Tom Copeland 2/22/13 Letter to IRS on Safe Harbor Rule

February 22, 2013

Internal Revenue Service

Attn: CC:PA:LPD:PR

(Rev. Proc. 2013-13), Room 5203

PO Box 7604

Ben Franklin Station

Washington DC, 20044

 

Re: Rev. Proc. 2013-13

 

To whom it may concern:

I am writing to ask for clarifications on several issues raised by IRS Rev. Proc 2013-13. I am also offering several recommendations for modifications of the rule.

All of my concerns are related to how this rule will impact hundreds of thousands of family child care providers who run their business out of their home. I believe that the vast majority of child care providers will not benefit from this new rule and that it will cause great confusion for them and their tax professionals.

I am an attorney with over thirty years of experience in this field who has represented family child care providers in five U.S. Tax Court cases. I provided feedback to the first and second editions of the IRS Child Care Provider Audit Technique Guide in which many of my suggestions were adopted. I successfully lobbied the IRS to adopt the standard meal allowance rule in IRS Revenue Procedure 2003-22. I also convinced the IRS to adopt Form 944 Employer’s Annual Federal Tax Return that reduce the record keeping requirements for many small employers. I have written three recordkeeping and tax books on the unique tax rules facing family child care providers. I work with the National Association for Family Child Care to help child care providers understand record keeping and taxes through workshops, webinars, and writings on my blog (www.tomcopelandblog.com).

Clarifications

1)   Family child care providers use IRS Form 8829 Expenses for Business Use of Your Home to not just calculate and claim the business portion of their house expenses, but also to determine the business portion of many other expenses they claim on Schedule C and Form 4562. These are expenses that are used for both business and personal purposes include such items as toys, swing sets, fence, furniture, appliances, household cleaning supplies, etc. Without filling out Part I of Form 8829, how should a child care provider determine the business portion of these business/personal expenses? One answer might be for the provider to only fill out Part I of Form 8829.

2)   Would a child care provider who chooses the safe harbor rule be allowed to claim her normal business deductions for the following items: furniture, appliances, playground equipment, patio, fence, computer, kitchen utensils, furnace cleaning, etc.? These are expenses that are claimed on either Schedule C or Form 4562 Depreciation and Amortization. I recommend that these expenses
continue to be allowed. Under Section 4.05 it’s not clear what the “expenses unrelated to the qualified business use of the home” covers. It would be helpful to post a longer list of allowable expenses. I can imagine that many tax payers who use the safe harbor rule will be looking to move expenses from
Form 8829 to Schedule C. Should cable television be claimed on Form 8829 or Schedule C? Or how about light bulbs, toilet paper, curtains? Do the following repairs go on 8829 or Schedule? Repair to dishwasher, couch, furnace, microwave (built in and not built in), carpet cleaning, window broken by day care child, etc. It would be extremely helpful to give some guidance on these points.

3)   Some child care providers have rooms in their home used on an exclusive basis for their business. In these rooms they might have children’s furniture, computer, and other business equipment. According to Section 4.06, a child care provider would not be able to deduct “Section 179 expenses for the portion of the home that is used in a qualified business use of the home.” Please clarify what this
means. Does this refer to the expenses associated with the cost of the room rather than with the items in the room? Would the items I mentioned above continue to be allowed to be deducted using the Section 179 rule? Would other items eligible for the Section 179 rule that are in non-exclusive business use rooms in the home also continue to be deducted as Section 179 expenses on Form 4562? Family child care providers are entitled to claim business expenses under IRS Code Section 280A when rooms are used on a “regular” basis.

4)   Please clarify what is meant in Section 407(1) when it refers to using an “optional table” in a situation where a taxpayer is restarting depreciation deductions in a year using Form 8829 when in the previous year the safe harbor rule was used. IRS Publication 946 How to Depreciate Property tells providers to depreciate their home over 39 years using the MACRS rules. Is the optional table the ADS
table? If so that would indicate that the provider would use 40-year depreciation tables. True? If so, it seems unnecessarily complicated to require switching from 39 to 40 year depreciation given the small difference. I suggest allowing taxpayers to continue to use 39 years for home depreciation.

