Commentary on the IRS Child Care Provider Audit Technique Guide

Commentary on the IRS
Child Care Provider
Audit Technique Guide

By Tom Copeland, JD

Introduction

On April 17, 2009 the IRS published a revised edition of the Child Care Provider Audit Technique Guide. [http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/Child-Care-Provider-Audit-Technique-Guide].

This Guide was written to help instruct IRS auditors how to conduct an audit examination of family child care providers. It also identifies the unique tax issues and business practices of family child care providers. In 2000 the IRS published the first edition of Child Care Provider Audit Technique Guide. This Guide is part of the IRS Market Segment Specialization Program, a series of IRS Guides that focus on particular business industries.

This second edition of the Guide is a major improvement on the first edition. It offers a greatly expanded explanation of key tax issues and clarifies a number of points in ways that are favorable to family child care providers. Notable changes include:

An expanded section highlighting the importance the IRS places on looking for unreported income in this field.
The clearest explanation in any IRS publication of how to report Food Program reimbursements as income.
A new section on the use of the standard meal allowance rule for claiming food expenses.
An expanded section on how to allocate expenses for items used for both business and personal purposes.
A detailed discussion of how to calculate the business use of home percentage. This section includes, for the first time, a statement that the area of a basement and garage should be included in the total square footage of the home when calculating this percentage.
A recognition that items purchased before the business began and then later used in the business can be depreciated under the normal rules of depreciation.

This commentary on the IRS Child Care Provider Audit Guide is designed to help a family child care provider who is being audited or a tax professional who is representing a provider in an audit. It highlights, explains, and expands upon the key points made in the Guide to help the reader better able to anticipate what the auditor will do and better prepare for the audit. I strongly recommend that the reader review the Guide and my commentary before meeting with an auditor.

At the invitation of the IRS I made a series of recommendations for how the second edition of the Guide could be improved. The IRS did incorporate many of my suggestions.

I will continue to offer suggestions to the IRS on how to improve future editions of the Guide. If you have experiences with IRS audits or have your own recommendations for other changes in the Guide, please contact me and I will pass them on to the IRS. I may be reached at 800-359-3817 (x321) or This email address is being protected from spambots. You need JavaScript enabled to view it. .

If you are a member of the National Association for Family Child Care I can offer some free assistance with your audit. If you are a tax professional I can answer your questions and offer free advice. I would very much like to hear from those who have been or are currently being audited or are providing professional audit assistance so that I can continue to be a resource to the family child care field.

Commentary

"Kith and Kin" (Care Provided by Relatives, Friends and Neighbors)

These caregivers (also called exempt providers or informal caregivers) are often not aware of their responsibility to report their income and expenses. The Guide says, “These providers often believe that this income is not taxable and, therefore, need not be reported. However, this could result in both taxable income and self- employment tax.” In fact, all such income should be reported on Schedule C. For many of these providers it may come as a shock to discover that they owe 15.3% of their net profit in Social Security and Medicare taxes.

All kith and kin providers are required to follow the same IRS rules regarding reporting income and expenses as licensed family child care providers. IRS Publication 587 Business Use of Your Home makes it clear that providers who are exempt from state licensing rules are entitled to claim the same house expenses on Form 8829. Many kith and kin providers are not keeping business receipts and are likely paying too much in taxes. In addition, when these providers sell their home they will have to pay tax on the depreciation they were entitled to claim, even if they didn’t claim it. Kith and kin providers who don’t show a profit are not eligible to claim house depreciation and thus won’t owe tax on the depreciation when they do sell their home.

Family Day Care

“This type of child care is provided in the home of the provider, is nonmedical and is usually for less than 24 hours,” says the Guide. In the previous version of the Guide it said, “and is for less than 24 hours.” There are some providers that work 24 hours a day who are still entitled to claim all “ordinary and necessary” expenses. At my suggestion, this change was made.

Child Care Centers

This Guide is not addressed at child care centers and should not be consulted if you are a child care center.

In-Home Care

If you are a nanny or au pair who is caring for a child in the child’s home, the IRS considers you to be an employee of the parent (unless you work for a nanny agency). This Guide is not written for you.

Status

This section identifies the most important areas that an auditor is likely to examine in an audit. The IRS recognizes that many providers are not adequately reporting their income or expenses and keep inadequate records. This is also my experience. As a result, the IRS will likely be suspicious of a provider’s records. Providers who do have good records will likely surprise the auditor and make a favorable impression. Therefore, providers should do everything they can to organize their records before meeting with an auditor, even if this means reconstructing lost records.

One of the issues most often audited is “supplies and miscellaneous expenses (may include personal expenses).” Providers can expect an auditor to look closely at these expenses to see if they are personal or business. To show that these are business expenses, be careful to save the receipts for all household supplies that are used by your family as well as your business. Don’t claim 100% of one type of expense (paper towels, laundry soap, etc.) unless you can show receipts for personal use of these same items. If you didn’t save all of these receipts, look to see if you have cancelled checks, credit or debit card statements for purchases at the stores where you bought these items. This can be used to show that you did buy a lot more of these types of items than you deducted. If you have better records in tax years subsequent to the years under audit, show these records as evidence that your business deduction is reasonable.

