«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 ...»
Food may be bought in large quantities in larger child care operations. Freight charges may be included in the food account. Some centers might have special occasion activities for the children in which the parents are invited, such as Christmas, where meals are provided. Such special occasion costs are deductible as a special activity cost.
Substantiation Requirement: IRC Section 6001 and IRC Regulation 1.6001-1(a) provide that every person must keep records to substantiate the amount of any deduction.
If the provider deducts the actual food expense incurred, they must maintain receipts which clearly identify the cost of the food allowed as an IRC Section 162 trade of business expense from those costs that are nondeductible personal expenses under IRC Section 262.
Revenue Procedure 2003-22 was issued 2-24-2003 to simplify recordkeeping requirements by providing an optional standard meal and snack rates that “family day care providers” may use in computing the deductible cost of food provided to eligible children in the day care in lieu of actual costs. The rate is based on the Tier I rate under the CACFP. 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 still a recordkeeping requirement, which includes the name of each eligible child, dates and hours of attendance in the family day care, and the type and quantity of meals and snacks served. More information on this method, including which providers qualify and who is an eligible child, can be found in Publication 587 under the chapter Daycare Facilities specifically the section entitled “Standard Meal and Snack Rates.” A sample log can be found in Exhibit A, which is at the end of the Publication.
If the provider chooses to use the standard meal and snack rates, he/she must do so for the complete tax year. The provider cannot use the actual method during that tax year but can switch methods in a subsequent tax year if he/she wishes.
Caution to Examiners: The standard meal and snack rate method in Revenue Procedure 2003-22 is available to a trade or business which provides child care 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. The revenue procedure applies to any “family day care provider” whether or not the provider received
Business Use of the Home:
Introduction Child care providers are allowed a deduction for expenses associated with the business use of their homes. The requirements for the deduction are different than those for other businesses since qualifying usage does not require exclusive use for business. Regular usage is generally qualifying. A provider may have a combination of exclusively used rooms and regular used rooms, which is discussed in the instructions of Form 8829. See IRC Section 280A(c)(4).
If the child care provider meets the requirements to qualify to take the deduction (discussed below), it is computed on Form 8829, Expenses for Business Use of Your Home.
Requirements to Qualify for Business Use of Home Deduction for Day Care Facilities (Regulatory) In order to claim the business-use-of-the-home deduction, the taxpayer must meet the
following two requirements:
1. The provider must be in the trade or business of providing day care for children, persons age 65 or older, or persons who are physically or mentally unable to care for themselves. (IRC Section 280A(c)(4)(A)).
2. The provider must have applied for, been granted, or be exempt from having, a license, certification, registration, or approval as a day care center or as a family or group day care home under state law. The provider does not meet this requirement if their application was rejected or the license or other authorization was revoked. (IRC Section 280A (c)(4)(B)).
The examiner should check the requirements of the state in cases where the provider claims exemption from the state licensing requirements.
Note to Examiners: The licensing requirement applies only to the deduction for business use of the home. An unlicensed provider may still deduct other business expenses, such as food, toys, supplies, etc.
Limitation on Deduction (Regulatory) IRC Section 280A(c)(5) limits the deduction if the taxpayer's expenses exceed gross income from the child care activity. See IRC Proposed Regulation 1.280A-2(i) attached as Exhibit B for more details.
The qualifications for business-use-of-the-home expenses are different for child care providers than for other businesses. Unlike most businesses, qualifying usage does not require exclusive use; however, Congress did impose a regular basis usage test in IRC Section 280A(c)(4) for the child care providers. In Uphus v Commissioner, T.C. Memo.
1994-71, the issue of regular use was addressed. This case discussed the regular basis usage test imposed by Congress in the law. The court stated: "Consistent with the Senate report, we have found that regular basis test is met where the taxpayer is able to establish that the business use is continuous, ongoing or recurring. …However, where the business use of the area is merely an incidental or occasional business use, expenses incurred for that area are not deductible."
Revenue Ruling 92-3 provides specific guidance for the calculation of the deduction for the business use of a home by day care providers. In determining whether a space in the home passes the “regular use” test in computing business use of the home, Revenue
Ruling 92-3 outlines the following:
If a room is available for day care use throughout each business day and is regularly used as part of A’s routine provision of day care (including a bathroom, an eating area for meals or a bedroom used for naps), the square footage of that room will be considered as used for day care throughout each business day. A day care provider is not required to keep records of the specific hours of usage of such a room during business hours. Also, 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 day care (e.g., a bedroom ordinarily restricted from day care use but used occasionally for naps) will not be considered as used for day care throughout each business day.
Determining Business Percentage
The business percentage consists of two elements: the space percentage and the time percentage discussed in detail below. The two percentages are multiplied by each other to get the business percentage. Part I of Form 8829, Expenses for Business Use of Your Home, walks you through the actual computation. The Form 8829 instructions provide detailed computation directions for the cases where the provider’s business usage consists of a combination of exclusively-used rooms and regularly-used rooms.