In the example 2 on page 12 of the Rev Proc it has the taxpayer using the GDS depreciation table for year five (2.564%), rather than year 5 of the ADS table of 40 years (2.5%). Which is it?

In addition, the GDS period for property that has no class life is 7 years and the GDS period for a land
improvement (fence) is 15 years. The ADS table for personal property that has no class life is 12 years and since land improvements don’t appear in the ADS table I assume this would also be treated as 12-year property under ADS. If so, a provider would lose depreciation deductions by switching to ADS from 7 year GDS property, but would gain depreciation deductions by switching to ADS from 15-year property. This is confusing and lacks consistency. This issue is important to family child care providers because they have many household items (furniture, appliances, fences, and other items) that fall into the 12-year ADS depreciation period.

5)   If a child care provider and her husband both qualify to claim house expenses under 280A, (his business qualifies under 280(c)(1) and her business qualifies under 280A(c)(4)) can they each choose to use or not use the safe harbor rule? In other words, can he use the save harbor rule for his business and she file Form 8829 for her business?

6)   If a provider had rollover depreciation expenses not allowed in 2012, and chose the safe harbor rule for 2013 she wouldn’t be entitled to these roll over expenses in 2013. If she went back to using Form 8829 in 2014, could she then claim these same roll over expenses on her 2014 8829 (assuming they would be otherwise allowable)?

7)   A licensed provider lives in a home with her boyfriend whose name is on the mortgage/rental contract. Currently, she is not entitled to claim 8829 expenses unless she directly pays for some of the 8829 expenses out of her own pocket. Would she be entitled to use the safe harbor rule if she paid some of the house expenses? What if she only paid for half of the utilities or rent? Is there a minimum amount she would have to pay for house expenses for her to be eligible to choose the safe harbor rule?

8)   Some family child care providers may realize that they will pay lower taxes if they use the safe harbor rule because it will lower their overall business expenses and generate a higher Earned Income Tax Credit. Because of the high scrutiny on taxpayers claiming the EITC, it would be helpful if you make it clear that using the safe harbor rule to get a higher EITC would not be disallowed.

Recommendations

1)   I strongly recommend that you increase the number of square feet allowed to be counted under this rule by family child care providers. The main reason is that family child care providers follow a vastly different standard than every other business when claiming house expenses under IRC 280A.

All home-based businesses, except family child care (or adult day care), can only deduct house expenses if they use one or more rooms in their home “regularly and exclusively” for their business. These non-child care businesses typically use one room for their office and the 300 square foot allowance under this rule bears a reasonable relationship to what most businesses use as exclusive rooms.

Child care providers, however, can deduct house expenses if they use rooms “regularly” for their business. Child care providers must also track the hours they use their home for business activities each year.

Many family child care providers use most, if not all, of their rooms on a “regular” basis. After calculating the hours they work, most providers have a business use of their home percentage between 30 and 40%. I have successfully won audits where this percentage was above 50%. This higher business use percentage of the home allowed for family child care providers more accurately reflects their use of the home (wear and tear) than any other home-based business.

Limiting family child care providers to 300 square feet of their home for their business would unnecessarily discourage them from using this rule.

Let’s look at an example: A provider with $5,000 in house expenses ($2,000 of which are property tax and mortgage interest) and a business use of home percentage of 35% would receive about the same tax benefit whether using the safe harbor rule or filing Form 8829. Below $5,000 in house expenses the safe harbor rule generates higher tax savings.

As the amount of house expenses rises about $5,000 the more likely it is that a provider would benefit by filing Form 8829. In addition, as the business use of home percentage rises above 35% the more likely it is that a provider would benefit by filing Form 8829.

