Home-based S-Corps – how shareholders can deduct home office & personal car use
Let’s talk S-Corps. An S-Corporation, or S-Corp, is a taxation election where an entity chooses to be taxed under Subchapter S of the Internal Revenue Code. For tax purposes, the entity is a “pass-through” entity, similar to a single-member LLC or partnership, but has management advantages, rigid formalities and wage payment structures that are similar to a C-Corporation. The S-Corp election has gained major popularity in the last few years (thanks Google & YouTube), but all too often, business owners elect it based on minimal research and/or no personalized consultation. I typically don’t recommend it to my clients until I can determine that the additional tax savings from electing S-Corp taxation exceed the cost of running an S-Corp. You didn’t think this tax-savings vehicle would be as lenient as your single-member LLC, did you?!
For starters, you need to evaluate reasonable compensation. You’ll incur payroll service costs and generally speaking, be on payroll before taking distributions. There’s an additional tax return to be filed (Form 1120S), unlike a single-member LLC that’s taxed as a disregarded entity. The penalties are steep for a late or unfiled return, and the filing schedule differs from that of a single-member LLC, taxed as a disregarded entity. And the ever-popular home office or mileage deductions aren’t as simple as they are for the single-member LLC.
The rules, however, are similar. To take advantage of the home office deduction, you must have a work-only dedicated area (separate room or separately identifiable space.) Not the kitchen table. Not your couch. Not your bed. it must be a room or a separate area of a room (with or without a partition) that is used both regularly and exclusively for business, and should represent the principal place of business. If you rent an office space, and also have a home office, the home office deduction generally isn’t available to you (as always though, there are some special situations where it may still apply).
A sole proprietor/single-member LLC can take advantage of the home office deduction on a form 8829 as part of their personal tax return. For the sole proprietor/single-member LLC, this deduction has the possibility of reducing both income taxes and self-employment taxes.
But for the S-Corp owner, it gets more complicated. Grab a pen and paper. And maybe an Advil. There is no tax form for the home office deduction on the S-Corp tax return (Form 1120S), and with the Tax Cuts and Jobs Act (TCJA), employees who work from home are no longer entitled to claim home office expenses on Schedule A (Itemized Deductions). Shareholders can, however, be reimbursed for an allocated portion of their related home expenses for their home office, including rent, mortgage interest, property taxes, home interest, home insurance, utilities, repairs and maintenance. Just a quick note though – although many taxpayers no longer benefit from itemizing deductions, if you do, any mortgage interest and property taxes reimbursed by the S-Corp must be excluded from the amounts included on the shareholder/employee’s Schedule A. To deduct home office expenses, the S-Corp must set up an accountable plan to have the company reimburse for home office expenses.
An accountable plan is essentially a formal reimbursement arrangement that allows the S-Corp to pay employees and shareholders for their business expenses. Your accountable plan must meet 3 requirements to meet the IRS’ standard (and should apply Section 1.62-2(d)(1) regulations).
1) The expense must have a tight business connection. If it’s mileage, it needs to be for business-related driving. If it’s meals, it needs to be meals to meet with clients or potential clients. If it’s travel, it needs to be for business. If it’s a mixed-use expense, like home office expenses, home internet and/or cell phone, the reimbursement must be for the business-portion only. Note that a square footage based allocation method may not always be appropriate for mixed-use expenses. The IRS does allow reasonable allocation methods, and that can be the actual business-use percentage, or any other reasonable method that can be consistently applied.
2) You must substantiate the deduction with documented support. Receipts, expense exports and explanations of business purpose are key to substantiating these deductions. Speaking of which, did you know you can take pictures of receipts with the QuickBooks Online app?
3) Excess reimbursements over actual expenses must be promptly repaid. If the S-Corp’s accountable plan allows for advances to the shareholder, any excess over the actual expenses must be promptly repaid by the shareholder to the S-Corp within 120 days.
So what does all of this mean? Accountable plans provide a structured and legal way to deduct reimbursements for necessary expenses (like home office use and mileage) that would not typically be deductible by shareholders and/or employees on their personal tax return due to the change in the tax code with the Tax Cuts and Job Act. As long as the S-Corp and the shareholder/employees follow the accountable plan’s rules, the reimbursements are counted as valid business deductions, and the reimbursements are tax-free to the shareholder/employee.
Without an accountable plan, you’re operating with what’s called a nonaccountable plan, and under that plan, tax law requires that these reimbursements be reported on the shareholder/employee’s W2 as taxable income. Moreover, with the Tax Cuts and Job Act, you’re not even able to deduct them as miscellaneous itemized deductions anymore, so employees would have additional income, and no additional deductions.
Need a sample accountable plan? Start here.
Revise as you see fit, and sign it. Once in place, make a schedule – every month or quarter, shareholders should turn in detailed expense reports with receipts and explanations, and the S-Corp should pay those reimbursements to the shareholder/employee (either paper check or via payroll (as a reimbursement) will do). It’s a win-win! The S-Corp gets to deduct the expenses, and the shareholder gets a tax-free reimbursement. And that’s how it’s done! If your head is spinning, or you could use some assistance setting up your accountable plan, you know where to find us. We’re here and ready to hold your accountable plan, accountable!