TAXATION OF DAYCARE PROVIDERS

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2 Hour(s) - Other Federal Tax

NASBA: 116347

CTEC Provider #: 6209CTEC Course #: 6209-CE-0054

IRS Provider #: UBWMFIRS Course #: UBWMF-T-00215-21-S

The information provided in this publication is for educational purposes only, and does not necessarily reflect all laws, rules, or regulations for the tax year covered. This publication is designed to provide accurate and authoritative information concerning the subject matter covered, but it is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

To the extent any advice relating to a Federal tax issue is contained in this communication, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

COURSE OVERVIEW.............................................................................................................................................................. 7

Course Description ....................................................................................................................................................................... 7

Learning Objectives ...................................................................................................................................................................... 7

JONELLE MARIE BROADLY V. COMMISSIONER ................................................................................................................. 7

TC Summary Opinion 2008-63 .................................................................................................................................................... 7

DEFINITIONS: TYPES OF CHILDCARE PROVIDERS ............................................................................................................. 8

Kith and Kin Caregivers ................................................................................................................................................................ 8

Babysitters ..................................................................................................................................................................................... 9

In-Home Care ..............................................................................................................................................................................10

Childcare Centers........................................................................................................................................................................10

Tax-Exempt Daycare Providers .................................................................................................................................................11

INCOME ISSUES.................................................................................................................................................................. 14

In General ....................................................................................................................................................................................14

Food Program Reimbursements...............................................................................................................................................14

EXPENSE ISSUES................................................................................................................................................................. 16

Substantiation Requirements ...................................................................................................................................................16

Depreciation of Property Other Than the Home ....................................................................................................................18

Vehicle (Car and Truck) Expense...............................................................................................................................................19

Travel and Meals.........................................................................................................................................................................19

Food Expense ..............................................................................................................................................................................20

Business Use of the Home.........................................................................................................................................................21

Toys ..............................................................................................................................................................................................24

Advertising...................................................................................................................................................................................24

Bad Debts ....................................................................................................................................................................................24

Commissions and Fees ..............................................................................................................................................................25

Employee Benefit Program/Pension and Profit Sharing........................................................................................................25

Insurance .....................................................................................................................................................................................25

Office Expenses and Supplies ...................................................................................................................................................25

Rent ..............................................................................................................................................................................................26

Start-Up Costs .............................................................................................................................................................................26

Telephone Expense ....................................................................................................................................................................26

Utilities .........................................................................................................................................................................................26

Bank Charges ..............................................................................................................................................................................27

Wages/Compensation ................................................................................................................................................................27

GLOSSARY .......................................................................................................................................................................... 28

Glossary .......................................................................................................................................................................................28

Course Description 7

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COURSE OVERVIEW

COURSE DESCRIPTIONIt is estimated that over 130,000 daycare businesses employ almost one million workers in the U.S. Most of these businesses have five or fewer employees, and many are sole proprietorships run out of the owner’s home. Many daycare providers are unaware of, or simply misapply, the somewhat confusing tax rules to which they are subject. This course guides the practitioner through the tax complexities, focusing on the proper determination of deductions, so that you may be better positioned to identify the issues and help your client minimize tax burden and the chance of noncompliance.

LEARNING OBJECTIVESIdentify different types of daycare providers

Identify the standards by which an expense is classified as a business deduction

Understand which types of property qualify for depreciation deductions, as well as rules for determining basis

Determine sources of business expenses such as business related travel, payments for food and toys, start-up costs, and business use of home

Identify when a daycare provider can consider bad debt as an expense

Understand rules for paying wages and compensation to all levels of employees, including family members and independent contractors, as well as classification of payments made to the business owner

JONELLE MARIE BROADLY V. COMMISSIONER

TC SUMMARY OPINION 2008-63 

Jonelle Marie Broadly was an unmarried mother of four small children who never considered herself an entrepreneur. Raising four kids did not leave time to work outside of her home in Bowie, Maryland, and what ended up as a business started, more or less, by accident.

First, her sister asked if she could look after her children. Shortly thereafter, her boyfriend's sister asked Jonelle the same thing. The extra money came in handy, and Jonelle was apparently a good care provider. Soon she began receiving similar inquiries from neighbors, parents at her children's school, and parents she met while shopping in the supermarket.

She agreed to provide care for these children, but never applied for a daycare license. By 2003, Jonelle was caring for at least eight children other than her own. She provided breakfast, lunch, and two snacks to the children in her care. She used most areas of her home for the activity, including the family room, dining room, and kitchen. She also took the children on educational field trips using her own car.

Jonelle provided care for the children five days a week, from early morning through the early evening. She charged $80 per week for full-day services and $60 per week for after-school care. She accepted only cash, which she primarily used to purchase items related to her care for the children. Any remaining amounts were deposited into her personal checking account and used for personal items. At the end of each calendar year, Jonelle would provide the parents with a dated receipt showing the total number of weeks of care she provided to them and the total cost.

On her 2003 income tax return, Jonelle dutifully reported the income from her childcare activities, but she did not claim any expenses. The IRS audited her return and denied the additional child tax credit and the earned income credit on the ground that she had no earned income. Like Jonelle, it seems, the IRS did not consider her activities a business.

8 Definitions: Types of Childcare Providers

During the audit, Jonelle amended her return to report expenses in the amount of $12,445 related to her childcare activities. These expenses included advertising, car and truck expenses, office expenses, repairs and maintenance, and utility costs incurred in her daycare business. The IRS did not accept her amended return and took the position that her expenses were unsubstantiated.

No doubt due to her failure to recognize the childcare activities as a business, Jonelle had scant records to support either her income or her deductions. Even the Cohan rule, which provides for estimating of business expenses by the Tax Court under the proper circumstances, could not come to her rescue. The Tax Court even felt that Jonelle had overstated her income from childcare. Although she claimed to have made $22,190, the court found that the actual number was more like $17,950.

As far as expenses, all she was able to provide were copies of her checking account statements and canceled checks made payable to the electric company. Jonelle testified as to having printed business cards and placing advertisements in the "Pennysaver" gazette, using her car for occasional field trips with the children, buying arts and crafts supplies, and feeding the children at least two meals and two snacks each day. She did not, however, provide any records or receipts to substantiate any of these expenses, and could not even produce a sample of her business cards.

Jonelle Broadly learned the hard way that a casual attitude about a daycare business can have substantial tax consequences. Had she recognized her activities as a business and kept adequate records, she could have saved herself a lot of stress, not to mention a hefty tax bill. Given the prevalence of casual daycare services, practitioners are well-advised to understand the rules so they can better assist their clients in avoiding the same fate.

DEFINITIONS: TYPES OF CHILDCARE PROVIDERS

KITH AND KIN CAREGIVERS 

"Kith and kin" caregivers are the most informal type of childcare providers. They are typically relatives, friends, and neighbors who provide care while the parents are working, whether paid or not, in either their home or child's home. For example, it is not uncommon for a parent to take care of one or two additional children for extra income.

Generally, this type of care is not under much state regulatory control and may be exempt from licensing requirements in some states. In Wisconsin, for example, a person who provides care to fewer than three children who are related to the caregiver is generally not required to be licensed. On the other hand, in Connecticut childcare arrangements that are for more than 3 hours a day outside of the child's home on a consistent basis require licensure.

Because of this general lack of state regulation, these providers often believe that the income generated is not taxable and, therefore, need not be reported. Absent a specific exclusion, however, all income, from whatever source derived, is taxable.

Kith and kin or family childcare providers may be able to deduct related expenses from their taxable income. If a caregiver does not comply with any applicable state regulations, however, deductions may be denied. As long as the regulations are adhered to, the mere fact that the children are related to the caregiver will not impact the deductibility of ordinary and necessary expenses.

Even this situation may be fraught with tax uncertainty. For example, when the daycare provider selected by the parents under a government-subsidized program is a family member, the tax situation is unclear. Is the money received for the care of the related child business income? The most common scenario is when a grandparent -- who otherwise does no childcare -- is selected as the daycare provider and is paid by the state for this service. At tax time, the income must be reported on the grandparent's tax return, but how? As earned income on Schedule C? As other income on Schedule 1 Is this a daycare business? This issue was raised in Steele v. Commissioner in the Tax Court. The court ruled in this case that the income was subject to income tax, but not self-employment tax.

