«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 ...»
IRC Section 265(a)(1) disallows otherwise allowable deductions for expenses attributable to the business use of the home to the extent that such expenses are allocable to taxexempt income. The courts have stated that the legislative purpose behind IRC Section Page 23 265 is to prevent taxpayers from reaping a double tax benefit by using deductions attributable to tax-exempt income to offset taxable income See Induni v. Commissioner, 98 T.C. 618, 621 (1992), aff'd, 990 F.2d 53 (2d Cir. 1993). Thus, for example, expenses incurred to maintain the home (deductible under IRC Section 162), casualty losses suffered due to the partial or complete destruction of the home (deductible under IRC Section 165(c)(1)), state and local real property taxes (deductible under IRC Section 164(a)), and depreciation of the home (deductible under IRC Section 167) are subject to the Section 265 limitation. However, under IRC Section 265(a)(6), the recipient of a taxexempt military housing allowance or a parsonage allowance may deduct the full amount of otherwise deductible mortgage interest and real property taxes.
In determining the amount of business expense properly deductible in the event (1) a taxexempt military housing allowance or a parsonage allowance is received, and (2) the home is used for the business of providing child care, the methodology described in Revenue Ruling 92-3 should first be applied to each type of deductible expense. The business portion of the mortgage interest and real property taxes so determined should be claimed on the Form 8829 with the balance claimed on Form 1040, Schedule A (assuming itemized deductions are used). All remaining deductible expenses relating to the business use of the home should then be 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 resultant amount is the amount to be disallowed.
The effects of this formula may be shown as follows.
The taxpayers 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 child care activity). There is a 30-percent time and space use allocation of the home to the child care activity. The deductibility of the property taxes and mortgage interest is unaffected by IRC Section 265. Accordingly, the normal allocation required by IRC Section 280A should be performed. So, 30 percent of the $4,000 in property taxes and mortgage interest, or $1,200, should be reported on Form 8829 as allocable to the child care business. The remaining $2,800 should be reported on Schedule A in the appropriate categories.
An allocation of the remaining $3,000 of expenses is required by IRC Section 265. First, determine the amount attributable to the child care activity by multiplying 30 percent by those house expenses other than house depreciation ($2,500), which equals $750. Then 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`s of the $1,250, or $1,071.43, cannot be allowed as a deduction by virtue of IRC Section 265. This leaves only $178.57 of the additional housing expenses that are deductible on Form 88=29.
Depreciation of the Home This only applies to the residence building and not to the value of the land, equipment or other depreciable assets. 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.
Modifications to the Home
Expenses incurred to modify a residence should be treated as capital expenditures even if it is to comply with licensing requirements. 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.
Sale of Home
A capital gain issue may arise if the provider/owner sells the residence (home) in which he or she operated a business and depreciation deductions were allowed or were allowable. All or a portion of the gain on the sale of the home may qualify under IRC Section 121 to be exempt from taxation if the provider meets certain requirements discussed below. However, IRC Section 121(d)(6) provides that the exclusion provided under IRC Section 121 does not apply to any gain from the sale of a principal residence attributable to depreciation adjustments (as defined in IRC Section 1250(b)(3)) allowed or allowable for periods after May 6, 1997. Therefore, a provider/owner who used part of his or her home for business purposes may not exclude any gain from the sale of that residence that is attributable to depreciation adjustments taken or allowed for periods after May 6, 1997.
If the business is conducted within the primary residence structure, then the gain, except for depreciation allowed or allowable, can be excluded if the provider/owner meets certain requirements, including the time and ownership test discussed 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 under Section 121 for exclusion unless the provider/owner can show 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. (IRC Regulation 1.121-1(e) and Publication 523 provide more information and examples relating to this issue.) Time and Ownership test: 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
Toys This can be a significant expense depending on the size of the operation. Some toys may be depreciable while others may be deductible. Refer to IRC Sections 167, 168, and 179 and Publication 946, How To Depreciate Property, for information on this distinction.
Examine this item for large, unusual, questionable, and personal items.
Advertising Advertising is usually a minimal deduction for the “kith and kin” care providers and family child care operations. Usually the program sponsors or agencies provide free referral services.
Child care centers usually advertise in telephone directories, local newspapers, church bulletins, flyers, etc.
Note to Examiner: Use the RGS lead sheet for the audit steps.
Bad Debts A “cash method” taxpayer should not have a bad debt expense. An “accrual method” taxpayer may have bad debts generated by nonpayment for services provided.
