Time-Space Percentage: a Case Study

When the IRS audited family child care provider Kay Gillock last fall, there were two main issues in dispute: how much space in her home did she use in her business, and how many hours did she work in her home. Kay claimed she used 98.87% of the space in her home and worked 84.8 hours per week (50.3%). When the auditor issued his report that allowed only 57.31% of her space and 44.4% of her time, Kay fought back—and won.

The way that Kay responded to the IRS report is a textbook example of how to make a case to the IRS in an audit. With Kay’s permission we have made the IRS report, her response to the report, and the IRS letter that conceded these two issues available on our website. Family child care providers can learn much from these documents on how to prepare their own audit defenses.

Space

In the IRS report, the auditor said, “To calculate the allowable business use percentage and using the figures provided by the taxpayers, each room that is necessarily used regularly for the daycare was included. The taxpayers’ master bedroom and bath and their children’s bedrooms and bath were not included, as it is not necessary for the operation of the daycare that the taxpayer use these areas. The taxpayers choose to put the children in these areas, but they could also have allowed them to sleep in the area used exclusively as a daycare room. As for storage areas, if the taxpayers choose to store paperwork or supplies in small corners of each room of their home, it does not follow that they should then be allowed business use for each of the areas.

“For example, because a taxpayer places a child’s block set in one corner of his 200 square foot family room, he may not then include this entire area as apart of the business use percentage of the home. This does not follow the ‘reasonable person’ test. A reasonable person would not expect that a small daycare operation would need to utilize an entire home for the care of 3-5 children.” (emphasis added) Later, the report said, “Spreading the children throughout the upper level of the personal residence is not considered necessary for the operation of the daycare and will not be allowed as a way to obtain a larger business-use percentage deduction.”

Time

In this case, Kay worked an average of 24.8 hours a week on daycare activities in addition to working 60 hours a week caring for children. This represents a large number of hours spent working after the day care children were gone. The auditor’s report said, “The operation of a small daycare should not require this dedication of time, particularly one that, according to the taxpayers, produces zero profit every year…An additional 15 hours per week is a reasonable amount of time for tpw (sic) to take care of those things that she cannot during operational hours such as cleaning, paperwork and preparing for activities, whether they are performed during weekdays or on the weekend.”

It is significant that the auditor determined that it was “reasonable” for Kay to claim 15 extra hours per week. I have seen many audits where auditors initially determined that no more than 5 hours a week was “reasonable.”

Responding to the IRS Report

After receiving this report, Kay contacted me and we discussed how to reply. Her ten-page letter to the auditor contains the following key elements that should be used as a guide for all providers in responding to IRS positions:

Ask the IRS for written authority to support their position.

Usually the auditor will not be able to do so. In this case, the auditor referred to a “reasonable” position. When the auditor thinks something is “reasonable,” it opens the door for the provider to argue that it’s not. What is reasonable or not will often depend on the facts of the situation and it is easier to argue facts than the law.

Cite any IRS authority that supports your position.

Kay’s letter cited a Revenue Ruling, Tax Court case, IRS publication, and the IRS MSSP Child Care Audit Guide that all supported her position. Faced with IRS authorities that challenge their position, auditors will often back down.

Cite any state licensing rules that support your position.

Kay cited several state licensing regulations that required her to store poisons and cleaning supplies in separate areas, that required children to sleep in a quiet, dark room, and a recommendation by her licensing worker that infants sleep in each of her own children’s bedrooms. This helps support a provider’s claim that her position is reasonable.

Educate the auditor about the business of family child care by describing the facts in detail.

Kay’s letter explained in great detail how each of her rooms were used and how she spent her time. Providers can never give too many details in describing how they use their home for business, and Kay’s letter is an excellent example of how to educate an auditor about what goes on in family child care. Even though the auditor had visited her home, Kay’s letter offers evidence that clearly rebuts the auditor’s conclusions. Kay’s letter is believable because she kept daily records of the hours she worked.

Conclusion

After receiving Kay’s letter, the auditor’s supervisor issued a new report five months later. A letter accompanying the new report said, “This report is the result of extensive research on the part of the examiner and myself and discussions with Internal Revenue Service District Counsel. As you will see in the report, we have conceded the issues of square footage of the home allowable as business use and the amount of time spent working on your business per day.”

In other words, it was reasonable for Kay to use practically all of the rooms in her home for her business, even though she had 3-5 children in care. In addition, Kay’s 85 hours of work per week were also deemed to be reasonable. Although her work hours were higher than the average provider she kept careful records to back up her claim. I strongly advise providers to keep at least two months a year of detailed records of the hours worked. The longer the hours you work the more detailed your records should be. Kay’s detailed records made a difference in her case.

Although individual audits cannot be used as precedents in other cases, Kay’s audit is instructive. The IRS did check with District Counsel, who backed up Kay’s position. This gives weight to other providers who take a similar position to Kay’s. The IRS did not provide any written authorities to support their bogus claim that it was not necessary for Kay to use all the rooms in her home. Providers and tax professionals should not be afraid to forcefully respond to an audit report with their own additional facts and authorities.

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