In the past month I have spoken with many family child care providers and tax professionals across the country about this rule. I’ve also spoken before hundreds of child care providers in workshops
I’ve conducted in several states. Well over 90% of them tell me that they pay more than $5,000 in house expenses and most have a greater than 35% business use of their home. They conclude that they will not benefit from this rule. I understand that the additional expenses on Schedule A are an added benefit to using the safe harbor rule. However, even taking this into account the vast majority of child care providers and tax professionals say this rule will not benefit them or their clients.

Child care providers who have exclusive use rooms in their home (in addition to regular use rooms) have higher business use of home percentages and are thus more likely to benefit using Form 8829.

Child care providers who have house rollover expenses are likely to be better off using Form 8829.

Those child care providers who stand to benefit from this rule are those who keep poor records and care for only one or two children, and low income caregivers who are entitled to claim the Earned Income Tax Credit.

If the intent of the safe harbor rule is to encourage taxpayers to use it, then it will be far less useful to
family child care providers as compared to all other home-based businesses.

I also heard from many that they are concerned that tax professionals may push unknowing child care providers into using this rule without realizing that it is not beneficial to their clients. Or, that they won’t take the extra time it will take to figure out if it will be beneficial.

I recommend that the rule be changed to allow family child care providers to claim all the square feet of allowable business space they use for their business. This would then be multiplied by $5 per square foot. A family child care provider with a large home of 2,500 square feet would be able to deduct $12,500 (2,500 x $5) under this rule. This number is much more in line with what child care providers are currently deducting on Form 8829. You may want to look at the average amounts
child care providers are claiming on Form 8829 to see if my assertions are true that few would benefit under the current rule.

I would therefore add the following language under 4.01(2): “The allowable square footage for a qualified family child care providers (or dependent care provider) is not to exceed the total square
feet of the home, not counting any structures separate from the main building, except for a garage.” I included the garage because the IRS Child Care Provider Audit Technique Guide requires providers to include the garage in the total square feet of their home.

If the IRS did increase the number of square feet allowed by family child care providers they could follow the similar formula outlined in Section 4.08 (4) for child care providers who change square footage during the year.

2)   I recommend that the all businesses be allowed to amend their tax return in later years and change their method of claiming house expenses. I do not understand the purpose behind not allowing amended tax returns.  Allowing a taxpayer to change from using Form 8829 to the safe harbor rule in an IRS audit would certainly help reduce the paperwork and time spent by both sides in the audit. Child care providers can now amend their tax return to change methods of claiming food expenses (standard meal allowance rate vs. actual food expenses) and can amend to use the actual car expenses
method from the standard mileage method. By not allowing child care providers to amend when determining the method of claiming house expenses, the IRS will make it even less likely they will use the safe harbor method. Determining whether to use the safe harbor method or Form 8829 will be a complicated calculation to make for both the child care provider and tax professional. It will require more time and paperwork than before the safe harbor rule existed. Many will make mistakes. Not allowing amended tax returns will punish those who choose the wrong method.

3)   I recommend that the IRS add a cost of living adjustment to the $5 per square foot allowance. Any increase in this amount can be limited by allowing only a minimum increase of no less than $.25 in a year.

4)   I recommend that taxpayers be told to enter their safe harbor rule deduction on Schedule C, Part V Other Expenses.

5)   Lastly, I recommend that you explain this new rule in IRS Publication 587 Business Use of Your Home in the existing Day Care Facility section. I urge you to add some clarifying language here that explicitly states that child care providers can use this rule if they have applied for a license or are exempt from a license. Although this language now appears in the section, it is often overlooked, in
my experience, by tax professionals and providers.

If you do decide to add language to Publication 587 I recommend that the IRS make some additional changes that would help reduce confusion. This publication is the most widely read IRS document by tax professionals and family child care providers regarding tax issues in this field. However, some
of the language in the publication conflicts with other IRS documents or needs clarification.

Business Use of Home Examples

The publication gives three examples on how to allocatehouse expenses in a family child care business. Examples one and three has a child care provider using only her basement area for her business. Example two adds the use of one room for naps. As a result, the examples show the child
care provider with a business use of home percentage of 17.08%, 20.53% and 17.76% respectively.