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Babysitters 9

During 2005 Derrolyn and Terry Steele cared for their young granddaughter. In this regard, the Steeles received $16,974 from the State of Illinois for providing that care. They did not contend, and there was no evidence to suggest, that the payments were qualified foster care payments.

At that time the State of Illinois offered a Child Care Assistance Program ("CCAP") to low-income, working families to provide them access to affordable childcare so they might continue working or participating in eligible education programs. Under this program, the State of Illinois made payments directly to a childcare provider chosen by the parents or legal guardian of the child. The childcare provider received a Form 1099-MISC from the State of Illinois at the end of the year reflecting the CCAP payments.

Both Derrolyn and Terry received Forms 1099 from the State of Illinois for payments made during the year at issue, and the income reflected therein was includable in their gross income under Code section 61. The remaining issue was whether that income was also subject to self-employment tax pursuant to Code section 1401.

Code section 1401 imposes a tax on the self-employment income of individuals. Code section 1402(a) provides that such income is subject to the self-employment tax if it is derived from a taxpayer's participation in a "trade or business" carried on by the taxpayer. Section 1402(c) explains that the term "trade or business" in the self-employment context has the same meaning as when used to apply the expense provisions of Code section 162. "Trade or business" under section 162 has been interpreted to mean an activity conducted "with continuity and regularity" and with the primary purpose of making income or a profit.

There was no question that Derrolyn and Terry regularly provided care for their granddaughter and that they were compensated for doing so. But, the Tax Court concluded, they were not carrying on a "trade or business." Not every income-producing and profit-making endeavor constitutes a trade or business, observed the court, rather the primary purpose for engaging in the activity must be for income or profit.

Derrolyn and Terry were providing care for their granddaughter because their daughter was unable to do so. There was no allegation by the IRS that they were running a daycare center and their granddaughter was one of the children being cared for. The money they received from caring for their granddaughter was not their main source of income, nor did they seek to deduct expenses against the money they received from the State of Illinois. Based on the facts presented, the court concluded that it was clear that the couple's primary purpose in caring for their granddaughter was not to profit such that they were engaged in a "trade or business". Accordingly, the Steeles were subject to income tax on the amounts received from the State of Illinois, yet those amounts were not subject to self-employment tax under Code section 1401.

BABYSITTERSBabysitters provide childcare in the child's home on an irregular basis, such as when the parents go out to an event leaving the children under the care of a college student. As with "kith and kin" childcare, the income generated by a babysitter is taxable income.

A taxpayer is generally responsible for social security and Medicare taxes ("FICA") if he or she pays someone $2,300 or more in 2021 in cash or other equivalent compensation for the year. The FICA tax, however, does not apply with respect to domestic service (such as babysitting) performed in the private home of the employer by an employee under the age of 18, as long as the domestic service is not the principal occupation of the employee. Thus, a teenager hired for occasional babysitting would generally not give rise to federal employment taxes.

But if providing babysitting services is the person's principal occupation, employment taxes would apply, even if the person is under age 18. Note that being a student counts as a principal occupation. So, for example, a 17-year-old student who babysits is generally not subject to FICA. On the other hand, a 17-year-old single mother who drops out of school and earns money principally from babysitting would likely be subject to FICA.

Furthermore, a babysitter may be considered a household employee (and thus subject to FICA) if the taxpayer can control both the work to be done and how it is to be completed. Thus, if the babysitter is considered a household

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10 Definitions: Types of Childcare Providers

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employee and is paid at least $2,300 during 2021, the payor would be responsible for FICA taxes. Generally, a taxpayer is not required to withhold federal income tax from a household employee's wages unless the household employee so requests. In that case, the babysitter would have to provide a Form W-4.

Often, a household employer will opt to pay the employee's share of the FICA taxes, as well as their own, instead of withholding them from the employee's wages. In that case, the tax is paid by the employer and the employee's wages must be "grossed up" to reflect the additional payment. This liability is reflected on Schedule H of the payor's Form 1040 rather than on an employment tax return.

IN-HOME CARE 

In-home care includes services provided by a paid housekeeper, maid, governess, "au pair" or nanny. The in-home caregiver is generally paid as a household employee, as described above, and the parents show wages on Schedule H attached to their Form 1040. This situation is not a childcare business because the in-home caregiver receives wages but does not incur expenses as a childcare provider. Most states do not regulate in-home caregivers, but some states regulate nanny-placement agencies.

CHILDCARE CENTERSChildcare centers provide services in facilities separate from the caregiver's residence. A childcare center may be organized as a corporation and taxed under Subchapter C or Subchapter S of the Internal Revenue Code ("Code"). They may also be organized as partnerships or limited liability companies taxed under Subchapter K. Sometimes such businesses are run as stand-alone facilities, or there may be multiple facilities operated by the enterprise. All states require childcare centers to be licensed, although the specifics vary from state to state. State law may require these centers to report attendance records or other similar information. Often they have large commercial kitchens, playground equipment, swimming pools, and large quantities of toys.

State laws vary greatly in terms of regulated activities and exemptions. For example, in North Carolina the following programs are exempt from regulation:

Recreational programs operated for less than four consecutive months in a year (e.g. summer camps);

Specialized activities or instruction such as athletics, dance, art, music lessons, horseback riding, gymnastics, or organized clubs for children, such as Boy Scouts, Girl Scouts, 4-H groups, or boys and girls clubs;

Drop-in or short-term care provided while parents participate in activities that are not employment-related, and where the parents are on the premises or otherwise easily accessible, such as drop-in or short-term care provided in health spas, bowling alleys, shopping malls, resort hotels, or churches;

Nonpublic schools that are accredited by the Southern Association of Colleges and Schools and that operate a childcare facility for less than six and one-half hours per day;

Vacation Bible schools;

Centers and homes located on federal property over which the federal government has control (military based and the Cherokee Indian reservation); and

Cooperative arrangements among parents to provide care for their own children as a convenience rather than for employment.

On the other hand, all regulated childcare centers in North Carolina have to meet specified standards. The state childcare requirements ensure that programs are meeting the minimum standards for care in North Carolina. Programs in that state must maintain a compliance history of 75% for the past 18 months or the length of time the facility has operated. Some of the childcare licensing requirements that are checked in a program's compliance history are:

Supervision of children

Tax-Exempt Daycare Providers 11

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Condition of equipment and materials

Discipline practices

Child/staff ratios

Sanitation practices

Staff education and training development

In addition, centers are required to meet sanitation, building and fire codes as required by other state agencies.

In Texas, the Department of Family and Protective Services licenses childcare centers and group childcare homes and registers family childcare homes. That state distinguishes between centers that must be licensed, those that must be "registered," and those that must be "listed."

In Oregon a provider must be licensed as a "Registered Family Child Care Home" if: the provider provides childcare to more than three children, unless they are all from the same family; the provider provides childcare on other than an occasional basis (i.e., fewer than 70 days in a calendar year); or if the provider receives payment from an agency that requires you to be licensed.

Oregon specifically exempts providers that:

provide care to a child in his/her own home;

provide care to three or fewer children, not including the provider's own children;

provide care to the children of only one family;

provide care only on an occasional basis and are not ordinarily engaged in providing childcare;

are the child's parent, guardian, or person acting in place of the parent; or

are related to the child by blood, marriage, or adoption.

Because the rules vary greatly from state to state, each provider should become familiar with his or her own state's rules. Those rules are generally easily located on the internet.

TAX-EXEMPT DAYCARE PROVIDERS 

While daycare providers may operate on a tax-exempt basis, they must be careful to strictly adhere to the organizational and operational tests under Code section 501(c)(3). Much can be learned by daycare providers from Rameses School of San Antonio, Texas v. Commissioner, where the Tax Court upheld the revocation of the tax-exempt status of an organization known as the Rameses School. The court found that the assets of the exempt organization inured to the benefit of the President and CEO of the school. The private benefit and inurement, in this case, included undocumented expenditures and withdrawals made on the President and CEO's behalf, and questionable payments made for real estate transactions and lease payments. The court also found that there was no proper oversight, as the CEO and President were allowed to direct questionable payments for her benefit, unchecked by the board of directors or any other internal control mechanism.

It was beyond question that some of the activities of the Rameses School were consistent with tax exemption. Nonetheless, the court noted that the presence of a single nonexempt purpose, if substantial in nature, precludes exempt status, regardless of the number or importance of truly exempt purposes. The court went on to state that, if an organization can be shown to benefit private interests, a limitation substantially overlapping but encompassing more than simply the inurement of earnings to insiders, it will be deemed to further a nonexempt purpose. Private benefits within the scope of the prohibition may include an advantage, profit, fruit, privilege, gain, or interest.

