Do your S corporation clients have home offices where they perform some or all of the work for their businesses? Since S corporation shareholders are considered employees of their businesses, they are limited in the ways they can deduct home office expenses.
As employees, they can only deduct home office and other miscellaneous business-related expenses on Form 2106, Employee Business Expenses, where those expenses are limited to those exceeding 2 percent of their adjusted gross income. These miscellaneous itemized deductions are an add-back for the alternative minimum tax (AMT), so this can put your clients in AMT land. In contrast, partners in a partnership can deduct unreimbursed expenses directly on Schedule E as unreimbursed partnership expenses.
However, if you help your clients set up an accountable plan, everyone wins. The shareholder gets a tax-free reimbursement for the home office and other out-of-pocket expenses, while the S corporation gets a deduction for the reimbursed amount.
An accountable plan must meet three requirements to pass IRS muster:
- The expenses must have a business connection. The expenses must be incurred while the employee is performing work for the company, and must be ordinary and necessary expenses. These can include mileage for business-related driving, meals with clients and out-of-pocket travel expenses. They can also include a portion of mixed-use expenses – that is, those with a personal and business component, such as home office expenses, cell phones and home internet.
- There must be substantiation to support the deduction. This can be easily accomplished by submitting a detailed monthly or quarterly expense report with the relevant documentation attached. Apps, such as Expensify and ReceiptBank, simplify this and sync with QuickBooks® Online.
- Any excess reimbursements over actual expenses must be repaid promptly. If the S corporation provides an advance to the shareholder for travel expenses, any excess over actual expenses must be repaid within 120 days.
Setting up an accountable plan is quite simple. Here’s a sample agreement you can adapt for your clients and have them sign. Then, once a quarter or once a month, the shareholder files a detailed expense report and the S corporation cuts a check to the shareholder. The S corporation gets a deduction and the shareholder gets a tax-free reimbursement.
For home office expenses, shareholders can be reimbursed for an allocated portion of their home maintenance expenses, including mortgage interest, property tax, insurance, utilities, home internet, trash, and repairs and maintenance. Any portion of mortgage interest and property taxes that’s reimbursed through an accountable plan must be deducted from the amounts reported on Schedule A.
To qualify as a home office, the area must be used regularly and exclusively for business. The home office portion of household expenses is allocated according to relative square footage. Some employees include a floor plan of the home, with a calculation of the square footage with their expense reports, to add additional credibility to their assertion.
An allocated portion of depreciation for the house should also be included in the reimbursed amount. When the house is sold, the “allowed or allowable” portion of the home office depreciation expense will be recaptured as ordinary income, so clients may as well receive a benefit now.
For some mixed expenses, such as cell phone or internet, allocation on a square footage basis may not be appropriate. The IRS allows a “reasonable” allocation method for these expenses. This can be the actual business percentage calculated on a sample period of a few days or weeks, or another method that can be consistently applied.
Without an accountable plan in place, these reimbursements are taxable income to the shareholder and should be reported on their W-2.
Setting up an accountable plan is one of the best methods for a shareholder to get cash out of their corporation. Rent, distributions and wages are the other main methods. But, in contrast to those methods, accountable plan reimbursements are tax-free to the shareholder (as are distributions) and deductible to the S corporation, as are rent and wages. Accountable plans are truly a win-win all around for your S corporation clients.