In the first edition of the Guide it said, “A net loss is unusual expect at the corporate level.” I wrote to the author that in fact it is not unusual for a provider to show a loss, particularly in her first year or two of business. Fortunately, this sentence was taken out, thus giving some hope for providers who do show a loss to defend this position in an audit. Showing losses several years in a row does, however, increase a provider’s chances of being audited. I asked for clarification on how a provider could avoid showing a loss when caring for only a few subsidized children but the Guide does not address this issue.

Introduction

The Guide refers to the different business entities that providers might operate under: sole proprietor, partnership, corporation or LLC. The partnership and corporate tax return is more complicated to file. A sole proprietor and a single person LLC fills out their tax return in exactly the same manner. In general, providers are better off operating as a sole proprietor. If you are considering operating as anything other than a sole proprietor you should carefully consider a number of factors, including the tax and limited personal liability issues. I strongly advise you to consult with both a tax professional and an attorney before making this decision. For a detailed discussion of the business structure options, see my Family Child Care Legal & Insurance Guide, published by Redleaf Press.

Interview

This is an entirely new section of the Guide. The large number of questions included here that auditors are recommended to ask providers during an audit interview is a reflection of how important the IRS condsiders the reporting of income in family child care. In other words, the IRS will be initially suspicious that a provider has not properly attempt to uncover unreported income that can then be taxed.

The Guide focuses on the many different rate terms that may be listed in the contract or policies: illiness, vacation, late pickup, overnight, transportation, diaper fees, holding fees, etc. The auditor will be looking at this to see if the provider got paid additional amounts beyond the regular child care rate. Because parent fees are the main source of income, providers should take steps to keep careful records that can back up the income reported on her tax return.

Here are some suggestions for how to do this:

Report on your tax return all income from parents, the Food Program, subsidy program, and grants.

Keep records showing the source of all deposits into your checking or savings accounts (both business and personal). Indicate on a deposit slip, check register, software program, or other record where the money came from (husband’s paycheck, business deposit, transfer from savings, etc.). The IRS likes to look at bank deposits and compare them to what you reported as income. If you cannot identify where all the money came from for each deposit the IRS will assume the unidentified deposit is business income.

Give parents an end-of-year receipt of the total amount the parent paid you for the year and ask them to sign a copy for you to keep in your files.

If you receive, cash from parents and do not deposit all of it in a bank account, make a note on a ledger or your calendar of how much you did deposit of these cash payments.

The IRS will initially assume that a child is enrolled in your program for 52 weeks a year at your full time rate. They will look at your contract to identify your rates. For example, if your rate is $150 a week the IRS will assume you earned $7,800 a year to care for one child. You need to keep attendance records that show when a child was not present (sick day, vacation, holiday, etc.) and if the child was part-time for all or part of the year.

If your rates change in the middle of the year, or you do not charge the parent your full rate (because of a family layoff or illness), keep records to show that you did not receive your full-time rate for this child for part or all of the year.

Here is an example: You care for a child for 52 weeks and the child is on the Food Program. However, because of a layoff in the child’s family, you decide to charge the family half your regular rate for three months. The IRS will look at your Food Program records and attendance records to see that the child is present for the entire year. They will then assume that you were paid your full rate for the year. You need to show with your parent payment records that the parent did pay less for those three months.

If your contract says that you charge for a late pick-up fee, or for overnight care, or early drop off, or for transporting the child, and so on, be sure that if you do not charge for any of these fees your records show this. In other words, if your attendance records show that the child was picked up at 7pm and your contract says the pick-up time is 6:30, with a $1 a minute late fee, the IRS will assume that you earned an extra $30 each day that this happens. If you are not charging parents for these late pick-ups put a note in your attendance records (“No late fee charged”).

Reconstruction Methods to Verify Income or Reconstruct Income

In this section of the Guide the IRS is again stressing the importance of looking closely at the records of providers to make sure that all income was reported. Auditors may rely less on bank deposit statements when auditing a “Kith and Kin” provider because parents are more likely to pay in cash. The Guide indicates that the auditor may want to contact parent clients directly to verify how much they paid their provider.

The Guide gives a new example of a how an auditor might try to verify income using sign-in/out sheets and rate schedules. In this example the provider reported $38,400 of income based on her bank deposit records. But when the auditor looked at attendance records and multiplied the days the children were in care with the stated rate of $250 a week, the income totaled $61,250. This provider is in trouble because it looks like she underreported her income. How would a provider respond to this situation? The provider might make the case that parents didn’t actually pay the stated rate consistently throughout the year for a variety of reasons. To support this position the provider should ask parents to write letters indicating how much they did pay that was less than $250 a week for part or all of the year.