The Rameses School was formed as a nonprofit corporation under the laws of the State of Texas on September 22, 1995. Pursuant to its articles of incorporation, it was organized for the stated exempt purpose of operating a school "to provide a sound education for all school-age children within the City of San Antonio and Bexar County, Texas." The

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12 Definitions: Types of Childcare Providers

school maintained its principal place of business in San Antonio, Texas. Patricia L. Fennell ("Ms. Fennell"), the founder, had from its inception served as the school's executive director, president, and CEO. The articles of incorporation and the bylaws adopted in accordance therewith provided for a board of directors to oversee governance of the school.

During 1996, the school submitted to the IRS, a Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. By letter dated May 9, 1997, they received recognition from the IRS as an organization exempt from taxation under section 501(a) by reason of being described in section 501(c)(3). Exempt status under section 501(c)(3) rendered the school eligible under the Texas Education Code to apply for an open-enrollment charter, and thereby to be recognized as a state public school entitled to receive public funding. The Rameses School so applied and on May 14, 1998, obtained from the Texas State Board of Education ("SBOE") the requested open-enrollment charter. The charter, in accordance with applicable state law, imposed upon the school conditions related to its operations, including rules to require compliance with generally accepted accounting principles and recordkeeping standards, to restrict conflicts of interest and less than arm's-length transactions, and to adhere to specific dictates governing student attendance and special education programs.

In 1995, the school began operating a school offering pre-kindergarten through grade 12 instruction to children. The school employed what is referred to as a "multi-age level" or "one-room schoolhouse" setting. Throughout its history, the school has focused on serving a racially and ethnically diverse, economically disadvantaged population, with the majority of the student body drawn from minority groups.

Classes were initially conducted on property leased to the school. However, the school later became the record owner of property constituting the school's principal place of business. Nonetheless, by a rental agreement, Ms. Fennell purported to lease the property to the school for $1,500 and $1,000 per month, respectively.

The school maintained various commercial checking accounts at Frost National Bank. Ms. Fennell possessed check-writing authority on these accounts. Checks from petitioner's bank accounts were issued to make purchase price and mortgage payments on the properties titled to Ms. Fennell in her personal capacity. Petitioner's funds were likewise used to make payments on leases entered by Ms. Fennell as an individual on other properties. Ms. Fennell, also from the school's bank accounts, issued checks to herself as payee and made cash withdrawals for which the record reflects no documented and established business purpose. The business purpose or board authorization is similarly lacking for thousands of dollars of expenditures directed to retail stores, credit card companies, financial institutions, Ms. Fennell's dentist, and other businesses. There was no evidence suggesting any documented system either (1) of loans to and repayments by Ms. Fennell or (2) of loans by Ms. Fennell and reimbursements from the school.

Examination by the IRS into the school's tax-exempt status began in late 2001, precipitated by the forwarding to the IRS of a newspaper article reporting the revocation of the school's charter. The IRS conducted an investigation into whether petitioner complied with the standards imposed under section 501(c)(3). In particular, the IRS sought financial and governance records in order to verify the information reported by the school on Form 990 and to evaluate the records for possible instances of private benefit and personal inurement. To that end, dozens of information document requests were issued to petitioner, but only a very limited portion of the requested materials was ever provided, and often only after repeated inquiries, missed or delayed appointments, and a general lack of cooperation on the part of petitioner. The examination culminated with a final adverse determination. The conclusion was that the school failed to establish that it was operated exclusively for an exempt purpose, in that it was operated for the benefit of private interests and a part of net earnings inured to the benefit of its founder Ms. Fennell.

The term "educational" for purposes of tax exemption under the Code relates to: (a) the instruction or training of the individual for the purpose of improving or developing his capabilities; or (b) the instruction of the public on subjects useful to the individual and beneficial to the community. The regulations also list several examples of educational organizations, including "An organization, such as a primary or secondary school, a college, or a professional or trade school, which has a regularly scheduled curriculum, a regular faculty, and a regularly enrolled body of students in attendance at a place where the educational activities are regularly carried on."

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Tax-Exempt Daycare Providers 13

However, regardless of the presence of what might otherwise be proper exempt purposes, an explicit exception to section 501(c)(3) status exists in that an organization is not organized or operated exclusively for one or more of the purposes unless it serves a public rather than a private interest. Thus, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests. In the case of the Rameses School the Tax Court found that the factual circumstances were more than sufficient to establish prohibited private benefit.

It is not unusual for the IRS to revoke the exempt status of daycare providers. Take, for example, the case of one particular organization that was granted exemption under Code section 501(c)(3) by the IRS as a daycare provider.The organization was governed by the President and her family. The husband of President was the Vice-President of the organization and the President's daughters served on the board of directors. The President was also the owner of related for-profit daycare centers.

The exempt organization made a significant loan to the President. The loan agreement in place stipulated an interest rate of 9%. Throughout the course of this loan, there were various advances made to President, increasing the loan balance. It was determined by the IRS that for a loan of this type, a 9.9% interest rate represented fair market value. This loan was shown by the exempt organization to have been paid off by the President at an interest rate of 5%, which was less than the loan agreement stipulated. In addition, there was a second loan extended to President. Throughout the course of this loan, there were various advances made to President, increasing the loan balance. This loan was shown by the exempt organization to have been paid off at a 0% interest rate. It was determined that for a loan of this type, a 9.9% interest rate also represented fair market value. Therefore, in the cases of both loans, the exempt organization provided the President with a private source of credit at rates below fair market value.

In addition to these loans, there were various expenditures made from the exempt organization by President, or on her behalf, that were for her personal benefit. The majority of these expenditures represent those of the type that were questionable and for the most part unsubstantiated. These expenditures included leasehold improvement expenses, such as a new fence and landscaping. However, during an initial tour of the facility by the IRS, there was no new fence or landscaping observed. The President provided no further explanation that would indicate the expenditures were that of the exempt organization. Based on visual inspections and the lack of substantiation, it was determined that 50% of the amounts expended on leasehold improvements were reasonably made for the exempt organization and 50% of the expenditures were made for the personal benefit of President.

There were also questionable telephone expenses. A review of the exempt organization's invoices revealed that the organization had a number of telephone lines at different locations. In addition, the exempt organization shared its cell phones with President's related for-profit organization. Based on the sharing of resources between the exempt organization and related for-profit, it was determined that 50% of the expenditures were reasonably made for the exempt organization and 50% were made for the personal benefit of President. Other questioned expenses were for repairs and maintenance and for advertising and promotion.

The financial records also showed that the exempt organization paid property taxes for the building it leased from the President. However, the lease did not state that the lessee would pay property taxes. A review of the exempt organization's canceled checks also shows that the Tax ID number on some of the canceled checks represents the Tax ID number of the President's home address. Because there was no documentation to show that the exempt organization was responsible for paying the property taxes on the building under the lease agreement and because the President's personal property taxes were paid with the exempt organization's funds, it was determined that all payments made to cover property taxes were made for the personal benefit of the President.

The records further showed that the exempt organization made a number of payments out of its account for reimbursements and payments on the President's personal credit card. The request to provide receipts to substantiate the reimbursements was not provided. In fact, copies of the credit card statements were provided and revealed that some of the amounts had already been reimbursed to employees out of petty cash. Documentation

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requested to provide clarification on the use of the vehicle expense and petty cash accounts was not provided. Based on the sparse details provided, it was determined that 33% of the vehicle expenditures were made for the benefit of the exempt organization and 67% were made for the personal benefit of the President.

The exempt organization was leasing six passenger cars and had ownership of four passenger vans. The organization was cited for using passenger cars to transport children because those vehicles were not authorized by the state to transport children. Because the vehicles had never been authorized to transport children, they were not leased to further the exempt purpose of the organization. Since there was no documentation showing why the exempt organization needed the vehicles and how they were used to further exempt purposes, it was reasonably determined that 33% of the expenditures were made for the exempt organization and 67% of the expenditures were made for the benefit of the President.

