Jeannie and Robert Peoples
vs. IRS Commissioner
This case is significant because a Tax Court allowed a family child care provider to claim an extremely high time-space percentage (93%) and large supply and repair expenses (tens of thousands of dollars).
I have heard regularly from family child care providers who tell me that their tax preparer wants to limit how many hours they should count when calculating their time-space percentage. I have also spoken with providers who delivered 24-hour child care for parts of a week, but never for as many weeks in the year as in this case.
In this case Jeannie had been doing 24 hour child care since 2000. In preparing her 2008 tax return she used the number of hours from her 2007 tax return (80% time). It’s never a good idea to use the same time-space percentage from one year to the next. It often changes because providers work longer or shorter hours or they use rooms in the home differently. When she did carefully count the actual number of hours she worked in 2008 and 2009 she came up with 8,571 hours in 2008 (97.8%) and 8,156 hours in 2009 (93%).
This case should give providers and tax preparers more confidence in claiming a high time-space percentage, if they have the records to back it up. This case involved hours children were in care that is easier to track or reconstruct than hours spent working in the home after children are gone.
In most audits I have been involved with, providers have not kept contemporaneous records of the hours they worked after children were gone. As a result it has always been difficult to defend a claim for these hours. I continue to stress in my workshops, my books and on my blog that the single most important thing providers can do to reduce their taxes is to keep at least two months of careful records showing their business activities after children are gone.
We don’t know why Jeannie Peoples got audited. It could have been because of the high time-space percentage or because of her low profit. Jeannie made $120,769 in 2008, yet showed a profit of only $8,754. In 2009 she made $121,930 and a profit of only $6,891. This is an unusually small profit for such a large income and this might have been what attracted the attention of the IRS. However, because of her extremely long hours and the large number of children in her care (27 in 2008 and 36 in 2009) I was successful in defending her expenses.
Tax Court cases cannot be used as a legal precedence in other IRS audits. In other words, if you are being audited about your time-space percentage you can’t argue that your auditor must accept your position because Jeannie Peoples won her case.
However, I believe you can cite other Tax Court cases to support your position in an audit. Tell your auditor, “A Tax Court cases (the Peoples case) allowed her to claim a 93% time-space percentage based on her attendance records. I have attendance records that support my claim. What IRS authority can you show me that says I can’t count the hours I cared for children?” If the IRS auditor can’t supply any supporting authority for his position you are in a stronger position to argue your case. In other words, this case can be helpful if the IRS tries to argue that there is a limit on how many hours you can claim you care for children.
Failure of Appeals
This case should never have reached the Tax Court.
It appeared that the original auditor and Appeals officer did not pay close attention to her records or were not familiar with family child care. The Appeals officer wanted Jeannie to provide “detailed information on what repairs were done to the house and which receipts go with which repairs because some of the amounts claimed as repairs may need to go into the basis of the house.” To ask for a breakdown of what type of repair each receipt represents seems unreasonable. The repair receipts were mostly self-evident: poison stickers, lawn maintenance, salt for soft water softener, etc.
It was reasonable for the Appeals officer to raise the question of whether some of the repairs were actually home improvements. The Tax Court officer raised this same question and asked whether this was true for two dozen of Jeannie’s repairs. After hearing Jeannie’s explanation that many of these receipts were for repairing her basement after a flood, the Tax Court officer accepted them.
The Appeals officer also determined that the amount of supplies claimed was “neither ordinary or reasonable or necessary.” How anyone could claim that diaper wipes, child locks, extension cords, dust mop, apron, soap, floor cleaner, sponges, stain removers, etc were not ordinary, reasonable or necessary supplies is mind boggling. The officer decided to allow Jeannie to claim average supply expenses based on Bizstats (an online resource of business statistics). Using statistical averages from businesses that are not family child care homes doesn’t make any sense.
The issue here is not whether Jeannie is an average provider deducting an average amount of expenses. The issue is whether Jeannie spent money on supplies that were used by her business and whether she had receipts for them. Although her supply expenses were high, they can still be defended as necessary in her situation. If Jeannie had shown a business loss, then it would be more reasonable for the IRS to argue that some of her expenses were not reasonable.
In my opinion, all of the issues raised at the audit should have been resolved by the Appeals officer. It’s the job of the Appeals officer to make a good faith effort to settle issues in dispute. To disallow 100% of all repairs and over 80% of all supplies (after Jeannie showed her receipts for every purchase) shows negligence on the part of the Appeals officer. She practically forced Jeannie to appeal to Tax Court.