The Guide updates an example of how to reconstruct income using a food reimbursement formula. The provider charges an average weekly fee of $200 per child and serves a lunch and two snacks per day, per child. The provider received $6,501 from the Food Program. The Guide tells the auditor to use the $6,501 amount to calculate how many child days this represents and to multiply it by the average weekly fee. Using this formula in this example, the auditor concludes that the provider must have earned $83,000.

If this provider is told that she earned $83,000 and this amount is much more than she actually earned, how can she argue that this formula may not accurately reflect her income:

Some of the parents may not have paid her full weekly rate for 52 weeks
Some part-time children may have eaten the same number of meals as a full-time child
The number of meals that were served may have varied during the year.
The rates for some children may have gone down during the year (for example, when an infant became a toddler)
The provider may have offered temporary free care to some children who were on the Food Program because of financial problems
The provider didn’t charge on a weekly basis to all families
A parent left, owing money.

There may be other reasons why this formula may not work in every case. Providers and tax professionals may want to check their tax return to see if they will have difficulty defending their reported income if this formula was applied to them. If not, write a note to yourself explaining the discrepancy. This note will be very important if you are ever audited. In addition, keep complete records of parent payments, children’s attendance, and the number of meals served (including unreimbursed meals).

Food Program Reimbursements (CACFP)

This new section in the Guide offers an explanation of how the Food Program operates. The Guide encourages providers to report Food Program reimbursements under “Other Income” on Schedule C. It also recognizes that reimbursements for a provider’s own child is not taxable income. For a complete discussion of how to report Food Program reimbursements see below under “Food Expense.”

Other Income

The Guide addresses for the first time a situation where a provider gets a forgivable loan and says that when the loan is forgiven it is taxable income on Schedule C. There are a number of loan programs for family child care providers operating across the country and some of them are forgivable after the passage of time. For example, if a $1,000 loan is forgivable 20% a year for 5 years, then the provider should be reporting $200 as income each year.

Expense Issues

This entire section is new to the Guide and is extremely helpful in many respects. It acknowledges that providers use many items for their business that have both business and personal purposes (fixed assets, toys, supplies, appliances, vehicle expenses). It recognizes that some property might be used “substantially” while in other cases it might be “minimally” used. It directs the auditor to evaluate “in a fair and objective manner whether the expense is deductible under IRC Section 162 as an ordinary and necessary expense and then determine what percentage constitutes business usage based on the facts and circumstances of each case. It is important to stress the fact that having a personal usage element present does not disqualify the property from being a deductible IRC Section 162 expense.”

The Guide then gives two examples of lawn expenses and laundry facilities and says that the proper way to allocate the business portion of these expenses is to use the “business usage of the home ercentage.” (IRS Tax Court case Neilson v. Commissioner, 94-1, 1990 allowed a provider to claim lawn care expenses for her business.) Note: In an early draft of the Guide it said that providers should calculate an actual business use of the laundry facilities. At my request this language was changed.

These statements may seem obvious to providers or experienced tax professionals, but they are the first time the IRS has given such explicit directions to auditors on how to handle family child care expenses. I have seen audits where the auditor claimed, in principal, that providers couldn’t claim deductions for items that were also used personally. I have seen other auditors who did allow some deductions for general household expenses (such as lawn care and laundry) but were very uncomfortable with the idea and had to be talked into it.

The sweeping statement in this section “there are many such examples in this industry of expenses incurred for both business and personal purposes” should encourage providers to claim a portion of all allowable household expenses and feel confident that this claim will be upheld in an audit. In addition, the advice to use the Time-Space Percentage (business usage of the home percentage) is also extremely helpful in clarifying how to allocate shared business and personal expenses.

Substantiation Requirements of IRC Section 274(a) and IRC Regulation 1.274-5T

This is another new section for the Guide. The language is not specific with regards to family child care, but rather summarizes the law dealing with the requirement that taxpayers must substantiate their expenses with “adequate records.” This is not new. However, placement in this Guide suggests that the IRS wants auditors to be stricter in accepting business records from providers.

The Guide points out that the Cohan rule is superseded by subsequent IRS regulations for certain types of expenses. These expenses include: travel, car, gift, and listed property. In the Cohan case the taxpayer didn’t have adequate records to claim business expenses but the court allowed him to make a close approximation of his expenses rather than disallowing them entirely. Here the Guide is implying that providers could lose an entire deduction without adequate records and that the unsupported testimony of a provider is not an adequate record. This seems like it may be more difficult for providers to have their deductions accepted if they don’t have adequate records and that the test for what is an adequate record may be more difficult to meet. Clearly, providers who have no records and are putting deductions on their tax return that are only guesses should not do so. Providers who are audited and find that they can’t back up their deductions still can try to make their case by uncovering receipts, cancelled checks, credit/debit card statements, parent statements, photographs and other records. Simply arguing that the deduction is “reasonable” without backup is not going to be allowed if the auditor follows this Guide.

