Eight Key Federal Tax Issues Unique to Family Child Care Providers

Family child care is a growing business across the country. Over 200,000 child care providers are licensed by their state to work out of their home caring for children. Unfortunately, when these providers seek help from tax preparers, too often they receive bad advice because the tax preparer doesn't understand their business.

A number of IRS rules governing family child care are unlike any other home based business. Unfortunately, many tax professionals have a hard time preparing an accurate tax return for family child care clients because they aren't aware that these special rules exist. Below is an explanation of each rule.

Rule 1 “Regular Use”

The standard for claiming a room in the home as business use in family child care is "regular use," not "exclusive use." Counting rooms for business purposes is an important part of filling out Form 8829, Expenses for Business Use of Your Home. What is the definition of regular use? A provider who uses her master bedroom for the day care children to take a half-hour nap in each day is using this room regularly for business. A room does not have to be used every day for it to be considered regularly used. Most providers use their living rooms, kitchens, hallways, dining rooms, pantries and bathrooms regularly for day care. The clearest definition of what is regular use for the day care business can be found in IRS Revenue Ruling 92-3. This ruling came about after I requested a clarification of this issue during an audit.

It is important to note that it is not necessary for day-care children to be present in a room for it to be counted as regularly used in the business. In 1994, I won two Tax Court cases on this point. In both cases the provider was using a basement laundry room and storage room for her business. The court said that the regular use of these rooms by the provider to do business laundry and to store items for the business met the definition of regular use, without the presence of children. This conclusion was not affected by the fact that the state licensing regulations prohibited the providers from bringing children into these areas.

Given the above clarification, it is not surprising to find that it is very common for family child care providers to claim that they are using 100% of the rooms in their home for their business.

Rule 2 “The Garage”

The garage (detached or attached to the home) should be included in the total square feet of the home when calculating the business use of the home. It clearly states this in IRS Publication 587, Business Use of Your Home. Despite this, many tax preparers ignore the garage when filling out Form 8829. Most family child care providers are using their garage on a regular basis for their business by using it for storage for the car, bicycles, tools, lawn maintenance items, firewood, toys, freezer, etc. This principle was also clarified in the Uphus and Walker cases cited above.

Rule 3 “The Special Exclusive Use Rule”

An increasing number of family child care providers are setting aside one or more rooms in their homes exclusively for their business. It can be a downstairs play room or a sleeping room filled with cribs for infants and toddlers. The instructions to Form 8829 spell out the unique rule that tax preparers should follow. The preparer needs to calculate a business use percentage of the room(s) used exclusively for business and add this to the business use percentage of the rest of the home.

Rule 4 “Business Hours”

Probably the most important number on a family child care provider's tax form is line 4 of Form 8829. How many hours did the provider use her home for business purposes? Providers can count the number of hours that their day care children were present in the home, as well as the number of hours spent on business activities when the day care children were not present. It's this latter category that is often overlooked.

Preparers should ask about hours spent on cleaning, lesson planning, parent interviews, record keeping, meal preparation, parent phone calls, and any other activities that are related to the business. Hours spent away from the home shopping or taking children to school cannot be counted. In the forthcoming Final Report of the Economics of Family Child Care Study by Kathy Modigliani and others, providers who were surveyed in three cities worked an average of 13.9 hours each week when their day care children were absent. This report also showed that providers cared for children an average of 54.5 hours per week. using these averages gives us a total of 40% business hours for the year. In my fourteen years experience of training family child care providers across the country I have found that it is typical for a provider to claim between 35% and 40% as a total business use percentage of the home.

Rule 5 “Food Program”

The vast majority of family child care providers participate in the Child and Adult care Food Program operated by the U.S. Department of Agriculture. This program currently pays providers $4.54 per day, per child, for serving food that meets federal nutrition standards. Reimbursements from the Food Program should be reported as taxable income on line 6 (Other Income) on Schedule C.

In 1994 the IRS added new language to Publication 587, Business Use of your Home in an attempt to clarify how to report such reimbursements. They stated that providers should only report the net income or expense for food served in the business. They also recommended this method even if the provider received Form 1099 from their Food Program sponsor. I have not been able to find a tax preparer or an IRS agent who agrees with this recommendation. The best advice is to report all the Food Program reimbursement as income and list all the expenses for food served to the day care children on line 27 (Other Expenses) of Schedule C.

I wrote to the IRS to ask them to clarify another situation when the provider is eligible to receive reimbursements from the Food Program for her own children. To be eligible, the providers must have an income below the federal poverty standard. Such reimbursements are not taxable income and should not be reported on Schedule C. The IRS added this clarification to Publication 587 in 1994. Tax preparers should be sure to ask their clients if their own children are eligible for this reimbursement. Food eaten by the provider's own children is never deductible as a business expense.

I continue to hear from providers that IRS auditors are taking the position that they cannot claim as a business food expense any amount greater than the amount they received as reimbursements from the Food Program. This is clearly not true. Most providers serve additional meals and snacks that are not eligible for reimbursement. Publication 587 also makes it clear that it is possible for providers to claim expenses in excess of their reimbursement. In my experience, many providers spend hundreds of dollars more on food than their reimbursement. Don't make the mistake of concluding that the food reimbursement and food expense are a wash. Encourage the provider to estimate her business food expense independent of the reimbursement amount.

Rule 6 “Non-Regulated”

Providers who are not regulated (either licensed or registered) under state law are still entitled to claim all the expenses for the business use of the home on Form 8829, if they have applied for or are exempt from mandatory regulations. Many providers care for only one or two children and are exempt from any state regulation. Despite the lack of a license, they can still claim the same business deductions as a licensed provider. This rule is clearly stated in Publication 587. A provider who applies for a license (and hasn't been turned down) can also claim the same expenses as someone who has received the license.

Rule 7 “Home Depreciation”

Every provider, no matter what the circumstance, is always better off financially if they claim depreciation on their home as a business expense. When a provider sells her home, she must lower the basis of her home by any depreciation she was entitled to claim, whether or not she actually claimed it. This is probably the most common mistake tax preparers make when doing family child care tax returns. This principle is clearly explained in IRS Publication 551, Basis of Assets.

Rule 8 “Sale of Home”

Family child care providers may owe two different taxes when they sell their home. First, a provider may owe capital gains tax on the profit on the sale of the home if the profit is above $250,000 (if single) or $500,000 (if married). Providers can take advantage of this rule as long as they have owned the home and lived in it for two out of the last five years before the home sale.

Second, providers will have to pay tax on the depreciation they were entitled to claim after May 15, 1997. This is true even if the provider never actually deducted this depreciation on her tax return! So, it's always better financially for a provider to depreciate her home.

Let's look at an example: A provider is entitled to claim $1,000 a year of home depreciation. She is in business for six years and then stops doing child care. Whenever she sells her home she will owe taxes on the $6,000 of depreciation even if she didn't deduct it on her tax return. Therefore, it's important for providers to always claim this depreciation deduction.

In Conclusion

If tax preparers master the above eight unique family child care rules, they will have made a major step towards completing an accurate tax return. Providers in every part of the country are looking for tax preparers who understand their business and can answer their questions. Preparers should consider taking advantage of this growing market. To identify family child care providers in your area, contact your local child care resource and referral agency, child care Food Program sponsors or family child care associations.

from the EA Journal, Spring 1996. Posted with permission.

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