«CHILD CARE PROVIDER Audit Technique Guide NOTE: This document is not an official pronouncement of the law or the position of the Service and cannot ...»
The method to be used will be determined on a case-by-case basis depending on the amount of records and source documents available. Some small providers, such as the “Kith and Kin” types, might have minimal records or documents. The bank deposit method is a good method since many parents pay by check to have proof of payment for the child care credit. However, for “Kith and Kin” type, it may not be the best method to test or reconstruct income since there might be a lot of cash transactions in this business.
The Cash-T might not be helpful since the income from the provider business may not be the main source of support. Bank account deposit details can provide information, such as the parent’s name and payments amounts, and provide a source for making third- party contacts. Third-party contacts may or may not be effective in “Kith and Kin” type businesses because there might be a close personal relationship with the provider. Be sure to follow third-party contact procedures (IRM 184.108.40.206.12).
Various methods to reconstruct income can be created using the information from the rate schedules, contracts, attendance records, sign-in and sign-out sheets, year-end statements, food program statements, etc. (Note: Under IRC Section 7602(e), the Service may not use indirect methods to reconstruct income unless it “has a reasonable indication that there is a likelihood of…unreported income.” See IRM 4.10.4 for the techniques that should be employed to determine whether there is a likelihood of unreported income.)
Examples of using this information:
“Kith and Kin” type where no records exist In the interview, the provider responded that she/he took care of two children from the same family and was paid $200 per week. The children were in the home 50 weeks of the year. No payment was received when the taxpayer took off two weeks for vacation and no extra fees were charged for any other services, such as diapers, field trips, etc. A review of several of the bank deposits showed recurring $200.00 deposits most weeks.
Other deposits, except for immaterial ones, could be traced to other sources of income.
Using sign-in/out sheets, rate schedules, etc. to verify income sample
A family day care provider reported income using the bank deposit information from the account maintained for the business. The sign-in/out sheets were used to create a client list with the appropriate period of time the child was a client. Emergency contact information sheets were used to verify that all children being cared for had been accounted for. The provider stated in the interview that all children were charged the same rate of $250.00 per week. The business was open 50 weeks during the tax year, and the provider did not charge for their two-week vacation. The sign-in/out sheets showed there were a few changes in the children cared for during the tax year. The policy of the business was that parents had to pay the provider for absences and vacations of the children. No extra fees were charged except for early drop-off and/or late pick-up. The sign-in/out sheets showed this was not a meaningful occurrence, hence it should be disregarded in the computation based on materiality.
Computation and Adjustment:
Income was reconstructed using the records as follows:
Child 1 50 weeks times 250.00 equal $12,500 Child 2 30 weeks times 250.00 equal $ 7,500 Child 3 50 weeks times 250.00 equal $12,500 Child 4 50 weeks times 250.00 equal $12,500 Child 5 20 weeks times 250.00 equal $ 5,000 Child 6 45 weeks times 250.00 equal $11,250 The total reconstructed income came to a grand total of $61,250. The reported income was $38,400 based on the bank deposit records. Hence it appears income was understated by $22,850. Remember to discuss the methodology and results with the provider to determine if there were other factors you did not consider. Adjust your computation as needed and make the appropriate income adjustment.
Reconstruction of gross receipts using a food reimbursement formula
The taxpayer received food reimbursement from a local government agency of $6,501 for the year under Tier 1. (The difference between a Tier 1 & 2 rates is explained in the following section.)The taxpayer provided lunch and two snacks per day, per child.
The reimbursement meal rates are $1.97 for lunch and $.58 per snack, totaling $3.13 per day for Tier I (see sample rates below).
Note: because the reimbursement rate changes mid-year for any exam year use the 2nd half of the year’s rate which is usually higher. The difference is not material and is in the advantage of the taxpayer hence more conservative for a reconstruction method. (i.e. for the exam year 2007 use the 2007/2008 rate.
The average fee per child per five day week is $200.
The computation, using the facts above is as follows:
Step 1: Divide the annual reimbursement amount ($6,501) by the daily reimbursement rate ($3.13) to arrive at the number of “child days” (2,077).
Step 2: Divide the number of “child days” (2,077) by the days of the operating week (5) to arrive at “child weeks” (415).
Step 3: Multiply the “child weeks” (415) by the weekly fee ($200) to arrive at the tentative gross receipts ($83,000).
Use this formula as a guide to determine if gross receipts appear reasonable. You should modify the computation methodology if the weekly fee changes during the year or if the fee charged is not uniformed for each child under the care of the provider to get a more realistic average weekly fee rate to use. Discuss with the taxpayer other factors that may make this method result in any significant discrepancy and modify the methodology base on those factors. If the taxpayer's own children are enrolled in the food program, reduce the gross receipts by the appropriate amount. This formula may be used for any number of children. If some of the children do not qualify for a reimbursement program, add the annualized fee for these children to the reconstructed gross receipts.
Note: The reimbursements from the food program are usually received in the month following the expenditure.
Reimbursement rates are for July through June from the U.S. Department of Agriculture, Child and Adult Care Food Program (CACFP), for Tier 1 and Tier 2. Reimbursement rates should be obtained from the applicable state agency, which will also provide the guidelines for making a Tier I or Tier II reimbursement determination. You can get the rates at the United States Department of Agriculture Web site.
