«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 ...»
As the House and Senate Committee Reports indicate, it was the intent of Congress to have the IRC Section 274 provisions supersede the doctrine found in Cohan case with respect to certain types of expenses. This fact has been cited in numerous court cases as the basis for disallowing expenses that fall under Section 274 that were allowed in cases decided prior to the regulation being issued.
IRC Regulation 1.275-5T explains the elements in detail with examples for the four categories of expenses covered by the regulations. Publication 463 (Travel, Entertainment, Gifts and Car Expenses) and Publication 946 (Depreciation (section on Listed Property)) summarize the key elements of the law in plain English.
Listed Property is defined in IRC Section 280F and IRC Regulation 1.280F-6(b) to include vehicles, computers, cell phones and property used for entertainment, such as photographic (cameras), phonographic, communications and video recording equipment (camcorders). (Note: Computers and property used for entertainment are not Listed Property if they are used exclusively at the taxpayer’s business establishment or exclusively in connection with his principal trade or business.) There are additional requirements for depreciated Listed Property, which is discussed in the next section.
Depreciation Depreciation (IRC Sections 167, 168 and 179) may be available for computers, vehicles, office equipment, kitchen equipment, playground equipment, furniture, appliances, etc., and any fixed asset that has a useful life over one year.
Challenges: An Examiner is faced with two main concerns in addition to whether
the expense is ordinary and necessary under IRC Section 162:
• The Business Use Percentage: The facts and circumstances of each case should be used to determine the business use percentage. For Listed Property, discussed below, the provider is required to keep records as to usage. It is recommended that some records of business usage and total usage be kept for other items also. For furniture and furnishing, the business use of the home percentage may be appropriate.
• The basis to be depreciated: If the provider purchased the item in the year it was placed in service in the business, the basis is the cost. For many providers, when they start their business many items which were personal use only are used in the business. They are entitled to depreciate the business use portion of those assets.
For assets purchased prior to being placed into service, the basis for depreciation is the lower of the cost or the fair market value at the time the asset is placed in service. Determining fair market value has been an area of controversy and must be resolved on a case-by-case basis. A good starting point for determining the fair market value is to go to some of the sites which provide valuations of those items
for charitable donations purposes, such as:
Salvation Army donation valuation site: The Salvation Army: Donation Receipts Valuation Guide 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. You would still need to value it as described above and apply the appropriate business use percentage, which does not need to be 100% business use and usually is not.
IRC Section 179 allows some qualifying assets to be expensed in the year they are purchased and put into service up to the limit set by the law, which can change from yearto-year.
Special depreciation allowances in addition to the normal depreciation deduction can be granted by Congress for periods of time or for special locations, such as federally declared disaster areas.
Check the law or Publication 946 for the year the asset is purchased and placed in service to determine the amount of the depreciation deduction allowed and the criteria to take the additional deduction as well as the Section 179 amount and limits.
Listed Property, which includes vehicles, computers, entertainment equipment, such as camcorders, VCRs, televisions, stereos, pianos, etc., have special substantiation rules of Section 274(d) as well as limitations on usage and the amount of the deduction (discussed below).
Less than 50% Business Usage of Listed Property (IRC Section 280F): If the business usage of listed property is less than 50%, the asset does not qualify for an IRC Section 179 deduction, and the taxpayer must use the Alternative Depreciation System under IRC Section 168(g) since the asset cannot be depreciated using MACRS. If the business usage falls to under 50% in a subsequent year, then the provider 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.
Passenger Automobiles (limitation of IRC Section 280F): For passenger automobiles, there is an additional limitation for the total amount of depreciation allowable for each
Elements Required to Be Substantiated under IRC Section 274(d) for Listed Property: IRC Section 274(d), discussed above, requires the taxpayer (provider) to “substantiate by adequate records or by sufficient evidence corroborating the taxpayer’s own statement” the expenses listed in that section.
Under IRC Regulation 1.274-5T(b)(6), the taxpayer must substantiate the following items
to be allowed a deduction for Listed Property:
• The amount of each separate expenditure, such as the cost of acquiring the item, maintenance and repair costs, capital improvement costs, lease payments, and any other expenses;
• The amount of each business use (based on an appropriate measure, such as mileage for vehicles and time for other Listed Property), and the total use of the property for the tax year;
• The date of the expenditure or use; and
• The business purpose for the expenditure or use.
The records should be made at or near the time of the expenditure or use.
For more details and information on Listed Property and what records must be kept, refer to Publication 946 and IRC Regulations 1.280F-6, 1.274-5T, and 1.274-6T.