Unfortunately, all three examples are atypical of how family child care providers use their home for business. Typically, child care providers use all or nearly all of their rooms on a regular basis for their
business: kitchen, bathrooms, living room, dining room, bedrooms and so on. Child care providers commonly are licensed to use their entire home in their business. In the situations where licensing does not allow children to be in areas where there are not two exits (typically basements) most child care providers use the basement on a regular basis for laundry, furnace area, storage and so on.

In the Uphus and Walker Tax Court cases (Uphus and Walker vs Commissioner, TC Memo 1994-71) child care providers were allowed to claim basement and garage areas even though children were not present in those rooms.

In my 30 years of experience talking with tax professionals and family child care providers, I would estimate that the average space percent (Form 8829, line 3) is between 80-90%. Therefore, I would recommend changing the three examples to include a child care provider who uses at least 80%
of her home on a regular basis for her business.

In addition, several national studies indicate that providers care for children, on average, eleven hours a day, five days a week. Many care for children longer than this. Child care providers also work
additional hours after children are gone cleaning, activity preparation, meal preparation, record keeping, parent phone calls, and more. One national study found that providers worked an average of 13.9 hours a week on these additional activities. It would be helpful if at least one of the examples in this publication included more than 60 hours a week of business activity. The IRS could also check to see what family child care provider’s space and time percentages average on Form 8829 to see if my assertions are reasonable.

Inclusion of the garage

The IRS Child Care Provider Audit Technique Guide says, “You must be sure that the square footage of the garage is added to the denominator (total home space) as well as the numerator (business usage space).” I recommend including language in Publication 587 that calls on child care providers to include their garage in the square footage of their home.

 “Netting” Food Program income and food expenses

The Publication says, “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. If your reimbursements are more than your expenses for
food, show the difference as income in Part I of Schedule C (Form 1040). If your food expenses are greater than the reimbursements, show the difference as an expense in Part V of Schedule C (Form 1040)…. Follow this procedure even if you receive a Form 1099-MISC, Miscellaneous Income, reporting a payment from the sponsor.”

These directions to “net” Food Program income and food expenses are not consistent with the directions in the more recently drafted Audit Technique Guide: “The netting method is not a preferred method since an Examiner will always be looking for the food reimbursement amounts.”

This language in Publication 587 continues to confuse tax professionals and child care providers. It causes many to show this as a “wash” when this is not an accurate accounting. Child care providers trying to “net” sometimes report food expenses, but not Food Program income. In my experience,
IRS auditors always ask to see documents showing Food Program reimbursements and food expenses.

I recommend changing this language with a more direct series of statements: “Reimbursements received from the Child and Adult Care Food Program must be reported as income in Part I of Schedule C (Form 1040). This includes any amounts reported on a Form 1099-MISC, Miscellaneous Income. Food expenses are reported as a deduction in Part V of Schedule C (Form 1040). Do not include payments or expenses for your own children if they are eligible for the Food Program.”

Clarification of the use of the standard meal allowance method when the provider is caring for relatives

The Publication (page 13) describes situations where the standard meal allowance rule cannot be use. One example involves care provided in the home of a child or whose parents are residents of the same home as care is provided. There are situations where a grandmother is being paid to care for her grandchild and the grandmother lives in the home of the child. This grandmother is also on the Food Program and receiving Food Program reimbursements for her grandchild. Under the language of this publication, the grandmother would not be able to use the standard meal allowance rate. This seems illogical, since the grandmother must report the Food Program reimbursements as income and is certainly entitled to claim food expenses as a business deduction. I would recommend adding clarifying language that allows the standard meal allowance to be used when a relative is being paid to care for the child.

Thank you for considering these clarifications and recommendations. I would be happy to discuss any aspect ofmthis letter by phone (651-280-5991) or email (tomcopeland@live.com).

Sincerely,

 

 

Tom Copeland, JD



Categories: Deductions, Record Keeping & Taxes, Tax Return

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