Unregulated Provider Wins US Tax Court Case

Tom Copeland

You don't need to be operating legally to claim business expenses as a family child care provider.

So says a US Tax Court who ruled that a family child care provider is entitled to claim business deductions on Schedule C even though she was in violation of state regulations. See Jonelle Marie Broady v. Commissioner; T.C. Summary Opinion 2008-63; No. 14675-06S (June 2008).

Jonelle Broady began offering child care in her home in Bowie, Maryland, as a favor to her sister and friends. By 2003 she cared for eight children, not including four of her own. Maryland child care regulations state that a family child care provider is required to be registered if she cares for non-related children for more than twenty hours in a month. Because Ms. Broady did not register her business with the state, she was in violation of state law.

Ms. Broady cared for children five days a week from early morning through the early evening. She provided four meal servings a day, and parents paid $80 a week for full time care. She passed out business cards and place ads in the local gazette. At the end of the year she gave parents a receipt for their annual fees and her social security number for the parents' tax records. Ms. Broady filed her own taxes using TurboTax and reported her income directly on Form 1040, where she also claimed the child tax credit and the earned income credit.

The IRS auditor denied her claim for the tax credits on the ground that she did not operate a business for profit and that even if she did operate a business she had failed to substantiate her income.

During her appeal, Ms. Broady amended her tax return with the help of an accountant. She filed a Schedule C and reported a gross income of $27,395 and business expenses of $12,445. Her business expenses included:

Advertising - $200 for business cards and ads

Car - $1,295 for mileage, insurance, and repairs

Office supplies - $6,500

Repairs and maintenance - $220

Supplies - $630

Utilities - $1,780

Food - $1,820

The Court ruled that Ms. Broady did operate her business with the primary purpose of making a profit. The Court stated, "we are convinced that she operated her daycare service in a reasonable manner as compared to other similar home-based daycare services. That is, while we do not condone petitioner's lack of a license, we are convinced from her testimony that she did in fact provide daycare services each weekday for 11 months of 2003 and that her stated goal ('to make money for the household') adequately satisfies the profit motive requirement."

Because she received cash from her daycare parents, Ms. Broady did not have any records to support the amount she reported as business income. Although she had presented her daycare parents with end-of-the-year receipts, she did not keep a copy of these receipts. For the trial, she reconstructed these receipts based on her recollection and determined that she had earned $22,190 in fees. She also presented an adding machine tape that showed that she earned $17,950. The Court accepted the adding machine tape as a better record.

The Court then looked at the records of business expenses and determined that Ms. Broady had failed to substantiate any of them. "The scant evidence she provided consisted only of copies of her checking account statements for 2003 and canceled checks made payable to Baltimore Gas & Electric. The only testimony offered was with respect to petitioner's advertising costs, car and truck expenses, supplies, and other expenses. Petitioner testified as to having printed business cards and placing advertisements in the 'Pennysaver' gazette, using her car for occasional field trips with the children, buying arts and crafts supplies, and feeding the children at least two meals and two snacks each day. Petitioner did not, however, provide any records of receipts to substantiate any of these expenses, copies of her business cards, or copies of the advertisements, and she did not introduce any evidence on which we may estimate the amounts that she paid for such expenses during 2003."

The Court concluded that because Ms. Broady had business income, she is entitled to claim the child tax credit and the earned income.

Ms. Broady quit doing child care and is now a real estate agent.

Comments on this case

If a family child care provider is operating illegally, she cannot claim any expenses associated with her home that appears on IRS Form 8829 Expenses for Business Use of Your Home. This includes expenses such as property tax, mortgage interest, utilities, house insurance, house repairs, home improvements, and house depreciation.

I have seen other IRS audits where auditors tried to deny business deductions when a provider was operating illegally. I've always argued that the legal status of a provider should have no bearing on her business deductions (other than the house expenses on Form 8829 that can only be claimed if a provider is in compliance with state regulations). I've called the IRS on this point in the past and was told that that as long as the taxpayer could show that the deductions were "ordinary and necessary," they should be allowed. This case supports this view. Several years ago there was an audit in Ohio where the auditor disallowed all home office expenses because the provider was out of compliance of state regulations for about 15 hours during the year. The provider had too many children for 15 minutes during 58 days. In the end, the auditor did allow most of the home office expenses.

The provider in this case was not well served by her accountant. Although the accountant prepared her amended tax return, she moved out of state and was not available for the Tax Court appeal. The accountant did not tell her about the standard meal allowance rule that would have allowed her to claim food expenses without food receipts. The accountant also tried to claim utility expenses that are clearly not allowed for providers operating illegally.

Ms. Broady did a poor job of presenting evidence of her business deductions at trial. She could have presented better evidence about her car expenses (canceled checks, credit card statements, etc.), advertising costs, and other items. In a phone conversation with Ms. Broady, she indicated to me that she was confused by the tax forms and represented herself at trial. Better professional representation would probably have made a difference in her case.

Lastly, we strongly recommend that all family child care providers follow their local licensing rules. Failure to do so can have a variety of negative consequences. Providers who are in violation of local rules will be more liable if children are injured in their care. Providers can also be prosecuted for failure to comply with the rules. Illegal providers may also not be covered by their homeowner's or automobile insurance policy and will not be able to purchase business liability insurance.

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

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