Listed Property

Listed property includes vehicles, computers, cameras, camcorders, cell phones and property used for entertainment, amusement or recreation. This could include televisions, VCR and DVD players as well as stereos and record players. The consequence of this designation is that taxpayers must have an “adequate record” to substantiate the business use of such items. Commonly, IRS auditors like to see a log showing business use. As a practical matter, this is virtually unheard of in the family child care field. Providers are not tracking their daily use of their home computer, cell phone or televisions. It’s unlikely that they ever will because of its impracticality. I have always argued that providers should use their Time-Space Percentage to determine the business portion of such expenses and have usually won on this point in IRS audits. The Guide may make it harder to argue this position.

In the previous Guide a number of items were identified that were excluded from the stricter record-keeping requirement of listed property. These items were: computer, camcorder, VCR, television, stereo, piano and guitar. Presumably these items will now need to meet the stricter record keeping standard.

Note that computers and entertainment items are not listed property “if they are used exclusively at the taxpayer’s business establishment or exclusively in connection with his principal trade or business.” The only time this would be the case for a family child care provider is if she had the computer in an exclusive use room or she operated her business in a building that was not her home (thus the space would also be exclusively used in her business).

Depreciation

This a greatly expanded section in the new Guide that is very helpful in clarifying two issues. First, in a discussion of how to determine the business use percentage it explicitly says that providers can use their Time-Space Percentage for furniture and furnishings. Second, the Guide clearly states that providers may depreciate items purchased before their business began that were originally exclusively personal use and then later put into business use. It says, “The fact that the asset was only used for personal purposes prior to being placed in service does not disqualify it from being converted to use in the business."

This last statement is significant in that it recognizes that providers can depreciate hundreds of items in their home that were purchased before their business began. I have always encouraged providers to do an inventory of household items and start claiming depreciation deductions when their business begins. Providers can also use IRS Form 3115 Application for Change in Accounting Method to recapture previously unclaimed depreciation if they have not already depreciated such items.

Providers who are audited and have not previously depreciated all of their household items should take the opportunity to claim any allowable depreciation. In addition they should file Form 3115 to help offset any tax deficiencies found in the audit. It is unlikely that providers will have receipts or other records of these items that were purchased before their business began. They should take pictures of their property and estimate their value at the time their business began. A reasonable estimate of this value should be accepted.

The old Guide offered little help on understanding how to depreciate items in a family child care business. It said, “Assets that are converted from personal to business use should use fair market value at the time of conversion as a basis for depreciation.” This left it unclear whether such assets had to be converted from 100% personal use to 100% business use.

I wrote to the author of the Guide that I had seen many audits where the auditor would not allow depreciation deductions for assets because they were originally 100% personal use, or because the provider had to purchase the items anyway (i.e. for personal use), or because the items no longer had any value when first used in the business because their useful life had expired. Fortunately, the author of the new Guide accepted my recommendations that this issue be addressed and such faulty thinking should now disappear.

Vehicle (Car and Truck) Expense

At my request, the Guide eliminated language that implied that trips for the benefit of a child at the request of a parent “would not generally be the responsibility of the child care provider.” Other language instructing the auditor to look at the car insurance policy to verify the business use of the car was also deleted.

The old Guide said, “If a trip involves multiple locations, then only the mileage to/from the business-only destination is deductible.” I asked for a clarification on what this meant and the Guide gives an example that says that if there is a business destination and a personal destination in one trip that only the round trip miles to and from the business destination are deductible.

The Guide also expands the discussion of car expenses to state that “there must be a profit motive present and the expense must be ordinary and necessary.” The discussion that follows indicates that the auditor may question mileage deductions that occur after normal child care hours or involve some, but not all of the children in care. Providers should protect themselves by keeping careful records of business trips. Such records could include permission forms, calendar notations, and parent contracts that spell out transportation policies. Since car expenses will be subject to the stricter record keeping requirements of listed property, providers can expect closer scrutiny at an audit

Travel, Meals, Entertainment

The Guide expands its discussion of deducting meal costs away from home by citing the regulations on this issue. Meal expenses away from home are subject to the 50% deduction limitation, while food served to the children in care are not. The cost of meals to entertain parent clients would be deductible (subject to the 50% limitation) but whether or not other meals are deductible depends on whether the expense is ordinary and necessary and if there is a profit motive present. In other words, a provider who spends $1,000 on meals for prospective clients and shows a $2,000 annual profit would have a hard time showing that this expense was undertaken with a profit motive. I had asked the authors to clarify whether providers could deduct meals when two providers ate lunch together to discuss business issues but they did not address my request.

The Guide instructs auditors to look closely at meals in which the other person present has a “close personal or family relationship with the provider.” Obviously, if a provider is taking her husband out to dinner to discuss business issues this will get a close scrutiny. Interestingly, however, the Guide goes on to say, “This should not be the sole reason to disqualify the expense.” Providers who do deduct meals served to family members should keep careful records, including receipts, names of persons at the meal, as well as a description of the business topics discussed. In addition, the annual deduction for such meals should reasonable in light of the overall business profit.