Jessie Read, EA, who prepared her tax return and handled Jeannie’s case with the original auditor and before the Appeals officer was extremely frustrated that she did not get a fair hearing by the Appeals officer. The officer improperly ignored her efforts to negotiate a settlement. Jessie suspected that perhaps this happened because the officer was unhappy that she had filed a Freedom of Information Act (FOIA) request to see the notes of the original auditor. It’s hard to know why the officer did not do her job.
Every provider has a right to file a Freedom of Information Act request and the IRS must turn over documents prepared by the original auditor. These notes can be helpful if they show the reasons behind an auditor’s decisions. I have seen FOIA documents that showed the prejudice of an auditor. In one case they showed research that the auditor had done that supported our position that wasn’t revealed to us in the audit! I have used such incidents to strengthen my case on appeals. In the Peoples case the FOIA documents did not provide any new information. However, the IRS did censor a number of pages that might have been helpful to us.
I discussed the actions of the Appeals officer when I met with the Tax Court officer. He agreed that the case should have been settled at the lower level. He said that in the past Appeals across the county have treated taxpayers very leniently and that the IRS was trying to reverse this trend. I asked about whether the results of our case would be shared with the Appeals officer and whether this would make any difference in how the Appeals officer handled future cases. The Tax Court officer said he didn’t know.
There seems to be little effort made by the IRS to collect information about how audits on similar issue are handled and to communicate the outcomes to all levels of the audit process (auditor, Appeals officer, Tax Court). As a result, there is no accountability and no assurance that other providers won’t be treated in the same way as Jeannie Peoples in the future.
For many years I have been trying to ensure that providers are treated fairly by the IRS. I’ve been offering free assistance via the phone and email to providers who have been audited and have represented a number of providers as well. The Peoples case is my sixth Tax Court case. In three of these cases we’ve won 100% of the issues in dispute and in the other three we have won on average about 80% of the issues in dispute.
I’ve learned a lot by representing providers and have communicated this knowledge through my blog, books, and workshops. I’ve also used what I have learned to successfully lobby the IRS to clarify many tax issues unique to family child care providers in its Child Care Provider Audit Technique Guide.
I’m able to do this work because of support I receive from the National Association for Family Child Care. I urge all family child care providers to join NAFCC so I can continue helping providers who are audited.
Jeannie did make a number of mistakes on her original tax return. She inadvertently counted many of her utility expenses twice. Although she kept all of her receipts, she sometimes claimed personal items contained on some of her receipts. Her calculation of house depreciation was incorrect. We admitted these mistakes early on with the Tax Court official. There is nothing wrong with admitting mistakes.
Jeannie originally lumped together her supplies and food expenses under Cost of Goods Sold on the back of Schedule C. Although there is no rule against doing this, the large sum that these expenses represented ($61,000 for 2008 and $59,000 for 2009) probably drew the attention of the auditor. The auditor required her to break them out.
Strategies at Tax Court
Because Jeannie saved all her records I believed we were in a strong position for our Tax Court appeal. Before I met with the Tax Court official I sent him a report containing my summary of the issues and copies of receipts and other records. We used this report as the basis for discussing the case at our meeting.
Supplies: We were claiming $65,000 in supplies for the two years and the Appeals had allowed only $11,000. The Tax Court officer said that there were some personal expenses (food, etc.) on some of Jeannie’s supply receipts. I didn’t want to go through each individual receipt (there were over 800), and neither did the IRS. So I immediately suggested we settle for 95% of the expense. The officer thought 90% was reasonable. I said I would look more closely at the receipts and we didn’t resolve this issue at the meeting. After our meeting I looked at a sample month of supply receipts and estimated that about 10% of the expenses on these receipts were personal. When the Tax Court official offered to allow 90% of these expenses in his settlement offer, I accepted.
Repairs: The Tax Court official said that some of the repairs might be home improvements that would have to be depreciated over 39 years. He raised this question for two dozen expenses. I called Jeannie and asked her to explain what they were (lumber, tools, contractor costs, mulch, water seal, etc.) and discovered that most of the larger items were for repairing her basement after a flood. I wrote a memo back to the official and described what the items were in more detail and he allowed them all to be deducted as repairs.
Time-Space Percentage: Jeannie had originally claimed 80% time-space percentage for both 2008 and 2009. After more carefully calculating her hours, she argued for 97% for 2008 and 93% for 2009. The auditor and Appeals allowed 80% for 2008 and 93% for 2009. This seemed odd to me. Why would Appeals allow 93% for 2009 but only 80% for 2008? It made more sense to only allow 80% for both years, or the higher percentages for both years. Jeannie’s records supported her higher claim.