Note to Examiner: Use RGS Lead Sheets for audit steps Vehicle (Car and Truck) Expense Child care providers generally will incur expenses related to a vehicle, which is Listed Property as defined in IRC Section 280F. The extent of the vehicle usage for business will depend on the type of provider, the age of the children, and the type of activities they offer in the regular course of their business. Some typical expenses relate to taking children to and from school, field trips, medical facilities, and trips to buy businessrelated supplies, etc.
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, depending on the facts and circumstances. However, since vehicles are Listed Property, the provider is subject to the substantiation rules under IRC Section 274(d) and the related regulations, especially IRC Regulations 1.274-5T and 1.274-6T, for Listed Property or no deduction will be allowed. Section 274 substantiation is discussed above and the elements are listed in the Depreciation section above. Examiners need to review the documentation to verify that it conforms to the legal requirements. In child care centers, it is not uncommon to maintain vans for transporting children, which are substantially used for business, hence the substantiation requirements would be different.
Page 16 Primarily for Business: Some trips are obviously primarily for business, while others might be personal or a combination of both. If a taxpayer 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 taxpayer'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 the examiner needs to determine for each location whether it was primarily for business and allow as deductible only the mileage to/from the business purpose location. For example: A provider went 6 miles to destination A (primarily business purpose), then 5 miles to destination B (primarily personal purpose) and then 9 miles home, the provider could deduct 12 miles as a business expense (roundtrip home to destination A).
For an activity to be classified as a “trade or business,” there must be a profit motive present, and the expense must be ordinary and necessary. If the examiner finds that expenses or trips being claimed seem unreasonable for any trade or business expecting to make a profit, a probe of additional factors should be made. Are there additional fees being collected for the field trips or other trips that were not reported as income? Was the trip during the normal time for the operation of the business? Who participated in the trip? Did most of the children participate? Is there a family or other special relationship with the children which might move the expense from being an ordinary or necessary expense of a trade or business to a personal one? This issue may more commonly be found in the “Kith and Kin” type businesses. Use the facts and circumstances of each case to determine the issues that may exist.
References: See IRC Section 274 and related regulations, Publication 463, Travel Entertainment, Gift and Car Expenses, for more details on the standard mileage rate versus the deduction of actual expenses, the recordkeeping requirements, and other valuable information.
Note to Examiner: Use the RGS lead sheet for the audit steps. Be careful to verify the substantiation in accordance with IRC Section 274.
Travel, Meals, Entertainment Most providers are licensed and are required to take courses to maintain their license. In addition, there are numerous child care organizations that sponsor conventions and seminars which providers attend. There might be local classes being offered or gatherings of child care providers in an area that will help the provider in providing a better product to the children. The provider may also meet with clients or employees. Some activities require travel away from home and others might be local but include meal expenses.
Page 17 Travel, meals and entertainment are covered under IRC Section 274 and the related regulations including IRC Regulation 1.274-5T, which deals specifically with the substantiation requirements. See the section above entitled “Substantiation Requirements of IRC Section 274(d) and IRC Regulation 1.274-5T” and IRC Regulations 1.274-5A and 1.274-5T. Under Section 274(n), meal expense is subject to a 50% limitation, except meals (food) and entertainment expense provided to the children under the provider’s paid care is fully deductible. See the “Food Expense” section below. Meal expenses are not deductible unless incurred while traveling away from home or serve a business purpose, such as entertaining clients.
In addition to the IRC Section 274 requirements, for the provider to be able to deduct the expense, the provider must be a “trade or business” and the expense must be an ordinary and necessary expense. To be a trade or business, there must be a profit motive present.
While following the normal audit steps, for each expense the examiner should review the business purpose, the business relationship for meals and entertainment, and the actual expenses to determine if the expense is an ordinary and necessary expense. He/she might find that some persons who the provider has a business relationship with also have a close personal or family relationship with the provider. This should not be the sole reason to disqualify the expense. The examiner needs to look at all the facts and circumstances together before deciding whether it is an ordinary and necessary expense.
Note to Examiner: Use the RGS lead sheet for the audit steps Food Expense Providers deduct the cost of food in several different places on their returns including, but not limited to, the "Cost of Goods Sold" line, the "Supplies" line, or the "Other Expenses" line.
IRC Section 162 allows a deduction for food provided to the day care recipients. This amount is not limited by the 50% reduction imposed under IRC Section 274(n).
Under IRC Section 262, 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 (discussed above) or any other program, the provider can report all 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. The netting method is not a preferred method since an Examiner will always be looking for the food reimbursement amounts. When
Note to Examiner: Food reimbursement payments from the sponsors are received approximately one month after the expense is incurred.
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 their wages as a de minimis fringe benefit.
For more information on meals that meet these requirements, see Meals in chapter 2 of Publication 15-B, Employer's Tax Guide to Fringe Benefits.