If you’ve recently shifted your business to an S-Corp and work from home, and now are wondering how to deal with the business use of home deduction, then this article is for you.
First of all, you cannot pay for home expenses out of your S-Corp bank account. That would be the easiest solution, but it does not fly with the IRS. The reason for this is that home expenses are considered "mixed" expenses— they are partially personal, and personal expenses are not deductible, or deductible only on Schedule A of your personal tax return. If you pay these expenses out of your business account, the IRS might see them as personal distributions. Excessive distributions are problematic, especially if they exceed shareholder wages, as this could trigger a reasonable compensation audit. You can learn more about reasonable compensation issue here.
An S-Corp is a separate entity from its owners and should act accordingly.
So, what’s the general process with an accountable plan in a one-shareholder S-Corp? Here’s a simplified explanation: The S-Corp employee (which is you) incurs business-related expenses. Then the employee calculates and substantiates these expenses and submits them for review and approval to the S-Corp (which, also happens to be you). The S-Corp reviews the expenses, approves them, and reimburses the requested amount. The S-Corp records this transfer in its books as an expense, reducing its taxable income (read: less tax). The employee you enjoys extra cash without reporting it as income (read: tax-free money). It seems pretty straightforward, except that the S-Corp employee and the S-Corp itself are often the same person. Oh well, that’s the best way I could explain.
Here’s a guide on how to properly process your home office deduction:
- Establish an Accountable Plan or find a template on the internet (see attached). The accountable plan should specify which expenses are eligible for reimbursement and the method of payment. Ideally, reimbursements should happen monthly or at least quarterly.
- Determine the Business Use Percentage of Your Home Office. Calculate the proportion of your home used exclusively for business. I've written more on what could be considered exclusive use here. To find the business percentage, divide the square footage of your home office by the total square footage of your home. For example, if your home office is a 10x10 room (100 square feet) and your entire home is 1,500 square feet, the percentage is 100/1,500, which equals 6.7%. I also recommend keeping a copy of your floor plan and snapping a few pictures of the office just to fend yourself in case of an IRS audit.
- Apply This Percentage to Your Home-Related Expenses. Home-related expenses usually include mortgage interest, rent, utilities, and repairs. You get to deduct only a business use percentage. Accounting hack: if you put all your home expenses on the same credit card, it’s much easier to track them (instead of hunting for invoices each quarter).
- Calculate Your Depreciation Expense if You Own a Home. Yes, you are allowed to reimburse this! Depreciation is a phantom expense that allows you to write off large items, like buildings. Depreciation for the home office is stretched out over 39 years. This means that if your business office is worth $60,000, you can deduct and reimburse $1,538 each year ($60,000/39=$1,538). To figure out how much your office is worth, take the full cost of the house and multiply it by the percentage from step 2. For example, if your house cost $1,000,000 and the office percentage is 6.7%, then your business office cost is $67,000. Please note: you would need to pay taxes on the depreciated part of the house when you eventually sell the house. You can read more about depreciation recapture here.
- Put Everything in the Template and send it to the employer. Oops! I meant to say to yourself. Don’t forget to keep the receipts or credit card statements as substantiation. See the template below.
- Reimburse Yourself. Transfer money to your personal account or write yourself a check from the S-Corp to you personally.
- Record the Reimbursement. In your S-Corp books, record the reimbursement under the BUOH reimbursement expense.
Accounting hack#1 Alternatively, if you took $100,000 in distributions each quarter, but after completing the accountable plan calculations, your S-Corp owed you $6,000 for business use of home, you can reclassify the $100,000 distribution as $94,000 personal distribution and $6,000 as the BUOH expense.
Accounting hack#2: Another way to handle shareholder reimbursement is to calculate and record all expenses at once during tax preparation. You would calculate the business use of home expenses for the entire year and record them as a shareholder contribution on your S-Corp books and tax return. This approach allows the S-Corp to deduct the expenses and increases the shareholder paid-in capital (which is generally good), but the cash itself doesn’t change hands, meaning you won’t get non-taxable cash.
At our firm, we understand that accountable reimbursement plans are time-consuming and bureaucratic, so we simplify the process for our clients. All our clients need to do is send us their total quarterly home expenses, and we handle the paperwork, calculate the percentages, tell our clients how much to withdraw, and then record the transactions in their books. Our clients' job is only to provide us with expenses and transfer the money.
For DIY people out there, here are the promised templates:
- An excel template for S Corp business use of home deduction
- A word template of an S Corp Accountable plan
And now a shameless plug: If you need help with your S Corp taxes, tax planning or bookkeeping, think of us. We work virtually and have assisted hundreds of business owners with their tax issues. You can explore our services here