You don’t want to mess with the IRS. That’s the bottom line especially if you’re planning to form an LLC. Although the IRS has a favorable view of small business owners, their generosity has an end and if you don’t know where the line is you may open your mailbox and find an audit notice. The problems with an audit are twofold. Not only can you end up having a higher tax liability along with hefty fines and interest payments but finding your business on the IRS’ radar screen is definitely something to avoid.
For decades there has been a deduction that has both scared and enticed small business owners. They know that if they maximize the deduction, that could mean a big drop in tax liability but if they push it, the audit could be financially painful. That deduction is the home office deduction. It was a favorite of the IRS in large part because of an anesthesiologist who lost his court appeal with the IRS. Dr. Nadir Soliman had declared a home office deduction because none of the hospitals where he practiced anesthesiology furnished him with office space. Because he needed a place to confer with other doctors, do research, and run the daily activities of his business, he committed a room of his home to a home office. This room wasn’t used for anything else other than that.
He was audited and the IRS found that he met the criteria of exclusive use because his office was used for nothing besides business but because the hospitals were his principle place of employment, he didn’t qualify. Because he took it to court and lost, it allowed the IRS to clarify the criteria and this gave them the opportunity to audit large numbers of returns claiming the home office deduction.
Nearly a decade later, the IRS was forced to respond to the rising amount of entrepreneurs who were working out of their home and because of that, the rules for the home office deduction now allow entrepreneurs to claim the deduction even if they perform services outside of their home providing they don’t have a second office space outside of the home.
If you have recently formed an LLC or you’re planning to do it in the near future, learn about the home office deduction by reading IRS publication 587. Although rules have been relaxed, the home office deduction still invites IRS scrutiny.