.

According to the IRS, they consider your individual facts and circumstances when determining regular use.[2] Great, but that leaves things pretty vague when you’re trying to plan for your tax return. So, instead, we’ll take a look at court precedents to get a better idea of what exactly you need to do to get your deduction.

  • The Frankel Case—Max Frankel was the editor of The New York Times. In his case, he claimed that he used his home office to communicate by phone with prominent politicians at all levels of government, as well as community leaders and labor leaders. Records indicated that Frankel averaged a call per night, and Frankel stated that it may have taken several calls to complete a single discussion. The U.S. Tax Court decided in his favor, stating that the frequency was enough to qualify Frankel’s home office for regular use.[3]
  • The Green Case—Because of the circumstances of his work, and because many of his clients were unable to make calls during daytime hours, John Green took a large number of client phone calls at home after his regular work hours. This was a required condition of his employment. The calls averaged 2 ¼ hours per night, five nights per week. Again, the Tax Court decided the frequency met regular use requirements for a home office.[4]

Like any tax strategy, passing the regular use test requires one important item—sufficient evidence. Another court case, involving Anthony Cristo, illustrates this need. The court stated:[5]

“We do not suggest that the frequency or regularity of meetings or dealings must match the level we faced in Green in order to meet the requirements for regular use. However, in this case we have so little information that we cannot tell whether the facts, if we knew them, would satisfy any reasonable interpretation of regular use.”

What does this mean for you? It means that no matter how good a claim you have to regular use of the office in your home, you will lose out on those deductions if you can’t prove it with substantial evidence. The truth is you only need two pieces of evidence in order to prove regular use:

  1. A log recording how you spent your time, and
  2. Documents that support your log of time spent.

Your log can be as simple as keeping an appointment notebook or printed sheets from a calendar application. Note your schedule, including phone calls, meetings, opening mail/responding to business email, and any other business activities you complete at your home office. Next, you need something to corroborate with the log.

  • You say you responded to emails on this day at a certain time? Keep your sent emails. They’re time and date-stamped and prove that you were indeed responding to email.
  • You claim to have met a client at your home? You could keep a guest log and have the client sign in. Or, you could provide email correspondence of your client’s agreement to meet at that time.
  • You devoted 2 hours each evening to making and taking phone calls? This one is easy to prove. You simply need to provide your phone bill as documentation. Make sure you get a detailed copy.

Sure, keeping records is a pain in the butt. Just set up a routine now and stick with it. You can make it even easier by creating a checklist for yourself. Every day, go through the checklist and make sure you took care of logging and documenting your hours, that way you won’t forget anything. Once it becomes part of your routine, you’ll see that keeping emails or having people sign a guest log really isn’t all that hard—and your deductions may hinge upon it.

A Checklist to Get You Started

What do you need to do to comply with the IRS regular use rules?

  1. Use your home office more than 10 hours per week on average (this is a subjective number because the IRS has never given a specific amount of time required, but 10 hours seems to be a safe bet based on past cases).
  2. Build proof indicating that you actually did work for those 10 hours or more.

That’s it. It shouldn’t be too hard to find business activities you can do from your home office for just a couple of hours per day/night. This article already gives you a few easy ideas, as well as simple ways to document them. Start keeping good records now, and taking care of any tax issues that arise will be no problem.

  1. Internal Revenue Manual Exhibit 4.10.10-3 — Standard Explanation Paragraph 4814 Test for Home Office (Last Revised: 01-11-2011). ↑
  2. Prop. Reg. Section 1.280A-2(h). ↑
  3. Max Frankel v Commr., 82 TC 318. ↑
  4. John W. Green v Commr., 78 TC 428; Rev on another issue, 52 AFTR 2d 83-5130, 707 F2d 404 (CA9, 5/31/1983). ↑
  5. Anthony B. Cristo v Commr., TC Memo 1982-514. ↑
Categories : Business Expenses, Home Office, Receipts, Records, Tax Planning

You Can Get Big Tax Deductions from Your Home Office

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Have you considered making deductions for your home office, but figured it wasn’t worth it? You should probably consider it more seriously. Even a small home office can save you thousands in out-of-pocket taxes. In fact, you can claim these deductions even if another office for your business is located outside your home. The IRS actually has special rules that allow the tiniest of offices to qualify. Don’t believe it? A man named Albert Mills actually (and successfully) defended a deduction for his office stationed in a 422 square-foot apartment[1].

Of course, there is a catch. You can’t just throw together any set up and tell the IRS you have an office in your home. They do have requirements you’ll have to follow to get the tax benefit. As long as you follow the tips in this article, you can also find out why small home offices can generate big money savings.