Note to Examiner: Since there are no set norms, the examiner must establish the facts and circumstances in each case to determine the elements that go into making up the business-use-of-the-home percentage, discussed in more detail below, including the total square footage of the house and the business-use portion. The initial interview is essential to gather the facts, especially the room(s) that are used regularly or exclusively or both.
Space Percentage (Form 8829 Part I lines 1-3)
The examiner should ask the provider how each room included in the business area was used. Evaluate whether each room included was regularly used, as discussed above. Use follow-up questions as needed. If the regularly used test is met, that area is included in the numerator. Many times we tend to be judgmental in our analysis. Be careful to stick to the facts to determine whether a particular room was regularly used for business purposes. For example, the taxpayer has three children in his/her care and three bedrooms which are used for naps. The provider explains that the children are put down for naps separately since they sleep better. While the provider could put all three children down for naps in the same room, the examiner should not limit the deduction to the use of one bedroom. On the other hand, if the taxpayer is claiming the square footage of a formal dining room in the business usage and your interview indicates that the children have their meals in the kitchen, you will need to probe to determine exactly how the dining room is used on a continuous, ongoing, or recurring basis.
The examiner will need to determine the total square footage of the home. This can be done in several ways, such as reviewing house plans, blueprints, escrow papers, or any other documents that substantiate the square footage. A common error made by taxpayers is to include only one floor in the total square footage. For example, the taxpayer operates a day care facility on the main floor of her 1800 square foot home. She used 1800 as the total square footage. However, her home has a full basement. The basement square footage must be added to the total square footage. Another common error occurs in cases where the taxpayer is using the garage in the business. You must be sure that the square footage of the garage is added to the denominator (total home space) as well as the numerator (business usage space).
Time Percentage (Form 8829 Part I lines 4-6)
The time percentage is the total number of hours the facility was used for the child care business during the year (the numerator) divided by the total hours in the year (8,760 hours). The provider should record how the total hours the facility was used, was computed. Hours spent cooking, cleaning, and preparing activities for the business of child care could be included in the calculation of the numerator of the time percentage if the tests for deduction under IRC Section 162 (ordinary and necessary expenses) are otherwise met under the facts of the particular case. As illustrated in Revenue Ruling 92one hour is added to the 11 hours of actual day care operation for the ½ hour before and ½ hour after regular hours spent preparing for and cleaning up after the children.
Note to Examiners: The Revenue Ruling example is not an absolute rule. The time outside of the regular hours to be added can be more or less depending on the facts and circumstances in each case, which need to be evaluated in line with Section 162 (ordinary and necessary expenses). Some providers, because of the type of service provided and/or Page 22 ages of the children, might spend more time preparing activities for the children than others and vice versa. In addition, some preparation work might be done on the weekends. Recordkeeping time can also be included. Often a provider will keep a detailed log of his/her activities for a significant part of the year. This detailed record keeping of the time spent and tasks performed is essential to provide the details needed by the examiner to make an informed determination under Section 162, so it is highly recommended that all providers keep such logs. Ultimately, examiners should make a decision based on the facts and circumstances of each case.
Figuring the Allowable Deduction:
Continuing on Form 8829, you will need to determine which expenses are direct and which are indirect. Direct expenses are those that are incurred exclusively for the business and provide no personal benefit. Indirect expenses are those that are not incurred exclusively for the business (i.e., expenses which benefit both the business and the home). Indirect expenses must be allocated using the business use percentage. The portion of mortgage interest and property taxes not deductible on Form 8829 should then be reported on Schedule A. Verify any necessary entries to the source documents, especially the total mortgage interest and taxes claimed on Form 8829 and Schedule A, since it is a common error that these expenses are either duplicated or that more than 100% is deducted between the two schedules.
Tax Exempt Income Used for Payment of Housing Used in Day Care:
In some cases, providers may operate their day care businesses in housing that is provided by an employer as a nontaxable benefit. The most common instances involve military personnel and the clergy.
Military personnel receive tax-free housing as a condition of their employment. See IRC Section 134. The structure of the housing arrangement can vary between branches of the military and from base to base. Some bases provide government-owned housing where the only out-of-pocket costs may be cable and Internet expenses. On other bases, housing is privatized. Military personnel receive the nontaxable allowance in their monthly checks and are responsible for paying the rent and utilities directly to the housing contractor. It is possible that the amount of rent and utilities could exceed the housing allowance. Military personnel may also live off base in privately owned housing. They may use the nontaxable housing allowance to pay for rent and utilities or to make their house payment if they own a home.
A member of the clergy may receive a nontaxable housing (parsonage) allowance. See IRC Section 107 and Publication 517 for more details on the requirements for the allowance to be nontaxable.