Food Expense

This new section offers the best explanation found in any IRS publication of how to report Food Program reimbursement payments. There continues to be false information circulating in the family child care field stating that reimbursements from the Food Program do not need to be reported as income on Schedule C. Even some Food Program sponsors continue to spread this misinformation thus creating the false impression in the minds of some providers that reimbursements from the Food Program are not taxable income.

The 2000 Guide said, “Federal food program reimbursements… are normally not taxable income if the food expenses are offset against this income.” This description of offsetting, or netting, of income is also found in IRS Publication 587 Business Use of Your Home: “Reimbursements you receive from a sponsor under the Child and Adult Care Food Program of the Department of Agriculture are taxable only to the extent they exceed your expenses for food for eligible children.” IRS Publication 525 also contributes to the confusion when it says, “If you operate a daycare service and receive payments under the Child and Adult Care Food Program administered by the Department of Agriculture that are not for your services the payments generally are not included in your income.”

Since the first edition of the Guide was released the IRS issued Revenue Procedure 2003-22 that introduced the standard meal allowance rule. The Guide summarizes this Procedure but adds nothing new. Providers should not

If a provider followed this advice and spent $5,000 on food and received $4,000 from the Food Program, she would report $0 as income and $1,000 as a food expense on Schedule C. In my experience, however, IRS auditors never wanted to see a netting of food expenses. Instead they wanted to see the reimbursements reported as income and the food expenses reported as expenses.

In this section of the Guide we now have the clearest statement yet that the IRS prefers to see all the reimbursements reported as income and all the food expenses reported as expenses on Schedule C. It describes this as the “recommended method.” It does say that providers can use the netting method, but then says, “the netting method is not a preferred method since an Examiner will always be looking for the food reimbursement amounts.” This is a major step forward in clarifying this issue.

I wrote several times to the author of this new Guide explaining how confusing and unhelpful the netting method was and I am happy to see this new language. In an earlier edition of the Guide it said, “Most food reimbursement payments are reported on a Form 1099.” In fact, this is not the case. Most Food Program sponsors do not issue Form 1099. A 1993 letter from Michael R. Gallagher, Chief, Technical Publications Branch of the IRS stated that sponsors were not required to issue Form 1099 under IRC section 6041. I’m also happy to see this language eliminated. I will now urge the IRS to clarify the language of Publications 587 and 525 to comply with the language in the Guide.

I have seen a number of auditors over the years try to limit a provider’s food deduction to the amount she received in reimbursements from the Food Program. Although the Guide does not directly address this issue, its instructions do not put any limit on food expenses (other than ordinary and necessary).

Since the first edition e that they can deduct up to six food servings per day, per child while they can only get reimbursed a maximum of three servings from the Food Program. Some providers mistakenly believe they can’t deduct more than three servings a day. To use the standard meal allowance rule the Procedure requires providers to keep careful records: name of each child, dates and hours of attendance and the type and number of meals and snacks served. Many providers are not keeping a daily record of the meals and snacks they serve that are not reimbursed by the Food Program.

A typical provider might serve breakfast, morning snack, lunch and an afternoon snack. She reports the first three servings on her monthly Food Program claim form, but doesn’t record the afternoon snack. In an audit she could be in trouble without a record to back up this snack. One snack a day per child is equal to $171 a year (2010 rates). This represents a lot of money for a provider with multiple children in care and I would strongly recommend that providers keep daily records of their unreimbursed meals and snacks. To defend this deduction in an audit when no daily records were kept, I would recommend that a provider use her attendance records to reconstruct the number of unreimbursed meals served to each child and ask the parents to sign a statement saying that they know that their child was served these meals. I have not yet seen this strategy used in an audit.

The Guide also makes it clear that all providers, whether or not they are on the Food Program or whether or not they are licensed can use the standard meal allowance rule. This includes Kith and Kin providers as well as providers who are operating illegally under state law!

On a separate issue the Guide says, “Some centers might have special occasion activities for the children in which the parents are invited, such as Christmas, where meals are provided. Such special occasion costs are deductible as a special activity cost.” I assume this same conclusion would apply to family child care providers. If so, then providers can deduct the full cost of such special occasions and not have to use the standard meal allowance.

Business Use of the Home

Calculating the business use of the home is at the heart of a family child care provider’s tax return and is always going to be examined in an audit. Because of the thousands of dollars of expenses that will be applied to the Time-Space Percentage formula it’s vital for providers and tax professionals to pay particular attention to claiming the maximum percentage that is allowed. This also means that this percentage should be strongly defended in an audit. It’s also possible for providers to claim a higher percentage at the audit if they have the proper records to back up their claim.

The Guide offers a greatly expanded discussion of how to calculate the business use of the home. It makes it clear that providers must use a regular use standard rather than an exclusive use standard that all other taxpayers must meet. At my recommendation the Guide also refers to the instructions to Form 8829 Expenses for Business Use of Your Home where it says that providers may have an exclusive use room as well as rooms that are regularly used. I have seen audits where the auditor insisted that a provider could not use the exclusive use rule and the regular use rule for different rooms in her home.