Let’s Find the Deductions

With an office in your home, you’ll be able to make deductions for two main types of tax savings. First, you can deduct a portion of your home expenses, like mortgage, property taxes, rent, and utilities[2]. Second, you can deduct the miles for the commute back and forth between your home office and your outside office[3].

How does this add up in terms of dollars? Let’s say you have an office about fifteen miles from your home. With a home office, the commute between the two now counts as business miles, which are deducted at a rate of $0.56 per mile (the standard mileage rate). So, your two-way commute generates a deduction of $16.80. Making this commute five days per week for fifty weeks generates a $4,200 deduction! Think about it—you would have had a $0 deduction for this without your home office.

What Are the Rules?

Important: For the IRS, the main consideration when designating a space in your home as an office is that you use it exclusively for business. This means you cannot use the space for personal reasons at all during the tax year[4]. But, don’t worry. You do not have to designate an entire room as an office. You just have to keep your office area dedicated to business. It doesn’t even require walls or partitions separating it from the rest of the room[5].

Additionally, the IRS actually provides a bit of leniency for those with very small homes. They allow what they call “de minimis” personal use[6]. You still can’t use your home office for non-business reasons, but they allow that passing through the area for personal reasons is fine. In one case, for example, a man had to pass through an office space built in a walk-through closet in order to reach his bathroom[7]. The court decided in his favor.

Just don’t get too lax with the “de minimis” exception. The courts deny this exception in cases of storing personal items in the office space[8] or hosting occasional family meals in it[9]. If you pass through the area, you’re fine. If you’re actually using it for personal uses, you’re probably breaking the exclusive use rule.

The Minimalist Home Office

Tax law states that your home office must be the principal office for your business in order to qualify for this deduction. This means you should be performing most of the administrative and management activities for your business at the office in your home. The good news is you don’t need a lot of space to make the area your principal office.

Would you like to know how to create a one square-foot office space? Just buy a tall, narrow cabinet or shelf that extends all the way to the floor. Store all your business documents, files, and supplies there. When working at home, you can simply pull up a small table and chair, and voila! You have a home office that cost you little time or money.

Whatever room your mini office is in, you can engage in personal activities anywhere in the room except where the cabinet is. Then, claim only the area of the cabinet space on your tax deductions. You can claim as much space as you use exclusively for business use. A mini office won’t generate big savings on home expenses, but it can create significant deductions on vehicle expenses.

Now, you see why even a small office space can be beneficial. The size of your business space makes no difference. Just devote some space in your home exclusively to business purposes and make sure it qualifies as the principal office for your business. Rather than just commuting to the office when you leave your home, you’ll be racking up miles of deductions for your vehicle expenses.

  1. Albert Victor Mills, TC Memo 1991-592. ↑
  2. IRS Form 8829. ↑
  3. Rev. Rul. 99-7. ↑
  4. Sam Goldberger, Inc. v Commr., 88 TC 1532. ↑
  5. Prop. Reg. Section 1.280A-2(g)(1). ↑
  6. Lauren E. Miller, TC Summary Opinion 2014-74. ↑
  7. Carl D. Hughes, Jr., TC Memo 1981-140. ↑
  8. Elmer Stalcup, TC Memo 1995-43; but see Ronald Culp, TC Memo 1993-270, in which the court did allow the de minimis exception for storage. ↑
  9. Paul M. Sengpiehl, (1998) TC Memo 1998-23. ↑
Categories : Business Expenses, Home Office, Tax Planning

Tips to Increase Your Home Office Tax Deductions

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Although it may not seem like it, the IRS is not out to make tax preparation as difficult as possible for you. If you make errors, it causes them headaches, too. That’s why they try to accommodate your reasonably documented calculations for home office deductions. According to the IRS in its home office deductions publication, “You can use any reasonable method to determine the business percentage” of your residence[1].

Methods Suggested by the IRS

In that same publication, the IRS then goes on to suggest two methods that may be easy for small business owners to implement:

  • Number of Rooms—This method is just what it sounds like. If all your rooms are approximately the same size, you can divide the number of rooms used for business purposes by the number of rooms in your house. It’s actually fairly simple; however, the calculations will be less precise than with methods in which you measure the size of your office space.
  • Gross Square Footage—For a slightly more in depth calculation (but still relatively simple), you can calculate gross square footage. Multiply the office’s length by its width. Then, divide that number by the total area of your house.

Either of these methods works fine, but it turns out there’s a different calculation that may better benefit your finances.