In summary, between the provision of loans at advantageous terms and the personal expenditures made on the President's behalf, the IRS determined that the assets of the organization were improperly used to benefit private interests. The assets of an organization exempt under IRC Section 501(c)(3) are not allowed to benefit private interests. Where the assets of an organization exempt under IRC Section 501(c)(3) benefit private interests, the law provides that such an organization is not exempt. The President of the organization stated in response that she was unaware of the issues involving inurement and would not have applied for exempt status had she known. As if often said, ignorance of the law is no excuse.

INCOME ISSUES

IN GENERALAs noted, income generated by a caregiver is taxable income and may be subject to self-employment tax. Sole proprietors report childcare income and expenses on Form 1040, Schedule C, with the net income reported on Schedule SE to compute self-employment tax. Partnerships report income and expenses on Form 1065 with the net income passing to the partners on Schedule K-1 and reported on the partners' Form 1040, Schedule E, and Form SE, if SE applicable. Similarly, S corporations report income and expenses on Form 1120S and pass through the net income to the shareholders on Schedule K-1, with the net income to be reported on the shareholders' Form 1040, Schedule E. C corporations report income and expenses on Form 1120.

Some providers may be doing business as limited liability companies ("LLCs"). Depending on the circumstance, LLCs may be taxed as a sole proprietorship, partnership, or corporation. If the LLC is owned by one person, it is a "disregarded entity" and the income and expenses are reported directly on that person's Schedule C of Form 1040. LLCs with multiple owners are generally taxed as partnerships, but may elect to be taxed as corporations under the "check the box" regulations by filing Form 8832.

PRACTICE TIP: WRITTEN RECEIPTS FOR PAYMENT

Providers should provide clients with a written statement of the amounts paid to the provider for childcare services each year. This statement should include the name, address, and taxpayer identification number of the provider. For this reason, it may be prudent to obtain a separate taxpayer identification number by filing a Form SS-4 so that the provider does not have to use his or her own Social Security number. Providers who have employees must obtain a separate taxpayer identification number in any event. While the written statement is not required, it will generally be needed by the provider's clients for their own tax records and is a convenient way to reconcile income.

FOOD PROGRAM REIMBURSEMENTS 

Food Program Reimbursements 15

Under the Child and Adult Care Food Program ("CACFP"), the United States Department of Agriculture provides reimbursement to daycare providers for nutritional meals served in their facilities. The reimbursement program is administered through grants to the states or sponsoring organizations. The daycare providers sign an agreement with the state or sponsoring organization to participate in the CACFP. The provider must be licensed or approved to provide daycare services in order to participate.

Reimbursement for meals served in daycare homes is based upon eligibility for Tier I rates (which targets higher levels of reimbursement to low-income areas, providers, or children) or the lower Tier II rates. Tier I daycare homes are those that are located in low-income areas, or those in which the provider's household income is at or below 185% of the federal income poverty guidelines. Sponsoring organizations may use elementary school free and reduced-price enrollment data or census block group data to determine which areas are low-income. Tier II homes are those family daycare homes which do not meet the location, parent income, or provider income criteria for a Tier I home.

Program reimbursements are based on the number of meals served to enrolled children, multiplied by the appropriate reimbursement rate for each breakfast, lunch, supper, or snack approved to serve. The provider submits a report to the administering agency showing the meals provided to the children.

Food reimbursement payments may be reported to the recipient daycare provider on a Form 1099. If the provider receives a Form 1099, he or she should report those payments as "other income" on Schedule C and designate it as "CACFP Income." Because the CACFP payments are considered public assistance to the recipient's children, any such payments with respect to the provider's own children should not be reported as taxable income (not that expenses related to the care of the provider's own children are likewise not deductible). If no 1099 is received, the provider can still report the payments as other income on Schedule C or, alternatively, net the payments against the provider's out-of-pocket food expense.

These rules follow the general precept that, in order for the taxpayer to have income under Code section 61, there must be an economic gain, and this gain must primarily benefit the taxpayer personally. This principle has been applied by the IRS in numerous revenue rulings.

For example, these rules are consistent with the situation faced by providers under the Child Care Food Program, a predecessor of CACFP. Payments received from a sponsoring charitable organization pursuant to that program were determined by the IRS to be excludable from a daycare home operator's gross income to the extent that such payments did not exceed expenses incurred in feeding children eligible for assistance under the program. The IRS held that any portion of the payment that compensates the operator for services, however, was includible in income. Out-of-pocket expenses in excess of reimbursement, of course, were deductible under section 170 of the Code where no profit motive exists and under section 162 where such motive does exist.

The IRS considered two scenarios. The first presented a situation in which, under the auspices of a sponsoring charitable organization formed to provide daycare and nutritional meals to needy children, an individual operates a nonprofit licensed daycare service in the individual's home and provides meals at lunchtime to the children cared for. Pursuant to the federal program, the sponsoring organization has entered into an agreement with the State Department of Education whereby the organization has agreed to accept final financial and administrative responsibility for the conduct of the food service provided in the daycare home under its authority. In the agreement, the sponsoring organization ensures the state agency that meals served in the individual's daycare home meet specified requirements, and that meals are served free or at a reduced price to all children eligible for free and reduced-price meals under the program. The sponsoring organization is also required (1) to provide consultative and technical assistance to ensure that meals meet prescribed standards, that adequate records are maintained, and that other program requirements are met, (2) to train daycare personnel responsible for the food service, and (3) to make periodic visits to the daycare home to monitor compliance.

In exchange, the state agency reimburses the sponsoring organization for the expenses incurred by the daycare home operator in providing free and reduced-price lunches to eligible children. The amount of the reimbursement payments is determined by the number and types of meals served and the need of the children enrolled in the program. In no

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event may reimbursement payments to the sponsoring organization exceed the operating costs of the daycare food service.

After receiving reimbursement payments from the state agency the sponsoring organization distributes the funds to the individual operating the daycare food service. In the taxable year in question, the payments made to the daycare home operator are equal to the operating costs of the program. No payments are made to the operator to compensate the operator for the value of services rendered in preparing and dispensing the lunches.

In the second scenario an individual operates a daycare service in the individual's home and provides lunches to needy children under the same facts as described above, except that in the taxable year in question the individual receives payments from the sponsoring organization that include not only reimbursements for operating expenses, but also payments for the value of the individual's services.

The IRS noted that the individual operating the daycare home in the first scenario does not have a profit-making motive in operating the daycare facility and is not, in fact, making a profit. The expenses incurred by the individual in that situation are incurred on behalf of the sponsoring charitable organization and are directly connected with the rendition of gratuitous services to the sponsoring organization. In contrast, the individual operating the daycare home in the second scenario does have a profit motive and, in fact, received compensation for services rendered in connection with the lunches provided under the federal program. Nevertheless, as in the first situation, the food service expenditures subject to reimbursement were incurred by the individual on behalf of the sponsoring organization.

The IRS reasoned that the payments received from the sponsoring organization in the first scenario were not includible in the gross income of the individual as long as the payments did not exceed the expenses incurred by the individual in feeding the children eligible for assistance under the program. Likewise, the portion of each payment received by the individual in the second situation from the sponsoring organization that represents reimbursement of actual expenditures incurred on behalf of the sponsoring organization is not includible in the gross income of the individual. The portion of the payment attributable to compensation for the value of the individual's services, however, would be includible in the individual's gross income.

In both scenarios, the individual's reimbursed expenditures are not the individual's own expenses, but are incurred on behalf of the sponsoring organization. Therefore, the reimbursed expenses are not deductible by the individual in either the first situation under section 170 of the Code or the second situation under Code section 162.

If in the first situation the operating costs of the program had been greater than the reimbursement payments, the excess of the out-of-pocket expenses over the reimbursement would have been deductible by the individual within the limitations of Code section 170 as contributions for the use of the sponsoring organization, because the individual would be rendering gratuitous services to the sponsoring organization by feeding the children. If in the second scenario the operating costs of the program had been greater than the reimbursement payments, the excess of the out-of-pocket expenses over the reimbursement would have been deductible as a trade or business expense under Code section 162.

EXPENSE ISSUES

SUBSTANTIATION REQUIREMENTSAs with any business, a daycare provider may deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business to the extent such expenses are substantiated by adequate records or by sufficient evidence corroborating the taxpayer's own statement. So-called "strict substantiation" requirements apply to:

Traveling away from home (including meals and lodging); or

Any "listed property" under § 280F(d)(4) and Reg. § 1.280F-6T(b).