The Guide repeats the language from IRS Publication 587 Business Use of Your Home that says that providers can claim expenses on Form 8829 if they have “applied for, been granted, or be exempt from having, a license, certification, registration, or approval as a day care center or as a family or group day care home under state law.” Tax professionals who are assisting Kith and Kin providers should note that they can claim house expenses on Form 8829.

The Guide also says, “An unlicensed provider may still deduct other business expenses, such as food, toys, supplies, etc.” This is important in that I have seen a number of audits where the auditor tried to deny deductions to a provider who was operating illegally under state law. Other than Form 8829 expenses, all providers, regardless of their legal status can deduct all ordinary and necessary expenses for their business.

The Guide defines the issue of regular use by quoting from Revenue Ruling 92-3 and from the Uphus case (I was the attorney representing the providers in both cases). These cases offer the clearest explanation of what is regular use. The Uphus case also states that a provider could count a room as regular use even if the state licensing rule prohibited day care children from entering the room. What matters, instead, is how the room was used. In that case the provider used the basement room for a variety of business purposes (laundry, storage furnace area, etc.).

In its discussion of the Space Percentage the Guide notes that, “Many times we tend to be judgmental in our analysis.” This comment is made, I believe, in response to my letter to the author of the Guide where I detailed a number of instances where auditors had denied square footage as being regularly used. I have seen auditors deny space because they said it didn’t have to be used for business purposes (the auditor said the provider should have moved cots from a bedroom to a play room). I’ve also seen an auditor deny, as a matter of principle, the ability of a provider to count all of her rooms as regular use. Fortunately, the Guide gives an example of a provider who uses three bedrooms for naps for the children in her care and notes that an auditor should not limit the use of these rooms simply because the provider could put all the children in one room for naptime.

The Guide gives another example of a provider claiming regular use of a formal dining room where the children do not eat their meals. In this case the provider could show that the room was used on a regular basis if she claimed that she and the parents sat at the table to discuss business, or that there were other business items in the room such as a stereo player, or that the children played in the room.

For the first time, the Guide explicitly states that providers should count both their full basements and garages as part of the total square feet of their home. IRS Publication 587 Business Use of the Home has always stated that garages (even if detached) should be counted as part of the square footage of the home, but I have seen many audits where the provider had to fight the auditor before this was accepted.

The inclusion of basements and garages into the Space Percent calculation can have different consequences for providers. For providers who use these areas on a regular basis for their business and have other rooms that are not regularly used in their business this is good news because it will increase their Space Percent. For providers who have exclusive use rooms and did not previously count these areas, this is bad news because it will decrease their Space Percent. For providers who use all of their rooms on a regular basis for their business as well as their basement and garage, this will not make any difference.

In fact, most providers can claim their basement and garage areas as regular use in their business. Most providers have a basement with a laundry room, furnace area, storage area (food, toys, etc.), and tool room area. Most providers have a garage containing a car that is used for business as well as bicycles, household tools, garbage can, storage, etc. See the Uphus case for a clear explanation of what constitutes regular use for such areas.

I had urged the author to clarify if providers should count unfinished basements or half basements, but this did not happen.

The Guide also offers very helpful guidance in its discussion of the Time Percentage. It repeats language from the earlier version (that’s taken from Revenue Ruling 92-3) saying providers can count hours spent “cooking, cleaning, and preparing activities” when children are not present in the home. The Guide then goes further and says, “The Revenue Ruling example is not an absolute rule.” It acknowledges that some providers do work longer than the one hour a day extra in the Revenue Ruling case. The Guide also says that hours spent on record keeping can count and hours spent on activities done on weekends can also count. I had urged the author to clarify these points. I have seen audits where the auditor wanted to limit the number of hours spent on business activities when children were not present in the home to one hour a day, based on the Revenue Ruling 92-3 example. Happily, this will no longer be cause for a dispute.

Fortunately, the Guide eliminated language from the earlier version (at my request) that providers should “multiply days used for day care during the year by the hours used per day.” This is taken from IRS Form 8829 Business Use of Your Home. Such language is not helpful because it implies there is an average number of hours that providers work each day.

I asked the author of the Guide to directly address the issue of whether or not there is a limit on how high a business use of home percentage can be. I have seen auditors set arbitrary limits (40%, 50%, etc.) without any authority to support this position. The Guide does not address this topic. However, there is nothing in the Guide to suggest that there is any limit.

The key to a correct calculation of the Space Percent is for providers to keep regular records of the hours they work in their home, especially the number of hours spent on business activities when the children are not present in the home. Few providers keep a daily log of such hours for the entire year. My recommendation is to keep twelve months of careful attendance records and at least two months of records showing hours worked when children were not present. Two months of such years kept each year may be adequate in the event of an audit, but twelve months is best. I represented a provider who kept twelve months of records and claimed an average of 24.8 hours of work each week when children were not present. The auditor tried to arbitrarily limit these hours to 15 hours a week, but we won in Tax Court without an argument. Without the twelve months of records it may have been more difficult to prevail with this many hours.