Follow normal procedures to substantiate the expense and the efforts to collect. Also, ask if the child is still in the program. If so, why is it a bad debt and was it subsequently collected?
Note to Examiner: Use the RGS lead sheet for the audit steps.
Commissions and Fees Fees paid to contractors for such things as landscaping, repairs, etc. are common among larger facilities and may be present in smaller sized providers. Filing of Forms 1099 Misc. for the work performed by the contractor may be required based on the amount the provider paid, and failure to issue the forms may be an issue and may result in the assessment of penalties (See IRC Section 6041 and Instructions for Form 1099).
Whether the expense is an ordinary and necessary expense per IRC Section 162 and what business use percentage is applicable depends on the facts and circumstances in each
A potential employment tax issue can be found in this type of business where “employees” are being treated as independent contractors. See the discussion below under wages and compensation.
Note to Examiner: Use the RGS lead sheet for the audit steps Employee Benefit Program/Pension and Profit Sharing There are numerous employee benefit programs available, some of which are medical, disability and other accident or health plans described in IRC Sections 105 and 106;
group term life insurance coverage described in IRC Section 79; coverage under a dependent care assistance program described in IRC Section 129; coverage under an adoption assistance program described in IRC Section 137, and coverage under an IRC Section 401(k) or other type of retirement plan. More sophisticated and/or complex child care providers might offer more benefit plans than smaller providers, while many others might have none. This can be a complicated issue. Follow local procedures to determine if a referral is necessary. See appropriate publications for further information on benefit plans, including Publication 15-B, Employer's Tax Guide to Fringe Benefits, and Publication 560, Retirement Plans for Small Businesses.
Note to Examiner: Use the RGS lead sheet for the audit steps Insurance This expense item normally includes general business liability coverage, workmen's compensation coverage for employees, casualty insurance for large assets used by the facility, and other property-related insurance costs. This does not include home owner’s insurance, which is one of the expenses reported on Form 8829, Business Use of the Home.
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.
Note to Examiner: Use the RGS lead sheet for the audit steps Office Expenses and Supplies The office expense and supply category can include numerous expenses, such as food (previously discussed), toys, diapers (often provided by the parents), office supplies, cleaning supplies, educational and art supplies, etc. If material, these categories should be examined to see if they include personal items or whether the business use percentage utilized is realistic based on the facts and circumstances of the case.
Page 27 The provider should list large expenses separately under the “Other Expenses” category as well as keep records how they determined the business usage percentage. Some items such as cleaning supplies, the business use of the home percentage would be appropriate to use while other expenses should use an actual usage method percentage such as computer related supplies would use the computer business usage percentage computed under IRC Section 274, discussed earlier. If the expense is material, records on usage should be maintained to avoid areas of controversy.
Rent Rental expenses should be allocated according to the business use percentage. If the rental is for the personal residence, see “Business Use of Home” section above.
Start-Up Costs (paid or incurred after October 22, 2004) Start-up costs are expenses the taxpayer incurs prior to opening the business that would ordinarily be 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 expenditures 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. Effective for expenses incurred or paid after Sept. 8, 2008, per IRC Regulation 1.195-1T a taxpayer is deemed to have made the election to expense and amortize the start-up costs unless the taxpayer 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 (begins). Taxpayers may apply the new regulations to expenses paid or incurred after Oct. 22, 2004, by filing amended returns, provided the statute of limitations has not expired.
Reference: IRC Section 195; Publication 535 Organizational Costs of Corporations or Partnerships (paid or incurred after October 22, 2004) Organizational costs paid or incurred to create a corporation or partnership may be deducted in the same manner as start-up costs for a sole proprietorship. Effective for organizational expenses incurred or paid after September 8, 2008, per IRC Regulations 1.248-1T and 1.709-1T, a taxpayer is deemed to have made the election to expense and amortize the organizational costs unless the taxpayer 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 (begins). Taxpayers may apply the new regulations to
Reference: See IRC Sections 248 and 709 and Publication 535 for more details.
Telephone Expense The monthly expense for basic local telephone service is a nondeductible personal expense (IRC section 262(b)) even though the state requires the provider to have a telephone in order to be licensed. Additional telephone charges incurred for business purposes are deductible under IRC Section 162 to the extent substantiated.
Cellular phones are Listed Property and are required to be substantiated in accordance to the IRC Section 274(d) and IRC Regulation 1.274-5T whose elements are discussed in the section on depreciation set forth above. Also see the previous section entitled “Substantiation Requirements of IRC Section 274(d) and IRC Regulation 1.274-5T” for a general discussion of the issue.