Net Square Footage

When you calculate net square footage, you only calculate the useable portion of your home. It takes a little more figuring, but you’ll come up with a more accurate number that increases your deductions and save you money. How? Because when you take away from the calculations the parts of your home that cannot be used as office space, you reduce the denominator by which you’re dividing. And, that equals a greater percentage of your residence being considered business space.

Areas that are subtracted to find net square footage include bathrooms, stairways, hallways, outside walls, water heaters, foyers, and heating and cooling equipment. This method is used in cost accounting standards[2] and in commercial real estate[3]. This means you have documented standards for using net square footage to calculate assignable space in your home, since cost accounting standards are used with government grants and contracts.

As long as you keep accurate records, you’ll only have to make this calculation once—unless, of course, you move or change your office space. Tip: Simply measuring the square feet of each assignable room will give you the same number as taking out measurements for bathrooms, hallways, and other spaces that are not available for use.

Form 8829

Despite the fact that the IRS itself states any reasonable calculation method may be used, the IRS Form 8829 only shows an option for the gross square footage calculation[4]. Don’t let that fool you. The instructions for this form clearly specify that you may use other reasonable calculation methods so long as they accurately reflect your business percentage.

Let’s check out an example so you can see the benefit of taking a net square footage measurement. For the example, assume you have a 2,600 square-foot home with eight rooms, excluding bathrooms. When you subtract the common areas that are unassignable space, you have 2,000 useable square feet, of which your office takes up one, 270 square-foot room.

Calculating gross square footage, you divide 270 by 2,600, getting 10.38% business area. Calculating by number of rooms, you take 1 divided by 8 and end up with 12.5% business area. However, the net square footage method takes 270 divided by only 2,000, making your business area 13.5% of the total house.

Using the number of rooms method, you actually allot 20% more space to your office. But, using net square footage, you increase the office portion by 30% more than using gross square footage. As you can see, that can increase your deductions significantly when you consider that accounts for 30% more of your mortgage interest, property taxes, rent, insurance, utilities, pest control, maintenance and repairs that benefit the whole house, or depreciation.

If the IRS allows you multiple options for deducting home office expenses, it makes sense for you to explore them. Under the right circumstances, the number of rooms method can yield greater deductions than gross square footage, and it’s simple to use. But, net square footage will always increase your deductions over the gross square footage method. Make sure you consider your options and get the most tax savings possible!

  1. IRS Pub. 587, Business Use of Your Home (2013), p. 10. ↑
  2. http://www.whitehouse.gov/omb/procurement_casb/ ↑
  3. http://www.cfcre.com/glossary.htm#N. ↑
  4. IRS Form 8829, Expenses for Business Use of Your Home (2013). ↑
Categories : Depreciation, Home Office, Tax Planning

Tackle the Gray Area and Claim a Home Office Deduction on Your Rental Property Business

By Kim M. Larsen EA CTFS
Sunday, January 25th, 2015

For those of you who run a real estate rental business, you may find that the IRS is a little tougher on you about claiming a home office deduction. The sticking point is that, depending on your circumstances, the IRS may consider your real estate business an investment rather than a business. In order to claim this deduction, your home office must be connected to a “trade or business”. So, the trick is to provide documented evidence that your rental endeavors are a business you run.

The Gray Area

A home office can save you thousands on taxes because you are able to deduct a percentage of your mortgage interest, property taxes, and even utilities as business expenses. However, when you’re lurking in the shadows of this gray area in tax law, you can find yourself arguing with an auditor who simply does not believe that your deduction is legitimate.

That is exactly what happened to Dr. Edwin Curphey, who owned a rental property business and had his home office deduction rejected. He ended up taking his case to court and winning his deduction.

It usually seems like the IRS has no end to specifications and rules to follow. However, in the case of deducting a home office for your rental property business, the law is fairly vague. This gray area leads some auditors to interpret such situations in different ways, so you have to be prepared with the right knowledge when tackling this deduction.

Unfortunately, no set method exists for proving your claim. You can, however, piece together information that will help in making your case. In order to determine whether you qualify for the deduction, your best bet is checking out precedent cases to see who has previously won the deduction and who has not.

Gray Area Guidelines

What’s the main difference between an investor and a business owner? It’s pretty simple. An investor collects money without having to perform any work, but a business owner actively works with a property. That means to be considered a business, you need to show the IRS that you do more than simply handle money[1].

Here’s where the fuzzy requirements come in. In order to qualify, you have to present evidence of activities that indicate you are doing work with your rental properties, but there is no definite set of activities that are required by the IRS. Some actions that indicate actual business activity may include[2]:

  • Management
  • Making repairs
  • Performing cleaning tasks
  • Advertising
  • Resolving tenants’ problems

You may not do all of these in association with your real estate rental business, but your chance of making a successful deduction increases with the more you do. The good news is you can still claim your rental property income on the Schedule E (just like investment property) while making the case that it’s a business. This means you’ll be able to avoid the self-employment tax, unless you offer your tenants significant services, such as a housekeeper[3]. In that case, you’ll need to use the Schedule C[4].

