On April 17, 2009 the IRS published a revised edition of the Child Care Provider Audit Technique Guide. Read the Guide [www.irs.gov/businesses/small/article/0,,id=206004,00.html]. 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.
I strongly recommend that any provider who is audited should read this Guide.
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 651-280-5991 or firstname.lastname@example.org
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
The Guide recommends that auditors ask providers a lot of questions about their income. This is a reflection of how important the IRS considers the reporting of income in family child care. In other words, the IRS will be initially suspicious that a provider has not properly reported all her income on her tax return and will ask these probing questions in an 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: illness, 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”).
The Guide gives a new example of a how an auditor might try to verify income using sign-in/out sheets and rate schedules. The Guide uses an example of a provider who reported $38,400 in 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 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).
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 percentage.” (IRS Tax Court case Neilson v. Commissioner, 94-1, 1990 allowed a provider to claim lawn care expenses for her business.)
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.
This is 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.
Travel, Meals, Entertainment
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.
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.”
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 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 note 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.
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.
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.