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"Listed property" includes vehicles and property used for entertainment (such as cameras and camcorders). The term no longer includes cell phones and computer or peripheral equipment, and does not include property used for entertainment which is used exclusively in the taxpayer's business establishment or exclusively in connection with the taxpayer's principal trade business. The burden, of course, is on the taxpayer to demonstrate the requisite use.

NOTE: The TCJA removes computer or peripheral equipment from the definition of listed property.

For expenses that must be strictly substantiated, the taxpayer must document each element of the expenditure or use. For example, for travel away from home, the elements to be proved are:

The amount of each separate expenditure for traveling away from home, such as cost of transportation or lodging;

The dates of departure and return for each trip away from home, and number of days away from home spent on business;

The destinations or locality of travel, described by name of city or town or other similar designation; and

The business reason for travel or nature of the business benefit derived or expected to be derived as a result of travel.

Previously, business-related entertainment expenses were deductible, however, the TCJA provides that no deduction is allowed with respect to:

An activity generally considered to be entertainment, amusement or recreation,

Membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, or

A facility or portion thereof used in connection with any of the above items.

The TCJA repeals the deduction for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50% limit to such deductions).

NOTE: Business-related meals are still deductible subject to the 50% limit.

The taxpayer must substantiate the business expenses through "adequate records" such as an account book, diary, log, statement of expense, trip sheet, or similar record, which is made at or near the time of the expense. It is not necessary, however, that every penny of the claimed expense be precisely documented, although this is preferable for obvious reasons. In the absence of adequate records, the regulations allow that sufficient corroborative evidence can be provided indirectly through sampling or extrapolation.

For example, suppose a sole proprietor operates a daycare center out of her home. The provider uses an automobile to visit local attractions with the children, to meet with suppliers and other subcontractors, and to occasionally pick up and return children from the daycare center. Assume the provider and other members of her family also use the automobile for personal purposes. Furthermore, assume adequate records are maintained for only the first three months of the year, and that those records indicate that 75% of the use of the automobile was related to the provider's daycare business.

If invoices from subcontractors and other paid bills indicate that the business continued at approximately the same rate for the remainder of the year and other circumstances do not change (e.g., the provider does not obtain a second car for exclusive use in her business), the business use of the automobile of 75% is based on sufficient corroborative evidence.

PRACTICE TIP: AVOID RELYING ON CORROBORATIVE EVIDENCE

Taxpayers should never rely on the "sufficient corroborative evidence" rule unless absolutely necessary. On audit the IRS is likely to challenge any such position and, even if the taxpayer ultimately prevails, he or she will only do so after significant time and expense in defending the position. Direct substantiation is always preferable.

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Note that the strict substantiation requirements supersede the Cohan doctrine, which provides that the Tax Court will make an approximation of a business expense where the evidence indicates a taxpayer incurred such expenses but the exact amount cannot be determined. To the contrary, the substantiation rules provide that no deduction or credit shall be allowed on the basis of such approximations or unsupported testimony.

DEPRECIATION OF PROPERTY OTHER THAN THE HOME

IN GENERAL

As with any business activity, a taxpayer running a daycare is allowed a reasonable depreciation deduction for the exhaustion, wear and tear, and obsolescence of tangible property used in a trade or business which has a useful life over one year. This includes depreciation for computers, vehicles, office supplies, kitchen equipment, playground equipment, furniture, and appliances used in a trade or business. While the class life for some assets may vary, the depreciable life for most equipment used in a daycare will be 7 years.

BUSINESS USE PERCENTAGE

The depreciation deduction is permitted only to the extent of the "business use percentage" of the asset. The "business use percentage" reflects the percentage of use of any property during the taxable year in the taxpayer's trade or business. The facts and circumstances of each case determine the business use percentage. For so-called "listed property" (computers, vehicles, cameras, etc.), the taxpayer is required to strictly substantiate actual business use, as described above.

PLACED IN SERVICE

An asset may be "placed in service" for business use when purchased or at a later time. Generally, the date an asset is placed in service is the date it is ready for use in the business. If the provider purchased an item in the year it was placed in service in the business, the basis is the cost of the asset. If the asset was purchased prior to being placed into service, the basis for depreciation is the lower of (1) the cost, or (2) the fair market value at the time the asset is placed in service. Thus, any item that is placed in service in a year subsequent to purchase and which declines in value has a lower depreciable basis than its cost. The fair market value may be determined using valuations of that particular item for charitable donations purposes.

Note that the fact that the asset was only used for personal purposes prior to being placed in service does not disqualify it from being converted to use in the business. Suppose, for example, that the taxpayer has play equipment used by his or her own children and later decides to put that equipment to use in the daycare business. The fair market value of the equipment at the time it is placed into business service is depreciable. Furthermore, it is common in this situation that the appropriate business use percentage may be below 100%. In any event, if challenged, the taxpayer has the burden of proving both the fair market value and the business use percentage, so good records are key.

If annual expenditure limits are met, the daycare provider may be able to deduct the full cost of depreciable equipment in the year of purchase under Code § 179. To qualify for immediate deduction, however, the item must be purchased and placed in service in the same tax year. There are also special depreciation allowances which dictate the useful life of an item. Lastly, there are special rules when it comes to listed property. If the business usage of listed property is less than 50%, the asset does not qualify for a deduction under § 179, and the taxpayer must use the Alternative Depreciation System ("ADS") under § 168(g), since the asset cannot be depreciated using the Modified Accelerated Cost Recovery System ("MACRS"). If the business usage starts out at more than 50% but falls to under 50% in a subsequent year, then the taxpayer is required to "recapture" the amount of depreciation previously claimed that exceeds the amount that would have been allowed had the business usage been less than 50% the whole time. For

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Vehicle (Car and Truck) Expense 19

passenger automobiles, there is an additional limitation for the total amount of depreciation allowable for each year, which is adjusted each year for inflation.

VEHICLE (CAR AND TRUCK) EXPENSE 

Daycare providers often incur expenses related to a vehicle. Among the typical vehicle expenses associated with daycare relate to taking children to and from school, field trips, medical facilities, and trips to buy business-related supplies.

The provider is allowed to deduct either the business use percentage of actual vehicle expenses incurred primarily for business, or the standard mileage rate for the business miles. However, since vehicles are listed property, the provider is subject to the strict substantiation requirements.

PRACTICE TIP: VEHICLE EXPENSES

In most cases, the standard business mileage rate is the easiest and most favorable method for deducting business vehicle expenses. Since vehicles are listed property, however, it is best if the taxpayer maintains a contemporaneous log showing the business purpose of each trip, as well as the beginning and ending mileage. Although such a log is not specifically required by law, the IRS is likely to disallow all or a portion of the deduction on audit without substantiation of this sort.

Obviously, some trips may be primarily for business, while others might be personal or a combination of both. If the provider travels to a single destination and engages in both personal and business activities, the expense is deductible only if the trip is related primarily to the provider's trade or business. If the trip is primarily personal in nature, the expense is not deductible even though the taxpayer engages in business while at such destination.

Whether a trip is related primarily to the taxpayer's trade or business or is primarily personal in nature depends on the facts and circumstances in each case. The amount of time during the period of the trip spent on personal activities compared to the amount of time spent on activities directly relating to the taxpayer's trade or business is an important factor in determining whether the trip is primarily personal. If a trip involves multiple locations, then taxpayer must determine for each location whether it was primarily for business and allow as deductible only the mileage to and from the business purpose location.

TRAVEL AND MEALS

As described above, most states require that providers be licensed. Additionally, providers may be required to take continuing education courses to maintain a license. Attendance at these courses may require travel away from home and others may be local but include meal expenses. The cost of the courses themselves is fully deductible, as is any reasonable travel expense.

Generally, the deductibility of meal expenditures is subject to the business purpose requirement and limited by the 50% reduction on meals. The same holds true for daycare providers, with the caveat that such providers may fully deduct the cost of food provided to children in the ordinary and necessary course of the trade or business, as discussed below.

 

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NOTE: The TCJA repeals the deduction for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50% limit to such deductions).

FOOD EXPENSEThe provider may fully deduct the cost of food provided to daycare recipients and, in this case, the amount of the deduction is not limited by the 50% reduction on meals. However, no portion of the cost of food provided to the provider's family, including food consumed by the provider or the provider's own children, is allowed as a deduction.