Figuring the Allowable Deduction

The Guide correctly points out the limitations of Form 8829 deductions and points out that a “common error” is for providers to claim property tax and mortgage interest in full on both Form 8829 and Schedule A. Providers using income tax software should be particularly careful to avoid this mistake.

Tax Exempt Income Used for Payment of Housing Used in Day Care

This section of the Guide generally repeats the earlier version discussion of how providers can claim house expenses when living in military housing. It says that military housing allowances are not taxable income. Providers who live in off-base housing are always entitled to claim the business portion of their property tax and mortgage interest on Form 8829 and the balance on Schedule A, even if the housing allowance covers all of these expenses.

Providers who spent less on their total house expenses than they receive as a housing allowance can still claim the business portion of property tax and mortgage interest, but no additional housing expenses. Providers who live in on-base housing can’t claim any house expenses, except for those that they pay out of their own pocket. This could include home repairs, fence, or home improvement.

Modifications to the Home

In the earlier version of the Guide it said, “Expenses incurred in modifying a residence to comply with licensing requirements should be treated as a capital improvement.” I urged the author to change this to reflect the fact that many providers make home improvements that are not required by licensing and this sentence may imply a limitation of a home improvement deduction to situations where it is required by licensing rules. Fortunately, this has been clarified and no such limitation is recognized.

Sale of Home

Although this section is expanded from the previous version it does not expand our knowledge of the sale of the home rules. The Guide makes it clear that providers must pay tax on any depreciation claimed (or entitled to be claimed) after May 6, 1997. Therefore, all providers should depreciate their home. I continue to hear from some providers that their tax professional recommends that they don’t depreciate their home. Obviously, this is terrible advice. Sale of the home can be an issue for Kith and Kin providers. Many of these providers may not be thinking of themselves as a business and have probably not claimed any house depreciation. Yet when they sell their home they will owe tax on house depreciation.

Toys

The Guide places special emphasis on toy expenses because they can be a “significant expense.” Auditors may look closely to see if the toys are personal, rather than business expenses. Preschool toys can be easily claimed as 100% if the provider’s own children are school age and older. When a provider’s owns children are of the same age as the day care children they should save all receipts for toys, even those they buy for their own children.

Employee Benefit Program/Pension and Profit Sharing

The Guide expands this section in describing the various types of employee benefit programs. Significantly, it does mention the medical and health plans under IRC Section 105. I won a US Tax Court case in 2006 for a family child care provider who hired her husband to work for her business (without paying him wages) in exchange for a medical reimbursement plan that resulted in a 100% deductible business expense (See Speltz v. Commissioner, Tax Court Summary Opinion 2006-25).

Office Expenses and Supplies

This is the only rewritten section of the Guide that takes a step backward from the previous version. The previous version simply listed a few examples of supplies. The new edition offers the same list but then creates confusion as it tries to offer guidance for how providers should allocate expenses that have both business and personal use. It refers to a “business use percentage,” a “business usage percentage,” a “business use of the home percentage,” and “an actual usage method percentage” in the space of three sentences! The Guide makes several references to items that are “material” and tells providers to keep records to show the business use for such items. This implies keeping some sort of log to show the actual business use. However, keeping logs showing the actual use of toys, diapers, office supplies, and education and art supplies seems extremely impractical. Elsewhere in the Guide it says that providers can use their business use of home percentage on lawn expenses, laundry facilities, and bank charges. Why these items could be allocated based on the business use of home percentage while toys and diapers must be allocated based on an actual use percentage is completely unclear. I would recommend that providers use their Time-Space percentage (“business use of home percentage”) on all office expenses and supplies that have both business and personal use. It’s a reasonable way to allocate these expenses. I have not seen audits where auditors required providers to calculate an actual business use percentage for anything other than listed property.

Start-Up Costs

The rules announced in 2004 dealing with start-up costs are incorporated in the Guide. The vast majority of providers will have fewer than $5,000 in start-up expenses for such things as toys, smoke detectors, supplies, advertising, training, licensing fees, and other items. Therefore, they will be entitled to deduct these items in the year their business begins.

Telephone Expense

Providers often ask why the cost of basic local telephone service is not deductible. It used to be deductible but many years ago Congress passed a law eliminating the deduction to reduce the budget deficit. The Guide specifically address cell phone expenses for the first time and repeats the rule that providers must keep strict records for this listed property. As a practical matter I don’t see how providers can tract the business and personal use of a cell phone. Providers often bring their cell phone with them into their back yard to be with the children in case there is an emergency. She may also bring along her cell phone on field trips for the same purpose. In these situations the phone is in business use even if no phone calls are made. To attempt to allocate the business use of the phone based on calls made seems inappropriate. I would recommend that providers use their Time-Space Percentage to determine the business portion of their cell phone. I have won this point in a state of Minnesota audit, but I’ve not see it addressed in an IRS audit.

