One of the most common conflicts that arise in IRS audits is how to allocate the cost of a variety of household expenses. Are they 100% business, 100% personal, or shared business and personal? And if they are shared, how do we determine what portion of the expense to deduct?
I have been involved in sorting out this issue on behalf of several family child care providers who were audited by the IRS. There are no specific IRS rules to guide us as we address how to allocate expenses. Should we look at how an item is used or why it was purchased to determine how much of its cost to deduct as a business expense? In general, I believe it is more reasonable to use the test of how an item is used in the business.
In one audit a provider began caring for a child with asthma and, at the direction of a health professional, cleaned out the heating ducts in her home. She deducted 100% of this cost because she said she would never had done this cleaning if it wasn’t for the fact that she cared for a child with special needs. The auditor originally said that only the Time-Space Percentage of this cost was deductible, but after listening to the provider’s argument she allowed 100% of the expense.
Here are some other examples of household expenses that are under dispute in audits: garage door opener repair, carpet cleaning, pest extermination, Internet access, and lawn fertilizer. The provider claimed 100% of the cost of these items as a business deduction. Providers will get into trouble if they try to deduct 100% of the cost of general household items unless the provider can make a strong case that the item was actually used 100% by the business.
If an item has both business and personal uses, then the most common way to allocate the expense is to use the Time-Space percentage (Form 8829, line 7). In my experience auditors never challenge the use of the Time-Space percentage for a variety of household items that appear on Schedule C. However, there is no rule that says a provider can’t claim an actual business use percentage upon which to base the allocation. To use an actual business use percentage, the provider should be prepared to show records to support this more assertive position.
In one audit a provider cared for 7 day care children and 2 children of her own. Her tax preparer had deducted 100% of many household items that were also used by the family. I told the provider to prepare an actual use statement that showed the number of waking hours the home was populated by business children and her family. Using this analysis, the provider showed a business use percentage of 60%, and the auditor is now considering whether to accept this position. If a provider can show that her licensing worker required (or even recommended) that the provider purchase a particular item (fence, fireplace or furnace screen, smoke detector, fire extinguisher, children’s safety gate, etc.), then this will strengthen the provider’s position in using an actual business use percentage.
To sum up: If you can show that an item is used 100% for your business, claim 100% of the cost. If you use an item for business and personal purposes, do not try to claim 100% of the cost as a business deduction. In these situations, you can either take a conservative position and deduct your Time-Space percentage of the cost, or take an assertive position and deduct a percentage of the cost that is higher than your Time-Space percentage, but lower than 100%. If you choose the assertive position, keep records showing your actual business use.