I had talked with Jeannie before meeting with the Tax Court official and she was comfortable with offering a compromise of 93% for both years. So, before we had any discussion about hours, I offered this compromise at the meeting. I don’t believe in hard bargaining on every issue in Tax Court. The difference between 93% and 97% was not significant in this case. I didn’t want to go to trial (too much time and effort) and I wanted to be reasonable in trying to reach a settlement that the client agreed to. When I presented this compromise at our meeting the Tax Court official seemed ready to accept it.
Food: Because Jeannie cared for so many children for so many hours, she had a lot of food expenses. Originally, she had used her food receipts to estimate her food expenses, but at the audit she realized it would be easier to use the standard meal allowance rule. But, she had not kept a daily record of the number of non-reimbursed meals and snacks she served each day to each child. So Jeannie went back to her attendance records and estimated how many meals and snacks each child ate. Although she was on the Food Program, she didn’t have copies of her monthly claim forms to show the meal and snack counts for 2008 and 2009. She wasn’t sure she could get these records from the Food Program sponsor because they were four to five years old.
Trying to sort out an accurate count of meals and snacks proved very difficult. The Appeals officer looked at the same attendance records and came up a different count. Both the Appeals officer and Jeannie’s tax preparer used the wrong standard meal rates at different times. When I tried to determine the meal counts based on attendance records I could not tell whether Jeannie or the IRS was correct. In some cases Jeannie over estimated meal counts and some cases she underestimated. The same was true for the Appeals officer.
I did notice that for three children Jeannie had claimed they ate four snacks in one day. The standard meal allowance rule only allows three snacks to be claimed in one day per child. So I subtracted out this amount from Jeannie’s food claim. I also noticed that the IRS was disallowing meals/snacks served to Jeannie’s son. IRS rules say that providers cannot deduct food served to their own children. But, since Jeannie had included the Food Program reimbursements for her son as income, she was entitled to wipe this income out by counting the meals and snacks served to him. In my opinion, it’s best to correct such minor mistakes made by your client before meeting with the IRS. This shows that you are being fair and are a reasonable person to deal with. The hope is that this will create an atmosphere where the IRS is more willing to compromise on the larger issues in dispute. So, I included these revisions in my first report to the Tax Court officer.
Because I didn’t want to spend time arguing over how many meals and snacks each child ate (remember, there were 27 children in 2008 and 36 children in 2009), I proposed at the meeting that we split the difference between what Jeannie was claiming and what the Appeals officer allowed. Offering this compromise cost us $1,000 in deductions, but was not that significant compared to the $56,000 of food expenses for the two years.
Depreciation: The auditor and Appeals officer had allowed only a few items to be depreciated. They disallowed, without explanation, 2008 expenses including a new washer and dryer. They also did not carry forward the 2008 depreciation deductions into 2009. This is an obvious mistake that never should be made at the Appeals level. In the course of looking over Jeannie’s records I noticed some additional items she purchased in 2009 that she had not tried to depreciate. I included these items in the report I sent to the Tax Court official. (It’s never too late to bring up new deductions, even at the Tax Court level!)
At our meeting I dropped our claim for a flat top trailer used to haul items from stores. It wasn’t worth arguing about and I wanted to win the bigger issues. He accepted all but one (kitchen island) of our other depreciation claims in his settlement offer, including our new 2009 items. I assumed he forgot to include the kitchen island, but I decided it wasn’t worth mentioning ($243).
Math: It pays to read all IRS reports carefully. The Appeals officer made a mistake in not using the correct percentage for depreciating the home (2.564%). The Tax Court official corrected it. The Tax Court official made a mistake in not using the correct basis of the home for purposes of depreciation and in not applying the 93% time-space percentage to the home basis. This was an oversight by the Tax Court official that he quickly corrected. Catching this last mistake saved Jeannie about $600 in deductions.
Sales tax: For some reason Jeannie sometimes included sales tax in the cost of the items she deducted and sometimes she did not. Providers are entitled to include sales tax as part of a deduction. Jeannie was anxious to get her case over with and did not want to go through hundreds of receipts in an attempt to add up unclaimed sales tax. Neither did I. So I briefly mentioned to the Tax Court official that although we were probably entitled to claim some additional business deductions by calculating her sales tax expenses, we would not pursue it in the interests of settling the case quickly.
Tom Copeland – www.tomcopelandblog.com