What If You Run Multiple Businesses?

If you run multiple businesses, you may be using the same home office space for all of them. In that situation, you’ll have to be extra careful because each business has to meet the home office requirements in order to qualify your office space for a deduction[5]. When one of the businesses does not qualify, you should find a separate office space for it, if possible. Otherwise, you’ll lose your legitimate deduction for the business or businesses that do qualify!

Three simple requirements must be met for the home office deduction:

  1. The home office must be your principal place of business;
  2. You must use it regularly; and
  3. The space must be used exclusively for business purposes.

In general, the requirements for deducting a home office are not hard to meet. Owning rental property, however, is a little different from other businesses. Don’t let a misunderstanding of the rules keep you from claiming your legal deductions. If you’re operating your real estate rental business and performing regular business activities for it, then it qualifies, regardless of whether you have another full-time job.

  1. Neill v Commr., 46 BTA 197. ↑
  2. Curphey v Commr., 73 TC 766. ↑
  3. Reg. Section 1.1402(a)-4(c)(2). ↑
  4. Schedule E Instructions (2013), dated Dec. 4, 2013, at p. E-5 (under “Line 3”). ↑
  5. Hamacher v Commr., 94 TC 348. ↑
Categories : Business Expenses, Home Office, Investments, Rental Properties, Tax Planning

How Commissioned Employees Have Vanquished the AMT and You Can, Too

By Kim M. Larsen EA CTFS
Tuesday, January 20th, 2015

When it comes time to prepare your taxes, you may have an unpleasant surprise waiting in the alternative minimum tax (AMT). Despite its intention of ensuring that top earners pay their fair share of taxes, the AMT really can be a kick in the pants for employees, who cannot deduct their business expenses. Particularly in the case of commissioned employees, this creates a huge difference in the amount of taxes they pay.

What You Need to Know about the AMT

The AMT was created during the 1986 tax reform, and it basically taxes income that is deductible under the regular tax, such as employee business expenses. Here are just a few of the types of employees who pay their own work expenses:

  • Mortgage brokers and bankers,
  • Insurance sales professionals,
  • Traveling sales professionals,
  • Real estate sales professionals, and
  • Emergency room physicians.

Why are commissioned employees particularly burdened by this tax? It’s because they often have a slew of business-related expenses that they pay out of pocket. Then, here comes the AMT to tell them they are not allowed to deduct any of those expenses. However, independent contractors performing the exact same duties as those commissioned employees can deduct many of their expenses.

What Employees Can Do about It

If your income level boxes you into the AMT, you don’t have to give up and lose thousands of dollars to additional taxes. And yes, it is potentially thousands. Take, for instance, the case of Dan Butts, an Allstate insurance agent. In one year, he paid about $10,000 more in federal income taxes than agents at State Farm.

What did Butts do wrong? Nothing—the difference lay in how he was designated by his employer. Butts was considered a W-2 employee, but the State Farm agents were independent contractors with 1099’s. Look at that scenario again. Butts did the same job, at the same pay, and with the same deductions as the agents at another company, but because of his designation, he paid $10,000 more in taxes.

That is a ridiculous situation for an employee to be in simply because the AMT does not permit deductions for business expenses! Fortunately, if you’re in a commissioned position, like Butts, you can do something about this unfair situation. He simply amended his tax return to put his W-2 employee commission earnings on the Schedule C form that self-employed individuals (including contractors) use. He deducted his expenses and saved that $10,000.

Of course, the IRS noticed that he used the wrong form, and he ended up going to court over the issue. . . and winning! Of note in this case is that the court granted Butts independent contractor status even though he had been employed as an employee with Allstate for years and enjoyed employee benefits[1]. The ruling went his way because he carried a “risk of loss”, just like the agents who were independent contractors.

However, you should keep in mind that using the Schedule C to avoid the AMT may work differently in various fields. For instance, a mortgage loan officer named Dan Cibotti worked for Liberty Trust Mortgage, Inc. as a commission-only W-2 employee. More and more commissioned employees are filing on Schedule C, and Cibotti was one of them. In his case, the court ruled that he was considered an independent contractor, despite having a W-2 that reported his income as an employee, because[2]:

  • He set his own hours and chose his own work location and method of finding clients;
  • His employer did not provide him an office;
  • He claimed a home-office deduction;
  • He was paid 100% on commission;
  • He had the possibility of gain or loss on his business activities; and
  • He received no employee benefits, such as a retirement plan or health insurance.