If the provider receives reimbursement for food costs through the CACFP or any other program, the provider may report the reimbursements under the income section of Part I of the Schedule C and then deduct the food expenses in full, which is the recommended method especially when the provider receives a Form 1099 from the program, or the provider can net the amount reimbursed against the food expense. If the provider uses the netting method and the food expense is greater than the reimbursement, then the provider may deduct the excess as a food expense. If the reimbursements exceed the total food expenses, then the provider should report the excess income in Part I on the Schedule C.

PRACTICE TIP: REPORT GROSS AMOUNTS

The netting method of reporting CACFP payments is not the preferred method because the food reimbursement amount is not shown on the return. The IRS always puts returns through a "document matching" program that is designed to match information reports, such as 1099s, with income reported on the return. If the income and expenses are netted, these amounts may not match, which will generate a "CP2000" letter from the IRS inquiring as to whether the payment has been reported as income. Although the matter might be handled easily, it could raise other questions and even lead to an audit.

For food provided to employees, generally, only 50% of the cost of food consumed is deductible. However, providers can deduct 100% of the cost of food consumed by their employees if its value can be excluded from wages as a de minimis fringe benefit. In order to be a de minimis fringe benefit, the food has to be provided infrequently; meals provided on a regular basis constitute additional compensation subject to the 50% limitation.

Food provided to employees does not have to be included in their wages if the food is furnished on the business premises and for the convenience of the employer. For example, if a daycare provider furnishes lunch to employees so that they can stay on the premises to be available for emergency care, the meals would not be included in wages and would be 100% deductible by the business.

Freight or delivery charges related to food are also deductible, particularly if food is bought in large quantities. Some daycare centers might have special occasion activities for the children, such as holiday celebrations for which parents are invited and meals are provided. Such special occasion costs are deductible as a special activity cost.

Generally, the provider must keep records to substantiate the amount of any deduction by maintaining actual receipts which clearly identify the cost of the food as trade or business expense. However, the provider may elect to use the standard meal and snack rates used by "family daycare providers" in computing the deductible cost of food under CACFP. The standard meal and snack rate is based on the Tier I rate. The provider may use the standard meal and snack rate for a maximum of one breakfast, one lunch, one dinner, and three snacks per eligible child per day. There is

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Business Use of the Home 21

still a recordkeeping requirement, which includes the name of each eligible child, dates and hours of attendance in the family daycare, and the type and quantity of meals and snacks served.

If the standard meal and snack rate is elected, the provider must do so for the complete tax year, and cannot use the actual cost method during that tax year. However, the provider may switch methods in a subsequent tax year. The standard meal and snack rate method is available to a trade or business which provides childcare to eligible children in the home of the provider that is (1) nonmedical, (2) does not involve a transfer of legal custody, and (3) generally lasts for less than 24 hours each day.

To satisfy the record-keeping requirements, family daycare providers who use the standard meal and snack rates must maintain records to substantiate their computation of the total amount deductible for each taxable year. The records should include the name of each eligible child, dates and hours of attendance in the family daycare, and the type and quantity of meals and snacks served. This information may be recorded in the meal and snack log contained in the APPENDIX to Rev Proc. 2003-22. A family daycare provider who uses that log to maintain accurate and required information will be deemed to comply with the record-keeping requirements of § 6001 and the regulations thereunder.

The standard meal and snack rate is adjusted annually. The Department of Agriculture adjusts the Tier I reimbursement rates each July based on changes to the consumer price index for the cost of food at home. Although the Tier I reimbursement rates apply for the period of July 1 to June 30 of each year, the standard meal and snack rates applicable for a particular taxable year are the Tier I rates in effect on December 31 preceding the beginning of the family daycare provider's taxable year.

Generally, the CACFP reimbursement rates may be found on the Internet at www.usda.gov under "Child and Adult Care Food Program." The Service includes the standard meal and snack rates that are current at the time of publication in Publication 587, Business Use of Your Home.

BUSINESS USE OF THE HOME

BUSINESS USE OF THE HOME DEDUCTION

 

A deduction is allowed for the business use of a portion of the home that is used for daycare. The provider may claim the deduction if two requirements are met. First, the provider must be in the trade or business of providing daycare for children. Second, the provider must have applied for, been granted, or be exempt from having, a license, certification, registration, or approval as a daycare center or as a family or group daycare home under state law. The provider does not meet this requirement if their application was rejected or the license or other authorization was revoked. Note that this licensing requirement applies only to the deduction for business use of the home; an unlicensed provider may still deduct other business expenses.

Generally, the taxpayer may deduct home business expenses only where a portion of the home is exclusively used for business. However, the exclusivity rule does not apply to daycare providers. In fact, daycare providers may deduct the business use of the home where such use is "regular."

Pursuant to Revenue Ruling 92-3, if a room is available for daycare use throughout each business day and is regularly used as part of the routine provision of daycare (including a bathroom, an eating area for meals or a bedroom used

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for naps), the square footage of that room will be considered as used for daycare throughout each business day. A daycare provider is not required to keep records of the specific hours of usage of such a room during business hours. The occasional non-use of such a room for a business day will not disqualify the room from being considered regularly used. However, the occasional use of a room that is ordinarily not available as part of the routine provision of daycare (such as a bedroom ordinarily restricted from daycare use but used occasionally for naps) will not be considered as used for daycare throughout each business day.

The business-use-of-the-home deduction is the product of total business expenses and the "business use percentage" (described below). The amount of the deduction, however, is limited to the gross income generated by the childcare activity.

The "business use percentage" itself is the product of the "space percentage" multiplied by the "time percentage."The space percentage consists of the area regularly used for business (the numerator) divided by the area of the entire home (the denominator). Square footage is a common measurement tool, although any other reasonable method can be used if it accurately reflects the business percentage.

The time percentage is the total number of hours the facility was used for the childcare business during the year (the numerator) divided by 8,760 (the total hours in the year). Hours spent cooking, cleaning, and preparing activities for the business of childcare are included in the calculation of the numerator if such tasks are otherwise ordinary and necessary to conduct the business. Revenue Ruling 92-3 provides that the provider should add one hour to the 11 hours of actual daycare operation for the 1/2 hour before and 1/2 hour after regular hours spent preparing for and cleaning up after the children. This ruling is not absolute, so actual time spent conducting the childcare business will depend on the facts and circumstances of each case. It is highly recommended that providers maintain time logs for this purpose.

Business expenses incurred in the home may be direct or indirect. Direct expenses are those that are incurred exclusively for the business and provide no personal benefit. Indirect expenses are those that provide benefit for the business and the personal use of the home. Such indirect expenses must be allocated using the business use percentage. For example, the provider may deduct a portion of home mortgage interest and property taxes allocable to business use on Form 8829, and report the remaining portion on Schedule A.

In some cases, providers may operate the daycare business in housing provided by an employer as a nontaxable benefit. The most common instances involve military personnel and the clergy. To the extent such expenses are allocable to tax-exempt income, the deduction for business use of the home is disallowed. Therefore, such providers may not reap a double tax benefit by receiving tax-exempt income and deducting expenses attributable to such income.

In these circumstances, the deductible expenses related to the business use of the home are multiplied by a fraction, the numerator of which is the tax-exempt housing allowance and the denominator of which is the total amount of the deductible expenses relating to the business use of the home (e.g. the total amount of the mortgage interest, real property taxes, depreciation, and maintenance expenses). The resulting amount is the amount to be disallowed.

For example, suppose Bill and Hillary receive a $6,000 housing allowance and their housing expenses total $7,000, of which $4,000 is property taxes and mortgage interest and $3,000 is other expenses of maintaining the home (including $500 for house depreciation allocable to the business use of the home for the daycare activity). There is a 30-percent time and space use allocation of the home to the daycare activity. With respect to property taxes and mortgage

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interest, 30% of $4,000 ($1,200) should be reported on Form 8829 as allocable to the childcare business. The remaining $2,800 should be reported on Schedule A in the appropriate categories.

With respect to the remaining $3,000 of expenses, first determine the amount attributable to the daycare activity by multiplying 30% by those house expenses other than house depreciation ($2,500), which equals $750. Second, calculate the amount of house depreciation that would normally be allowed if fully claimed on Form 8829 ($500) and add this to the business portion of the remaining expenses ($750) equaling $1,250. Next, $6,000 of the total $7,000 housing expenses is allocable to the housing allowance. Thus 6/7 of the $1,250, or $1,071.43, cannot be allowed as a deduction. This leaves only $178.57 of the additional housing expenses that are deductible on Form 8829.

