Here is a summary of audits involving family child care providers.
Family child care provider presents $4,000 of receipts of supplies as business expenses. On the same receipts are personal items that are not included in the $4,000 deduction. Provider also can show $300 of personal supplies with other receipts. Auditor will only allow 50% of $4,000 as a deduction. It is a common problem for providers to be able to show that specific items are used 100% in their business.
Provider shows $28,000 of business income and a $27,000 business loss. Tax preparer clearly made many errors. Auditor says provider cannot (by definition) claim more than a 50% Time-Space Percentage. Auditor also asserts that provider must have a mileage log and cannot depreciate furniture purchased before the business began without a receipt. Provider contacts IRS Taxpayer Advocate for assistance. Advocate insists that furniture cannot be depreciated because its useful life has expired (furniture is over 10 years old). The IRS MSSP Guide on Child Care clearly allows depreciation on furniture and appliances. The basis of the property is based on the lower of the price or fair market value at the time the item was first put into business use, and therefore any discussion of the expiration of the useful life of an item is not a valid position. Advocate also states that provider cannot claim 100% space on Form 8829. The case is now on appeal.
Auditor took the position that a provider must count how many hours a child was in each room, each day. This results in a Time-Space Percentage of 18%. After meeting with the provider and her CPA, the auditor backed off this position. The auditor disallowed the deduction of wages paid to the provider’s children for doing work around the home for her business. The auditor said this was an allowance. The provider paid each child (ages 14,13,9, and 8) $5 a week for their work. The provider had prepared a list of work activities for each child (she described them as “chores”) but kept no other records. Without further records it will be difficult for the provider to win this point. The IRS closely scrutinizes hiring of family members and will assume that any payments are an allowance.
- Auditor will only allow 50% of a refrigerator and freezer that the provider is claiming was used 100% for business. After some discussion the provider wins. The tax preparer had originally claimed the deduction on Schedule C and had not elected the Section 179 rule, so the items must be depreciated. The tax preparer also had not elected the 50% bonus depreciation rule. After the provider pointed out a math error on the auditor’s report, the report was corrected. The auditor would only allow as a food deduction the amount equal to the Food Program reimbursement received by the provider. The provider had inadequate food receipts, but there were over $1,000 worth of non-food supplies on her food receipts. After showing the auditor these non-food receipts, the auditor accepted these as business deductions.
- A provider hired a professional benefits company to set up a Section 105 medical reimbursement plan to enable her to hire her husband and deduct medical benefits as a business expense. The husband worked 2-3 hours a day caring for children in the afternoon. The provider paid him only with benefits, no cash wages. The auditor, supervisor, and appeals officer offered several reasons as to why she could not deduct the medical expenses of $3,000 – $4,500 a year: You can’t hire your husband. You can’t establish a medical reimbursement plan. You can only deduct these benefits if the husband had no access to insurance through his employer. You can’t hire anyone to do work that you would be doing anyway. Your husband is an independent contractor because you don’t directly supervise him. Your husband is your partner. Since you had never previously treated your husband as an employee you cannot now treat him as an employee to take advantage of the medical deduction. The provider asked the auditor to request a Technical Advice Memorandum but this request was denied.
At one point the auditor put in her report that the provider had a valid employer-employee relationship. When the provider continued to press her case about other deductions that had been disallowed (and were later accepted by the auditor), the auditor reversed her position and said that an employer/employee relationship did not exist. On appeal to Tax Court, the IRS lawyer did acknowledge that such a medical reimbursement plan was allowable, that no cash wages must be paid, and that a provider could hire her spouse. The lawyer identified two problems as to why there was no valid employer/employee relationship:
The medical reimbursement plan required the provider to redirect the money for the medical expenses into a “Flexible Spending Account.” The provider did have a separate business checking account (in her name) out of which she paid for the medical expenses. The husband could not write checks out of this account. The lawyer insisted that this did not meet the definition of a “Flexible Spending Account” but would not clarify what would be acceptable.
The medical reimbursement agreement called for the husband to work an average of 12.5 hours per week at $10 per hour, with a maximum of $6,500 in medical benefits. The husband did work about 12.5 hours per week, but the medical benefits were only $3,279 and $4,539 for each tax year in question. This works out to be around $6 per hour. The IRS lawyer took the position that no real employee would work for less than $10 an hour under this arrangement. We pointed out that an employee who was working for medical benefits would continue to work as long as the possibility of additional medical expenses could occur during the year. The IRS position seemed to be that the employer was being denied the deduction because there were too few medical expenses, or that the employee worked too many hours.