Although the Guide does not address this, providers can deduct the business portion of the cost of the cell phone, answering machine, and other phone services that are used in the business (call waiting, etc.). In addition, providers can claim any long distance calls associated with their business. With the rise of bundling of phone service with Internet and cable television it may be necessary for providers to ask their service provider to break out the cost of the services. Although I asked for clarification in this situation the Guide does not directly address this. Some providers who use all these services in their business may want to apply their Time-Space Percentage to the entire monthly fee.

Gifts

I asked the author of the Guide to clarify how providers should handles items purchased for the children in their care. Are these gifts, subject to the $25 per person per year rule, or are they activity expenses that are not subject to this limit? The Guide added the statement, “Examiners should not confuse expenses related to activities done with the children with gifts.” Therefore, providers who give children small items such as notebooks, stamps, books, and arts and crafts items should consider these as activity expenses and not gifts.

Wages/Compensation

This new section recognizes that providers may hire their own family members as employees in their business. This is a step forward as I have seen audits where the auditor refused to acknowledge the possibility that a provider’s child or spouse could be an employee. “You’re just trying to avoid paying taxes,” was the comment of one auditor. The Guide says that family members (like all employees) must perform services that are relevant to their business. Performance of household chores such as taking out the garbage, mowing the lawn, or general house maintenance should not be included in the job responsibilities of an employee. The Guide also urges providers to keep accurate records about when the work was done, how much was paid, and what work was performed. Auditors will be initially suspicious of the hiring of family members and providers would do well to heed this advice.

Employee Versus Independent Contractor

This section of the Guide is almost identical to the previous version. It is clear that providers who hire someone to work in their home helping them care for children will be treated as hiring an employee, not an independent contractor. This is true regardless of how little is paid to the worker or how few hours the worker works. Only a worker who has her own business caring for children or is providing special services (such as a puppet show or swimming lesson) will be considered an independent contractor.

Many providers do not treat their workers as employees by withholding Social Security and Medicare taxes, and paying federal and state unemployment taxes. In addition, such providers are not purchasing workers’ compensation insurance. Providers who do hire workers and do not follow these rules will not only suffer the tax consequences (back taxes, penalties, and interest) but face possible large payments for medical expenses and major fines by their state if the worker becomes injured on the job. These are serious financial penalties that should not be taken lightly. Providers or tax professionals who believe that workers can be treated as independent contracts are making a big mistake.

For details on how to file federal tax payroll forms for employees, whether family members or not, should see my annual Family Child Care Tax Workbook and Organizer.

Exhibit A Sample IDR

Basically the same as the previous version, this section of the Guide identifies records that auditors may request of providers during an audit. Providers who have notified that they will be audited should be prepared to produce these records.

Exhibit B Internal Revenue Regulation 1.280A-2(i)

This is a new section of the Guide. It offers a general description of proposed regulations for IRS Code Section 280A regarding the business use of the home. These regulations are manifest on Form 8829 where providers (and other home-based businesses) will claim their house related expenses. It is strange that in the first five paragraphs the examples used have nothing to do with family child care (teachers, retail sales, doctors).

One sentence says, “Expenses which are not related to the use of the unit for business purposes, e.g., expenditures for lawn care, are not taken into account for purposes of section 260A.” I assume they mean 280A. The Guide again mentions lawn care expenses in an example below and repeats that they are not deductible. When I reviewed an earlier draft of this Guide I pointed out that US Tax Court case Neilson v. Commissioner, Tax Court Decision 94-1, 1990 had allowed lawn care expenses for a family child care provider as ordinary and necessary in her business. In response, the author added a note to the end of the example saying, “Lawn expense may be an allowable business expense for a child care provider.” Earlier in the Guide (under Expense Issues) lawn care expenses were also recognized as business expenses for providers.

In paragraph six there is finally a mention of family child care. While it offers the general description of how to allocate the business use of the home based on hours worked, the example given has a provider working 36 hours a week! According to national surveys, providers work an average of 11 hours a day or 55 hours a week caring for children. In addition providers work another 13 or so hours a week on other business activities. Hopefully auditors will not use this example as some sort of standard to challenge hours that providers are claiming.

The next few paragraphs of the Guide gives an in-depth example of a home-based business and how this self-employed person would report expenses on Form 8829. But the example is that of a business consultant, not a family child care provider! Therefore, it’s not at all helpful.

Child Care Credit

The earlier edition of the Guide had a section dealing with the child care credit, but this section has been eliminated for the new Guide. Providers are entitled to claim the federal child care tax credit if they pay another person to care for their child while they are working. Some providers do send their own children to another preschool program for a few hours during their work week. In addition, some providers hire caregivers when they attend business training workshops or conference.

This handout was produced by Think Small (www.thinksmall.org).

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