DEPRECIATION OF THE HOME

The provider may depreciate the residence building only, not to the value of the land. To accomplish this, the basis of the building and the land must be separated. To determine the depreciable basis, use the lesser of (1) cost or other basis of the home, or (2) the fair market value on the date the property was placed in service for business purposes. The depreciable life for a residence used as a daycare facility is 39 years (not the 27.5 years allowed for noncommercial residential property).

PRACTICE TIP: USE PROPERTY TAX ASSESSMENT

Local property tax assessments commonly separate the value of the dwelling from the land. In the absence of information to the contrary, this ratio can be used to determine the cost basis of the residence building.

MODIFICATIONS TO THE HOME

Expenses incurred to modify a residence must be treated as capital expenditures even if the cost is required to comply with licensing specifications. A capital expenditure includes any amount paid for permanent improvements or modifications that have a useful life that extends beyond the tax year and which is made to increase the value of the property. These types of improvements are generally depreciable.

On the other hand, expenditures for repairs and maintenance are immediately deductible and not subject to depreciation. Whether an expense is a modification requiring capitalization or a repair is determined under the facts and circumstances, the factual question is whether the expenditure extends the useful life of the property or merely maintains it. The replacement of some worn-out asphalt roofing shingles, for example, would likely be deductible as a repair. The replacement of an asphalt shingle roof with a metal roof would most likely have to be capitalized.

SALE OF HOME

A capital gain issue may arise if the provider sells the home in which the daycare business is operated and depreciation deductions were allowed or allowable. All or some of the gain on the sale of the home may be exempt from taxation if the provider meets certain requirements under Code § 121. However, the exemption does not apply to any gain from the sale of a principal residence attributable to depreciation adjustments (as defined in Code § 1250(b)(3)) allowed or allowable for periods after May 6, 1997. Therefore, a provider who used part of the home for business purposes may not exclude any gain from the sale of that residence that is attributable to depreciation

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adjustments taken or allowed for periods after May 6, 1997. Such depreciation constitutes "unrecaptured Code section 1250 gain" taxable at a maximum rate of 25%.

If the business is conducted within the primary residence structure, then the gain (except for depreciation allowed or allowable) may be excluded if the provider meets certain time and ownership requirements described below. If the business is conducted in a structure separate from the personal residence, then the portion of the gain allocable to that structure would not qualify for exclusion, unless the provider shows personal use of the structure that meets the time and ownership test. An allocation between the separate business use structure and the personal residence structure is required.

Even if property is used exclusively as the provider's principal residence in the year of sale, the provider is not necessarily entitled to the exclusion. To qualify for the full exclusion, the provider must have owned and used the property as his principal residence for at least two years during the 5-year period immediately preceding the sale. If the provider does not meet the two-year requirement, then a portion of the exclusion will be allowed if the sale is made under the circumstances described in Code § 121(c).

TOYS 

The cost of buying toys is a deductible business expense for daycare operators. In fact, toys may be a significant expense depending on the size of the provider's operation. Additionally, some toys may be depreciable while others may be deductible. Generally, to be depreciable, the property must be owned and used by the provider in the trade or business and have a determinable useful life which is extended to last more than one year. As discussed above, however, the provider may elect to deduct all or part of the property in the year it is placed in service.

ADVERTISING

Advertising costs are deductible as long as they are ordinary and necessary expenses in conducting the taxpayer's business. For daycare providers, the amount of the deduction will depend on the form and size of the daycare operation. For example, "kith and kin" caregivers usually have minimal deductions because advertising is limited to word-of-mouth or free referral services. In contrast, larger childcare services may require more formal advertising to communicate services to a larger audience. Forms of advertising may include telephone directories, local newspapers, church bulletins, and community flyers.

BAD DEBTS

A bad debt expense is designed to offset an amount already recognized as income. Generally, the bad debt deduction applies when the taxpayer includes an item of income on his or her tax return in a prior year but never receives payment and must deduct the previously included amount in a subsequent year tax return. Since most small daycare providers use the cash method of accounting for taxes, income is not recognized until paid, and therefore no bad debt expense is available. This is commonly misunderstood by taxpayers, who sometimes believe that the failure of a customer to pay an amount owed results in a deduction on the cash basis.

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If the daycare provider uses the accrual method of accounting for income taxes and a customer fails or refuses to pay for services rendered, the provider may deduct this loss of income as a bad debt expense. The amount deductible is 67

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the actual amount of the receivable that is written-off and as to which collection activity has ceased. No accrual of an estimated amount of bad debt allowances is deductible.

COMMISSIONS AND FEESThe commissions and fees paid to contractors for such things as landscaping and repairs are deductible business expenses, provided the commissions and fees are ordinary and necessary expenses to the taxpayer's trade or business. When the taxpayer conducts business at home, only the portion of such commissions and fees attributable to business use are deductible. Nevertheless, the entire payment must be reported by the payor using Form 1099-NEC, Nonemployee Compensation, if the payment to any one service vendor is $600 or more during the year. Failure to issue the form may result in the assessment of penalties.

Starting with calendar year 2020, Form 1099-NEC (box 1) is used to report nonemployee compensation. Prior to 2020, nonemployee compensation was reported on Form 1099-MISC (box 7). Form 1099-NEC is used to report nonemployee compensation paid during the year of at least $600 for the following:

Services performed by someone who is not the taxpayer's employee (including parts and materials) (box 1);

Fish (or other aquatic life) purchased from anyone engaged in the trade or business of catching fish (box 1); 

Payments to an attorney (box 1); or

Each person from whom the taxpayer has withheld any federal income tax (box 4) under the backup withholding rules regardless of the amount of the payment.

EMPLOYEE BENEFIT PROGRAM/PENSION AND PROFIT SHARING

Depending on the size of the daycare operation, the provider may offer employee benefits which require the provider to contribute to an employee health plan, group term life insurance, dependent care assistance, adoption assistance, or retirement plan. The provider may deduct these expenses as an ordinary and necessary business expense.

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INSURANCE

Similarly, the provider may have insurance coverage, which normally includes business liability coverage, workmen's compensation, casualty insurance, and other property-related insurance costs. These costs are generally deductible.However, this amount does not include homeowner's insurance, which is one of the expenses reported on Form 8829, Business Use of the Home. Generally, the provider should evaluate the nature of the insurance and the assets covered to determine what business use percentage should be applied to the cost to be deductible based on the facts and circumstances.

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OFFICE EXPENSES AND SUPPLIES 

The office expense and supply category may include numerous expenses, such as food, toys, diapers, office supplies, cleaning supplies, and educational and art supplies. Generally, the provider should maintain records to determine the business usage percentage, and only report such expenses as used in the business. These expenses are typically reported in the "Other Expenses" category of the tax return. In some cases, the business use of the home percentage would be appropriate to use (such as home cleaning supplies) while other expenses should use an actual usage method percentage (such as computer-related supplies).

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26 Expense Issues

RENT

Rental expense should be allocated according to the business use percentage. If the rental payment is for the personal residence, the provider should determine the amount of the deduction as described under the "Business Use of Home" section above.

START-UP COSTS

The provider may incur start-up costs prior to opening the daycare business which are ordinarily deductible if the business was open and active. These include licensing fees, advertising costs, inspection fees, supply expenses, pre-opening payroll expenses, professional fees, and other miscellaneous expenses paid or incurred prior to the opening day. Depreciation on assets purchased prior to the opening day begins on the opening day or the day upon which the asset is actually placed in service after opening day.

Start-up costs are capital expenditures and cannot be deducted as a current expense. However, the taxpayer may elect in the year the business opens to deduct $5,000 (or the amount of the actual start-up expenses if less) and amortize the remaining expenses ratably over the 180-month period beginning with the month in which the active trade or business opens. If the total start-up expenses exceed $50,000, then the $5,000 deduction allowed is reduced by the amount by which the expenses exceed $50,000.

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The taxpayer is deemed to have made the election to expense up to $5,000 and amortize the remainder of the start-up costs unless he or she clearly elects to capitalize them on a timely-filed federal Income tax return (including extensions) for the year in which the trade or business becomes active. The election either to expense/amortize start-up expenditures or to capitalize start-up expenditures is irrevocable and applies to all start-up expenditures that are related to the active trade or business.