We represented the provider at a Tax Court trial in June 2005. The judge ruled in the provider’s favor in a lengthy court opinion. Tom Copeland then sued the IRS for his time to defend the provider and we settled our lawsuit for $6,800 that went to the agency he worked for.
State of Minnesota Audits
Auditor disallowed a series of expenses: activity expenses, supplies, lawn care, and other items. The provider had receipts for practically all of these items and she claimed that she used a variety of these items 100% for her business. The auditor said that since the provider couldn’t prove that she used the items 100% in her business, she was disallowing all of the expenses. On appeal, the state auditor initially took the position that the provider was not allowed any deduction because she had not proven that the items were used 100% in the business. We asserted that the receipt, plus the provider’s testimony, plus the fact that the various items were obviously business-related should be enough to make our case. We asked what more information we could submit that to allow these deductions to be accepted (sign to advertise her business, carpet pieces for the children to sit on while watching television, carpet cleaner to clean carpets after day care children had soiled them, bleach to clean toys, books, etc.). The auditor did not identify any more information we could provide. After much debate, the auditor finally allowed a portion of the cost of most of the items. It is not clear what evidence could be provided in future audits to allow the deduction of 100% of an item.
Auditor calculated a provider’s 2001 food expenses by multiplying the cost of the meals served by the average of the Tier I and Tier II Food Program reimbursement rate. Since the provider was reimbursed based on the higher Tier I rate, and because the 2003 IRS ruling now uses the higher Tier I rate as a basis for the standard meal allowance rule, we argued that this higher rate should be used. The provider also deducted 80% of the cost of an Electrolux shampooer based on the fact that she cared for 13 day care children and 2 of her own (no husband). The auditor only allowed the Time-Space Percentage of the shampooer. We are still in dispute over how to determine what portion of this cost is deductible. The auditor also allowed only 75% of basement and 50% of the garage in the calculation of the Time-Space Percentage, despite the fact that the provider used all the areas on a daily basis for business activities (laundry, bathroom, play room, storage, and furnace area. This clearly meets the test of regular use as defined by the Uphus and Walker cases (T.C. Memo 1994-71) and by Revenue Ruling 92-3. The auditor stated in her report that the garage was probably off limits as a play area according to licensing rules. In fact, the Uphus and Walker cases allowed rooms to be counted as regular use in the business even if day care children were not allowed in the rooms. Lastly, the auditor disallowed a number of business miles because the mileage records were not maintained contemporaneously. We had prepared monthly summary sheets showing business miles for the audit. We pointed out that the contemporaneous records were the receipts that were used to prepare the summary sheets. After four years of waiting we finally won the issue of the food deduction, and all of the use of the basement and garage. We also won most of the mileage and accepted less than 80% of the shampooer.
- Provider’s tax return shows no profit for three years, primarily because provider’s house expenses are high. Auditor will not allow Time-Space Percentage of 38%. Provider can show profit in subsequent three years. Auditor will only allow one hour a day cleaning after the day care children are gone. Provider shows the auditor the Neilson Tax Court case (Tax Court decision 94-1, 1990) in which provider spent 3 hours per day on business activities after the day care children were gone. Auditor then agrees to split the difference between what the provider claimed and the auditor’s original position. The auditor states that the provider cannot count hours the provider works on weekends when children are not present. The provider writes a letter pointing out that no IRS document limits working hours on weekends and presents evidence of national studies on the average number of hours providers work. After reviewing the provider’s letter, the auditor finally accepts all of the provider’s hours.
- Auditor denies all items that have any personal use (cable television, cell phone, call waiting on the first phone line, gardening items, $125 frame of taxpayer’s undergraduate diploma, new dishwasher, etc.). In addition, the auditor only allows the business use of 50% of the basement. The cause of the audit was the involvement of the tax preparer in a fraud scheme unrelated to the provider. After appealing the case, the hearing officer finally allows the Time-Space Percentage of the dishwasher and 75% of the space in the basement, but does not substantially change other positions. We appealed this case to Tax Court and met with the IRS lawyers before the trial. After a two hour meeting we were able to settle all of the issues. We won on all major items in dispute.