As you can see, the two situations were quite different, but each involved a commissioned employee who fought for his right to file as an independent contractor and won.

Going Forward

Now that other cases have set the precedent, it is becoming easier for insurance agents and other commissioned employees to avoid the AMT. In fact, the IRS, in chief counsel notice N(35)000-141(a), ordered its lawyers not to challenge individuals who claimed independent contractor status under the Butts precedent, but the IRS can be a stubborn entity. The notice that allowed independent contractor status also instructed the lawyers to:

  • Calculate self-employment tax on the agent’s net income and allow a credit just for the employee share of FICA and Medicare (i.e., employer payments are not included);
  • Calculate taxes on employee benefits, like employer-paid medical insurance and Section 125 contributions;
  • Calculate taxes on 401(k) contributions and make the taxpayer aware that they may not fall back on the Lozon decision, which concluded that such contributions were not taxable until withdrawn[3].

This notice has since expired, but if you plan to pursue independent contractor status, it would be wise to compare AMT savings with the potential tax disbursement outlined in the above IRS strategy.

Other Cases

Several other cases for independent contractor status have gone to court with varying results. Wesley Wickum, a district manager for Combined Insurance Co. of America, amended three years of tax returns and reclaimed $27,000. His salary included commission from his sales, bonuses, and override commissions based on the salespeople he recruited and supervised. In a funny twist, his company had previously considered the salespeople and managers to be independent contractors, but had changed the status out of fear of IRS penalties for wrongly classifying employees as contractors!

You can see the repercussions on business. The AMT hurts a company’s best salespeople—those who make the most commissions. When such a worker is classified as employee instead of contractor, the AMT comes into play, and may cause the best salespeople to leave the company.

A sales agent named Paul Hathaway also amended three years of tax returns after learning of the Butts case[4]. He was a commissioned employee, and although his company provided a W-2 each year and gave him benefits, he paid his own expenses for food, samples, travel, telephone, stationary, and business cards.

William Johnson and Barbara Lewis, on the other hand, lost each of their cases for independent contractor status. Johnson was a full-time hospital equipment salesperson who worked on commission, but the court ruled that he was an employee because his employer 1) restricted him from hiring employees and 2) required that he file daily call reports[5]. Lewis sold hair care products to salons and also made commissions. The court ruled her an employee by status because 1) her employer required her to file daily sales activity reports, 2) her employer supplied her with leads, which she was expected to follow up on, and 3) she had a negligible “risk of loss”[6].

AMT Tax Savings

If you’re going to claim independent contractor status for your commissioned income, take these cases as examples what kind of evidence you need. Remember, your savings could be thousands of dollars. Need an example? Let’s say you’re a mortgage loan officer, like Wickum in the case above. If you made $200,000 and spent $125,000 in business expenses, you have a net income of $75,000.

With regular taxes, those business expenses are reduced by 2 percent, leaving a regular taxable income of $79,000 (.02 x $200,000 = $4,000; $125,000 – $4,000 = $121,000; $200,000 – $121,000 = $79,000). But, for AMT purposes, this employee gets no deductions on those expenses. That means the taxable income is the full $200,000. That’s a huge difference!

So, if the employee files taxes on Schedule A, the amount owed is $45,000. On Schedule C (as an independent contractor), it would only be $15,000. You can see why commissioned employees argue for their contractor status.

If your work situation involves unreimbursed business expenses and a status as employee, you have options to establish your status as an independent contractor for tax purposes. Since the IRS has established a position on this issue, you can start by discussing your status with the local IRS district director. If necessary, you can escalate the situation by requesting a private letter ruling from the IRS. This route does cost money, but it will likely be less costly than going to court. Litigation like the Butts case has not happened in years, so you have a good chance of a ruling in your favor if your circumstances and evidence are sufficient. The AMT seems to be here to stay for the present, so don’t let thousands of dollars slip away from you every year.

  1. Butts v. Commissioner, TC Memo 1993 478, affd. per curiam 49 F.3d 713 (11th Cir. 1995). ↑
  2. Dean Cibotti v Commr., TC Summary Opinion 2012-21. ↑
  3. Lozon v. Commr., TC Memo 1997-250. ↑
  4. Paul E. Hathaway v. Commr., TC Memo 1996-389. ↑
  5. William O. Johnson v. Commr., TC Memo 1993-530. ↑
  6. Donald J. Lewis, Jr., v. Commr., TC Memo 1993-635. ↑
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