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Organizational costs paid or incurred to create a business structure, such as an LLC, corporation, or partnership may be deducted in the same manner as start-up costs for a sole proprietorship. As with an individual, the business organization is deemed to have made the election to expense/amortize the organizational costs unless it clearly elects to capitalize them on a timely-filed federal Income tax return (including extensions) in the year in which the trade or business becomes active. Likewise, the election is irrevocable and applies to all organizational expenses of the business organization.

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TELEPHONE EXPENSE

The monthly expense for basic local telephone service is a nondeductible personal expense, even though some states require the provider to have a telephone in order to be licensed. However, additional telephone charges incurred for business purposes are deductible to the extent substantiated.

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UTILITIES

The cost of utilities is generally an allowable expense. For facilities located in the personal residence, this is an expense includable in the business-use-of-the-home deduction (Form 8829) discussed earlier. For facilities that are located separate and apart from the residence, utilities should be listed on the Schedule C line for that expense.

Bank Charges 27

BANK CHARGES

Bank charges are allowable for a separate business account. For a combined business and personal bank account, bank charges are allowed to the extent of the business percentage.

WAGES/COMPENSATION

The daycare provider may have people who work either part-time or full-time. Wages for these people are deductible and normal employment taxes apply, but there are three issues to keep in mind.

First, payments to the daycare owner may not be considered wages. If the daycare provider is a sole proprietorship, then the payments made to the provider himself or herself are considered "draws" and are not deductible under wages or any other category. Partnerships are flow-through entities so payments to the partners are not deductible by the partnership in determining net income unless they are "guaranteed payments." Guaranteed payments are set payments that do not vary based on the partner's allocation of profit and loss. Guaranteed payments and the net income allocated to general partners are usually subject to self-employment tax. On the other hand, if the provider is organized as a corporation then the payments taken by the shareholders who perform services for the entity are subject to FICA employment tax and deductible as wages.

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Second, nothing prohibits family members from working as employees of the provider. Wages to family members are deductible, but only if bona fide services are performed.

PRACTICE TIP: KEEP PRECISE RECORDS FOR FAMILY WORKERS

Since the IRS is likely to be suspicious of deductions for wages paid to family members, it is a good idea to make sure that accurate time records are kept. Those records should indicate the specific amount of time the family member spends working for the daycare provider and the specific duties performed. Also, if non-family members are also employed in similar capacities, the wages of the family members and non-family members should be comparable.

Third, it should be noted that whether the worker is classified as an "employee" or "independent contractor" carries significantly different tax obligations for the provider. Contrary to popular belief, this classification is not merely an option subject to the agreement between the provider and the worker. Rather, the facts and circumstances dictate whether the worker should be classified as an employee or not. Unfortunately, this issue has many facets and a thorough treatment of the subject is beyond the scope of this course. The discussion below is designed to provide the broad outlines

Generally, the determination is made under what is referred to as the "common law standard." Under the common law standard, an employer-employee relationship exists where the daycare provider has a right to direct and control the worker. "Control" for this purpose refers not only to the result to be accomplished by the worker, but also to the means and details by which that result is accomplished. In other words, an employee is a worker who is subject to the will and control of the business not only as to what work shall be done, but also how it shall be done.

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Importantly, it is not necessary that the employer actually direct or control the manner in which the services are performed if the employer has the right to do so. To determine whether the control test is satisfied in a particular case, the IRS will look at behavioral control, financial control, and relationship of the parties.

28 Glossary

Behavioral control examines the right to direct or control the details and means by which the worker performs the required services. Virtually every business will impose on workers, whether independent contractors or employees, some form of instruction (for example, requiring that the job be performed within specified time frames). This fact alone is not sufficient evidence to determine the worker's status. The weight of "instructions" in any case depends on the degree to which instructions apply to how the job gets done rather than to the end result.

The degree of instruction depends on, among other things: (1) the scope of the instructions provided; (2) the extent to which the business retains the right to control the worker's compliance with those instructions; and (3) the effect on the worker in the event of noncompliance. The more detailed the instructions that the worker is required to follow, the more control the business exercises over the worker, and the more likely the business retains the right to control the methods by which the worker performs the work. The absence of detail in instructions reflects less control.

In most cases, this factor will favor classification of daycare workers as employees. As a result, in those circumstances where the provider thinks that the behavioral control factor is more consistent with independent contractor status, care should be taken to specifically document the facts supporting this position.

Financial control examines whether the business has the right to direct or control the economic aspects of the worker's activities. Economic aspects of a relationship between the parties illustrate who has financial control of the activities. Factors include whether the worker has a significant investment in the enterprise, whether the worker has unreimbursed expenses, whether the worker's services are available to the relevant market, whether the worker is paid by the hour as opposed to a flat fee for the services performed, and whether the worker has the opportunity for profit or loss.

The ability to realize a profit or incur a loss is probably the strongest evidence that a worker controls the business aspects of the services rendered. If the worker is making decisions which affect his or her bottom line, the worker likely has the ability to realize profit or loss. For example, if the provider pays a worker a flat fee for the services and the worker is responsible for his or her own expenses, then this factor would favor treatment of the worker as an independent contractor.

The relationship factor reflects the parties' intent concerning control. A written agreement describing the worker as an independent contractor is viewed as evidence of the parties' intent that a worker is an independent contractor, especially in close cases. As mentioned above, however, it is far from conclusive evidence and may merely be a self-serving recital. Ultimately, it is the substance of the relationship governs the worker's status, not the label used in the agreement.

GLOSSARY

GLOSSARY

Glossary 29

accrual method A method of accounting that requires the taxpayer to report interest income when earned, whether or not it has been received by the taxpayer.

amortize To provide for the gradual payment of a debt in regular installments over a period of time.

basis The amount of a taxpayer's investment in a property for tax purposes, adjusted for certain items.

calendar year The 12-month period from January 1 through December 31.

capital expenditures

An expense incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life extending beyond the taxable year.

capital gain The positive result of a sale or trade of a capital asset.

cash method A method of accounting which requires the taxpayer to report income in the year of constructive receipt.

continuing education

An instructional program that brings participants up to date in a particular area of knowledge or skills, and is often required to maintain a professional designation.

corroborative evidence

Evidence that tends to support a proposition that is already supported by some initial evidence, therefore confirming the proposition.

deductions Certain items that reduce the amount of income subject to tax.

depreciation Method used to recover the cost of tangible income-producing property, other than natural resources.

disregarded entity A business entity that is not separate from its owner for tax purposes.

enterprise A company organized for commercial purposes; business firm.

entrepreneur A person who organizes and manages any enterprise, especially a business, usually with considerable initiative and risk.

exempt Released from, or not subject to, an obligation, liability, etc.

expenses Charges incurred during a business assignment or trip.

extrapolate To infer (an unknown) from something that is known; conjecture.

fair market value The price that a property would sell for in an open market assuming a willing buyer and seller would likely agree upon the price when acting freely, carefully, and with complete knowledge.

federal income tax An income tax that is levied on the income of individuals or businesses (corporations or other legal entities).

FICA A United States Federal payroll (or employment) tax imposed on both employees and employers to fund Social Security and Medicare.

flow-through entities

A legal entity where income "flows through" to investors or owners; that is, the income of the entity is treated as the income of the investors or owners.

Form W-4 Employee's Withholding Allowance Certificate

gross income The total of earned and unearned income subject to tax.

30 Glossary

improvements An addition that adds to the value of property, prolongs its useful life, or adapts it to new uses.

irrevocable Not to be revoked or recalled; unable to be repealed or annulled; unalterable.

kith and kin caregivers

Typically relatives, friends, and neighbors who provide childcare while the parents are working, whether paid or not, in either their home or child's home.

licensure The granting of licenses, especially to engage in professional practice.

net Amount remaining after deductions, as for charges or expenses (opposed to gross).

net income The excess of revenues and gains of a business over expenses and losses during a given period of time.

obsolescence The state, process, or condition of being or becoming obsolete.

recapture The process of adding back an amount that a taxpayer had previously deducted from income.

repairs Costs that keep property in a good operating condition, but do not add value to the property or substantially prolong its life.

requisite Required or necessary for a particular purpose.

self-employment tax

A Social Security and Medicare tax primarily for individuals who work for themselves.

substantiate To establish by proof or competent evidence.

tangible property Property that is physical in nature.

unsubstantiated Unproved or unverified.

wages Money that is paid for work or services.