Food Program Reimbursements (CACFP)
The United State Department of Agriculture provides reimbursement to day care providers through the CACFP. The CACFP is authorized by Section 17 of the National School Lunch Act (42 U.S.C. 1766). The USDA administers the CACFP through grants to the states. The actual agency involved can vary by state. Independent centers and sponsoring organizations can enter into agreements with the individual states to administer the program.
The day care provider must sign an agreement with the state or sponsoring organization to participate in the CACFP. The provider must be licensed or approved to provide day care services in order to participate. Reimbursement for meals served in day care 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 day care homes are those that are located in low-income areas, or those in which the provider’s household income is at or below 185 percent 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 day care homes which do not meet the location, parent income, or provider income criteria for a Tier I home.
Program payments for day care homes are based on the number of meals served to enrolled children, multiplied by the appropriate reimbursement rate for each breakfast, lunch, supper, or snack they are approved to serve. Reports showing the meals provided
How to Report Food Reimbursement Payments Food reimbursement payments are sometimes reported on a Form 1099. If a provider received a Form 1099, the best way for the provider to report those payments is under the “Other Income” section of the Schedule C and writing in “CACFP Income.” The provider should not include the amount of the payments for his/her own children because it is not taxable. Clearly reporting the CACFP payments in this manner will assist the IRS in the selection of returns for examination. If no 1099 is received, the provider can report it under other income or as an alternative method net the payments against the food expense.
Other Income Other income may come from interest bearing accounts, dividends from investments, rental fees, or from the sale of assets.
Child care centers which have facilities separate from the home may rent out the facilities during nonbusiness hours to others for a fee. Some examples are weekly meetings of religious organizations, social clubs, investment clubs, kids clubs, etc., as well as one time events, such as fundraising activities of charitable or social club organizations or for family events (weddings).
Some child care providers might be granted a loan to purchase business equipment whose principal is forgiven after the passage of a certain amount of time. If this situation exists, then the loan forgiveness is taxable income reportable on Schedule C.
Introduction to Expenses – Determining the deductible amount under IRC Section 162 and the business usage percentage in child care provider businesses The examination of expenses of the child care provider can be a challenge to the examiner because many of the items being expensed are used for both business and personal purposes. Because of this unique feature of the provider, Congress passed a special provision of the IRC to provide the method to compute the business use of the home deduction, which is discussed below.
Other deductions, such as depreciation of fixed assets, amounts spent for toys, supplies, appliances, vehicle expenses, etc. may pose the same problem to the examiner. The provider is entitled to a deduction of the business use portion, subject to the limitation of the law for some deductions, such as vehicle depreciation (IRC Section 280F). In some Page 12 cases, the property might be substantially used in the business, while in other cases it might be minimally used.
The examiner needs to evaluate in a fair and objective manner whether the expense is deductible under IRC Section 162 as an ordinary and necessary expense and then determine what percentage constitutes business usage based on the facts and circumstances of each case. It is important to stress the fact that having a personal usage element present does not disqualify the property from being a deductible IRC Section 162
expense. A few examples of this are:
• Lawn expenses: If the children play outside in the yard on a regular and ongoing basis, then the expense of maintaining the yard, such as the amount charged by a lawn mowing service, has a business usage element and should be partially allowed. An appropriate business usage percentage could be the business use of the home percentage.
• Laundry facilities and soap to wash towels, blankets, etc. used by the children:
This is a necessary business expense for which the business usage of the home percentage would be appropriate based on materiality.
There are many such examples in this industry of expenses incurred for both business and personal purposes, and the examiner must be careful to first apply the IRC Section 162 criteria and then the facts and circumstances of the case to determine the deductible business portion of the expense.
Another area that must be kept in mind is the substantiation rules of IRC Section 274 (d), discussed below, which requires specific information to be maintained in the provider’s records for certain types of expenses to be allowed.
Substantiation Requirements of IRC Section 274(d) and IRC Regulation 1.274-5T The law basically states that for certain expenses listed in the below cited regulations, no deduction of any of these expenses will be allowed unless the taxpayer (provider) does “substantiate by adequate records or by sufficient evidence corroborating the taxpayer’s own statement” the expense elements that are clearly defined in the IRC and the regulations.
IRC Regulation § 1.274-5T, Substantiation requirements (temporary), states:
(a) In general. For taxable years beginning on or after January 1, 1986, no deduction or credit shall be allowed with respect to—
1. Traveling away from home (including meals and lodging),
2. Any activity which is of a type generally considered to constitute entertainment, amusement, or recreation or with respect to a facility used in connection with such an activity, including the items specified in section 274(e), Page 13
3. Gifts defined in section 274(b), or
4. Any listed property (as defined in section 280F(d)(4)and § 1.280F-6T(b)), unless the taxpayer substantiates each element of the expenditure or use (as described in paragraph (b) of this section) in the manner provided in paragraph (c) of this section. This limitation supersedes the doctrine found in Cohan v. Commissioner, 39 F.2d 540 (2d Cir.
1930). The decision held that, where the evidence indicated a taxpayer incurred deductible travel or entertainment expenses but the exact amount could not be determined, the court should make a close approximation and not disallow the deduction entirely. Section 274(d) contemplates that no deduction or credit shall be allowed a taxpayer on the basis of such approximations or unsupported testimony of the taxpayer.