Home office deduction rules don’t apply to C corporations that rent a portion of a shareholder’s residence -- but the rental arrangement must be bona fide for the corporation to deduct the rents, as demonstrated in a recent Tax Court case.
The case, Christopher C.L. Ng MD, Inc. APC v. Commissioner, T.C. Memo 2018-14, illustrates what was missing to prove a bona fide rental arrangement, according to Barbara Weltman, author of “J.K. Lasser’s Small Business Taxes.” These are “a written rental agreement, and the shareholder including the rental payments as income on his return,” she said.
Under Section 280A, the disallowance for a home office deduction would apply to an employee of either an S or a C corporation, Weltman indicated. “So the corporation can deduct the rent, and the owner-employee reports it. What is more usual today is to reimburse home office expenses through an accountable plan.”
Dr. Christopher Ng was the sole shareholder and employee of Christopher C.L. Ng MD, Inc. Dr. Ng practiced medicine at Good Samaritan Hospital in Los Angeles as a “physician independent contractor,” and used his personal residence for a business address. The second story of his residence was used solely for his business. It had a separate external entrance and consisted of a converted master bedroom, a den, a lavatory, and a furnace area. Dr. Ng used this space to perform administrative tasks for his corporation, such as to remotely access Good Samaritan’s electronic medical records to complete physician notes on patients he treated at the hospital, as well as to do continuing education training and medical board certification activities. The only individuals besides Dr. Ng who used or have been in the space were his paid assistant and malpractice defense attorneys who met with him from time to time.
With advice from a tax return preparer, Dr. Ng prepared and timely filed the corporation’s 2012 and 2013 Forms 1120. In 2012 he reported gross receipts of $369,864 and total deductions of $345,473. Among the deductions claimed were 100 percent of the mortgage payments on the house made to HSBC as “rents” of $30,899. The 2013 Form 1120 reported gross receipts of $335,835 and total deductions of $332,819, again reporting 100 percent of the mortgage payments to HSBC as “rents” of $29,321. On his personal Form 1040 Schedule A, Dr. Ng claimed home mortgage interest of $14,540 and $14,462, respectively, for 2012 and 2013.
The IRS issued a notice of deficiency, disallowing the claimed deductions for rent because they were mortgage payments made by the corporation for the shareholder’s personal residence.
Under Section 162(a), a C corporation may deduct payments made to lease home office space from an employee or from its owner as rent if they are ordinary and necessary expenses directly connected with or pertaining to the corporation’s trade or business. According to the Tax Court, the existence of a close relationship between a lessor and lessee does not mean that a valid lease agreement between them cannot exist, but it does require a careful examination of the circumstances surrounding the arrangement to determine whether the payments are, in fact, for the rental of property.
The court found that the corporation failed to prove that its arrangement with Dr. Ng was a bona fide rental arrangement and not an arrangement to make mortgage payments on Dr. Ng’s behalf.
The corporation did not produce any evidence of a written rental agreement or other documentation to support its position that the amounts claimed were actually rent. Dr. Ng also did not treat the arrangement with his corporation as a bona fide rental arrangement since he did not report any reciprocal rental income on his Schedules E for the years in question.
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