No. 235

February 2004

SMALL BUSINESS

RESEARCH

SUMMARY

Home-Based Business and Government Regulation

by Henry B. R. Beale, Microeconomic Applications, Inc.

2004 [188] pages. Washington, D.C. 20016

under contract no SBA-HQ-02-M-0464

This Small Business Research Summary (ISSN 1076-8904) summarizes one of a series of research papers prepared under contracts

issued by the U.S. Small Business Administration’s Office of Advocacy. The opinions and recommendations of the authors of this study do

not necessarily reflect official policies of the SBA or other agencies of the U.S. government. For more information, write to the Office of

Advocacy at 409 Third Street S.W., Washington, DC 20416, or visit the office’s Internet site at www.sba.gov/advo.

Previous research published by the Office of

Advocacy has documented the disproportionate

impact of federal regulations on small business: businesses with fewer than 20 employees pay 60 percent

more per employee to comply with federal regulations than business with 500 or more employees

(Crain and Hopkins, 2001). The current report continues this inquiry by investigating the impact of regulations (federal, state, and local) on the smallest of

firms, home-based businesses. The home-based business sector is substantial in size: 53 percent of small

businesses are based in the home (Pratt, 2000). Some

home-based ventures are the incubators of successful

ventures that evolve to locations outside the home,

while other occupations are well matched to the home

environment—bed and breakfasts and infant and toddler day care, small offices, or cottage industries.

Overall Findings

At the federal level, Internal Revenue Service regulations penalize home-based businesses in their treatment of deductions. At the local level, zoning laws

and prohibitions present home-based businesses with

a significant entry barrier. The report notes, however,

that some states have improved the environment for

home-based businesses.

Highlights

• The tax code treats home offices as commercial

buildings. Claiming a home-office deduction is complex; the depreciation is spread over an unrealistically long time; and returning the space to residential

use generally entails penalties.

• In order to qualify for a deduction, the tax code

requires that a home office be used exclusively for

business. Such a requirement ignores the realities of

family life and offsets many of the advantages of

running a business out of a home.

• Deductibility of other business-related expenses

(such as utilities and legitimate maintenance) is contingent on the deductibility of the home office.

• The tax code allows deductions for other equipment only to the extent that they are used in the business, regardless of the necessity to the business. This

requirement penalizes home-based businesses for

their small scale, creates recordkeeping burdens, and

is inconsistent with exclusive business use of an office.

• IRS assistance covers far too many topics that are

not relevant to most home-based businesses. Inadequate

tailoring to the needs of home-based businesses unnecessarily increases the familiarization and filing burdens on

a home-based business.
• Locally, many zoning codes incorporate outright

prohibitions, prescriptive requirements, or limits on

various aspects of home-based businesses (e.g., number of employees, visitors, parking, exterior changes,

or specific industries). Some jurisdictions, however,

have adopted more flexible and efficient zoning

codes based on a business’s performance and its relation to the character of the neighborhood.

• Few local jurisdictions have utilized the different

residential zoning categories (pertaining to density

and type) as a means of providing more flexibility in

home-based business regulation. Jurisdiction-wide

restrictions, which appear to have been designed to

protect the most vulnerable neighborhoods, are far

more common.

Scope and Methodology

The researchers used evidence available in

Advocacy’s database and thoroughly researched state

and local websites. They discussed a number of

issues with tax professionals as needed. The report’s

seven appendixes present extensive data on homebased business regulation, including a comparison of

regulation in six states: Arizona, California, Illinois,

Iowa, Pennsylvania, and Vermont.

References

Mark Crain and Thomas Hopkins, 2001. The

Impact of Regulatory Costs on Small Firms.

Washington, D.C.: U.S. Small Business

Administration, Office of Advocacy.

www.sba.gov/advo/research/rs207tot.pdf.

Joanne Pratt, 2000. Home-Based Businesses: The

Hidden Economy. Washington, D.C.: U.S. Small

Business Administration, Office of Advocacy.

www.sba.gov/advo/research/rs194tot.pdf.

Ordering Information

The full text of this report and summaries of other

studies performed under contract to the U.S. Small

Business Administration’s Office of Advocacy are

available at www.sba.gov/advo/research. Printed

copies are available for purchase from:

National Technical Information Service

5285 Port Royal Road

Springfield, VA 22161

(800) 553-6847

(703) 487-4639 (TDD)

www.ntis.gov

Order number: PB2004-102462

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