Provider was in debt and regularly borrowed against her checking account to pay for living expenses. At the end of the year she had paid over $3,000 in loan interest on the many short-term loans against her checking account. The auditor is disallowing the business portion (Time-Space Percentage) of this loan interest as a business expense. The auditor also found a $16,000 discrepancy between the provider’s income and her bank deposits. Part of this amount is due to the provider borrowing money from relatives. The relatives sent the auditor notarized statements saying that they did loan money to the provider, but the auditor refused to look at the statements. The provider is now asking the relatives to produce bank statements showing money withdrawn from their bank accounts. The auditor also is claiming that the provider is underreporting her income and is asserting that the parent payment of $125 a week is too low. The provider is presenting evidence of what is the average cost of care in her area, based on data from the local Child Care Resource and Referral Agency.
Auditor states that provider must report as income reimbursements received from the Child and Adult Care Food Program for the provider’s own child. IRS Publication 587 Business Use of Your Home clearly explains that this is not taxable income.
- Auditor denies all depreciation and home office expenses on Form 8829 because provider was occasionally over the limit on the number of children allowed on her child care license for 15 minutes a day, totaling about 10 hours for the year. The auditor’s position was that once a provider is in violation of the state’s licensing law, she is not entitled to any business deductions on Form 8829 or Schedule C (a total of $20,600 in deductions). Tax preparer pointed out that the provider maintained her state license throughout the year and that other businesses that violate state rules (health code violations, fire code violations, etc.) are still allowed business deductions. Even if the provider was operating illegally, she is always entitled to her Schedule C deductions that are “ordinary and necessary” are allowed even if the business owner is operating illegally.
- The auditor is only allowing 50% of the space in the provider’s basement for business use. The basement has a laundry room, bathroom, furnace area, and poolroom where the schoolage children play. This reduces the provider’s Time-Space Percentage from 49% to 39%. The auditor believes that areas not used by day care children cannot be considered regular use for the business. The provider is sending the auditor a copy of the Uphus and Walker Tax Court cases (T.C. Memo 1994-71) that clearly allows the counting of space even when day care children are not present in the room.
Auditor tries to assert that provider can only count hours towards her Time-Space Percentage for those hours in which she is licensed. IRS Publication 587 clearly states that providers who are exempt from state regulation can still claim all allowable deductions on Form 8829 Business Use of Your Home.
- Auditor disallows the deduction of a vacuum cleaner ($100) used 100% of the time for business in an exclusive business-use room (another personal vacuum cleaner is used for all other areas of the home). The auditor also disallowed mileage trips (trip to the bank to make business deposits, field trips, etc.) saying that the provider must produce a mileage log showing odometer readings. The provider had receipts and notations on her calendar showing business trips. She determined the distance to each destination and then multiplied the mileage by the number of trips she took (6 miles to the library x 10 trips = 60 miles). The auditor asked the provider to prepare a reconstruction of her mileage trips that included odometer readings. The provider did so, but the trips were still disallowed. At a meeting with the auditor and the supervisor these trips were later allowed.
The main dispute at the audit was the calculation of the Time-Space Percentage. The auditor took the position that the provider could not count hours spent doing business activities in the home after the day care children left. The auditor’s supervisor would not change the auditor’s report even after the provider pointed out that the IRS MSSP Child Care Guide allows the counting of hours spent after day care children are gone. The provider’s Time Percentage is 37%. The auditor says this Percentage is too high and is therefore unreasonable. The auditor also did not understand the rules regarding an exclusive use room in family child care. The Instructions to Form 8829 clearly explain how to calculate the Time-Space Percentage in this situation. The auditor did not understand that when there is an exclusive use room the Time percent is automatically 100% for that room.
Despite pointing out various IRS publications that supported her position, the provider was unable to get the auditor to change his position. The provider was unsuccessful in her request to have a meeting with the auditor to resolve the dispute. The provider then contacted the IRS Taxpayer Advocate office for help to avoid having to appeal her case. The Advocate talked to the auditor and reported back to the provider, saying that the auditor would not change his report and the provider would have to appeal. The provider then contacted the auditor’s supervisor and requested a meeting that was held. At the meeting with the auditor and his supervisor, they accepted the provider’s hours (although they continued to assert that 37% was high). After reviewing the Instructions to Form 8829 they finally agreed that the provider’s calculation of her Time-Space Percentage was correct. The auditor and the supervisor were surprised to learn that the provider’s position had been correct all along. Without the extraordinary persistence of the provider, she would have had to appeal her case.