Barbara’s Blog

If your business is incorporated, you can take a salary for the work that you do. Obviously, your company’s revenues are a big part of the decision on how much you can afford to take out of its coffers as compensation. Taxes are another important factor.

C or S?

Which type of corporation you run affects the decision on compensation. As a general rule (and by no means your guiding factor):

• C corporations want to optimize compensation to an owner to create as large a tax deduction as possible.
• S corporations want to minimize compensation to keep employment taxes low. Owners will pay income tax one way or the other (as their share of profits or as compensation).

IRS looking over your shoulder

The IRS is well aware of the general rules for C and S corporations. Thus, it seeks to disallow a C corporation’s deduction for any compensation that is not considered to be “reasonable” under the facts and circumstances of the situation.

By the same token, it is on the hunt for S corporations and their shareholders who try to avoid employment taxes by underpaying compensation. One recent court decision is a case in point. A CPA was the sole owner, shareholder, director, and employee of his S corporation. He had a contract with his corporation to provide exclusive services and took a salary of $24,000 each year (for the years in question). He also had dividends distributed to him of $203,651 and $175,470 in these years. The IRS recharacterized the dividends as compensation and imposed FICA taxes on them. A district court, affirmed by an appellate court, said that the economic realities of the situation — the earnings of the corporation based on the owner-employee’s services — should control the amount of compensation. (The IRS’ expert witness was used to determine what was appropriate compensation in this situation.) Thus, paying a minimum salary may not be sufficient to avoid an IRS challenge if the minimum amount is not reasonable under the circumstances.

Work with a tax advisor

Compensation to owner-employees typically is fixed in the annual meeting for the corporation and memorialized in the corporate minutes. It is a good idea to discuss the compensation matter with a tax advisor before holding the annual meeting and setting compensation for the coming year.

Today, 52% of small businesses are home based. Working from home may entitle an owner to treat a portion of personal living expenses as a deductible business expense called a home office deduction.

There are certain misconceptions about this write-off that I hope to clear up:

Myth 1: Minimal personal use won’t disqualify a home office.

Reality: Even minimal personal use of space in a home prevents a deduction.  The tax law requires that in order to claim a home office deduction, space must be used regularly and exclusively for business. Exclusive use means use solely for business; use for personal purposes, even one or two time during the year, fails the exclusive use test. So using a den/office a couple of times a year as a family room will prevent a home office deduction for that space.

However, as demonstrated in a recent Tax Court decision, mere nonbusiness passage by a family member, friend, or other nonbusiness person from one room to the next can be classified as a de minimis personal use of the room and will not disqualify the room from meeting the exclusivity test.

Myth 2: Occasional telework or after hours work creates a home office deduction.

Reality: The costs of home office are deductible only if the space is used as the taxpayer’s principal place of business or a place to meet and deal with customers or clients on a regular basis.

Many people spend hours working from home, but it doesn’t mean the costs of the space are tax deductible. Those who telework exclusively (i.e., there is no other fixed location for their work) may be able to take a home office deduction. If they are employees, working from home must be for the convenience of the employer and not merely a personal choice.

Myth 3: Claiming a home office deduction is a red flag for an audit.

Reality: There is no evidence that this deduction exposes a taxpayer to greater audit risk.

If you are entitled to a home office deduction because you meet all tax law requirements (e.g., you are a home-based freelancer who uses a space bedroom solely as an office), then take it.

Suggestion: It’s a good idea to photograph your workspace, just in case your home office deduction is questioned. In the case linked above, several photos showing that part of a room was used for business were considered “reliable evidence” of the business use.

Bottom line
Familiarize yourself with the home office deduction rules (they’re explained in Chapter 18 of J.K. Lasser’s Small Business Taxes 2011). When in doubt about your situation, consult with a tax advisor.


Every year at tax time, the question comes up:   Is the home office deduction an audit red flag for the IRS? 

The answer:  No one knows for sure. 

The best thing to do is to take the deduction if you’re sure you’re entitled to it.

First, ask yourself two things:

1. Are you using the space as your principal place of business or for another approved reason?
2. Are you using the space regularly and exclusively for business?

What you need to know about qualifying your office as your principal place of business: 

Usually, you must use space in your home as your principal place of business, which is where you earn most of your business income. If you earn your money outside of the home (e.g., at client or customer locations), you can still qualify if you use the home for administrative activities, such as scheduling appointments, keeping records, and ordering supplies, and do not have another fixed location (a storefront or other commercial space) for your business.

If you work from home after hours or a few days a week rather than go to your office downtown or in another location, you won’t qualify. But if you use a home office to meet customers or clients in the normal course of your business, you can qualify (talking to them by telephone isn’t good enough; you must meet in person).

What you need to know about regular and exclusive use:

To take a home office deduction, you must use the space regularly and exclusively for business. A den used for work during the day and as a TV room for your family at night won’t do.  Here’s the best strategy: take a time-stamped photo of the office, just in case the IRS questions your return and you are no longer using the space for business when you receive the IRS inquiry. This will help to prove you have a genuine home office.