«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 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 above. 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 Bank charges are allowable for a separate business account. For a combined business/personal account, bank charges are allowed to the extent of the business percentage.
Gifts Under IRC Section 274(b)(1), the deduction for gifts to the children or their parents are limited to $25 per person per year and must meet the recordkeeping requirements of IRC Section 274(d) and IRC Regulation1.274-5T. See also Publication 463. Examiners should not confuse expenses related to activities done with the children with gifts.
Other Expenses The “Other Expenses” category may be used to deduct expenses separately identified on the return, such as food, toys, gifts, etc.
Child care providers may have people who work for them either part-time or full-time.
Larger providers, such as child care centers, may have directors, assistant directors, teachers, assistants, cooks, drivers, etc. These workers are generally considered employees. Wages for these people are deductible and normal employment taxes apply.
Family members may work as employees of the business if bona fide services are performed. It is recommended for family member that the provider keeps a record of the dates, time, compensation rates, and work performed that clearly establishes the business purpose and to establish the bona fide service aspect. See Publication 15 for related employment tax details.
If the child care provider is a sole proprietorship, then the payments made to the provider are considered “draws” and are not deductible under wages or any other category.
Partnerships are flow-through entities. Payments to the partners are not deductible by the partnership in determining net income unless they are guaranteed payments. Guaranteed payments and the net income allocated to each partner are usually subject to selfemployment tax. If the provider is organized as a corporation or an S corporation, then the payments taken by the shareholders who perform services for the entity are wages subject to employment tax and deductible as wages.
Employee Versus Independent Contractor Note to Examiner: If you have a potential employment tax issue or a worker reclassification issue, refer the issue to the Employment Tax Specialty Group to work.
The discussion below is included to help you identify this issue in your case.
The following is a brief outline of the law regarding employment status and employment tax relief. It is important to note that either worker classification--independent contractor or employee -- can be valid.
The first step in any case involving worker classification is to consider Section 530 of the Revenue Act of 1978. Before or at the beginning of an audit inquiry relating to employment status, an examiner must provide the taxpayer with a written notice of the provisions of Section 530 ( Publication 1976). If the requirements of Section 530 are met, a business may be entitled to relief from federal employment tax obligations. Section 530 terminates the business's, but not the worker's, employment tax liability, including any interest or penalties attributable to the liability for employment taxes.
In determining a worker's status, the primary inquiry is whether the worker is an independent contractor or an employee under the common law standard. Under the common law, the treatment of a worker as an independent contractor or an employee originates from the legal definitions developed in the law of agency -- whether one party, the principal, is legally responsible for the acts or omissions of another party, the agent -and depends on the principal’s right to direct and control the agent.
Page 30 Guidelines for determining a worker's employment status are found in three substantially similar sections of the Employment Tax Regulations: Sections 31.3121(d) -1, 31.3306(i) and 34.3401(c) -1, relating to the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and federal income tax withholding. The regulations provide that an employer-employee relationship exists when the business for which the services are performed has the right to direct and control the worker who performs the services. This control 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, a worker 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. 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 facts and circumstances must be examined.
The Service now looks at facts in the following categories when determining worker classification: behavioral control, financial control, and relationship of the parties.
Behavioral Control: Facts that substantiate the right to direct or control the details and means by which the worker performs the required services are considered under behavioral control. This includes factors such as training and instructions provided by the business. 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 the scope of instructions, the extent to which the business retains the right to control the worker's compliance with the instructions, and 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.
Financial Control: Facts on whether the business has the right to direct or control the economic aspects of the worker's activities should be analyzed to determine worker status. Economic aspects of a relationship between the parties illustrate who has financial control of the activities. The items that usually need to be explored are whether the worker has a significant investment, 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 first four items are not only important in their own right but also affect whether there is an opportunity for the realization of profit or loss. All of these can be thought of as bearing on the issue of whether the recipient has the right to direct and control the means and details of the business aspects of how the worker performs the services.
Page 31 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. Significant investment, unreimbursed expenses, making services available, and method of payment are all relevant in this regard. If the worker is making decisions which affect his or her bottom line, the worker likely has the ability to realize profit or loss.
Relationship of the Parties: The relationship of the parties is important because it reflects the parties’ intent concerning control. Courts often look to the intent of the parties, which is most often embodied in contractual relationships. 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. However, a contractual designation, in and of itself, is not sufficient evidence to determine worker status. The facts and circumstances under which a worker performs services are determinative of a worker's status. The designation or description of the parties is immaterial. This means that the substance of the relationship governs the worker's status, not the label.
References: For an in-depth discussion, refer to Internal Revenue Manual 4.23.5, Technical Guidelines for Employment Tax Issues, which includes the Section 530 determination, and related exhibits. Publication 15B, Employer's Supplemental Tax Guide, is also available to provide guidance.
Exhibit A Sample IDR Shown below are items examiners may want to consider when preparing an Information Document Request (IDR) for a child care provider.
NOTE: While the list is not all inclusive, at the same time not all items should be requested in every case. Examiners should use this information as a guide and request only the items that are appropriate and relevant for their specific cases.
1. Be prepared to discuss the business history of your child care activity, including the starting date, a brief description of a typical day’s activities, rooms used on a "regular" basis, and internal controls for income and expense information.
2. If you are taking any deductions for the use of your home in your child care activity, provide a floor plan, blueprint, or other relevant documents that reflect the square footage of the residence. Provide the escrow and/or closing statement to verify the cost of the property. Provide mortgage company statements or other relevant documents that show the property taxes and mortgage interest paid during the taxable years (insert the taxable years). If you are renting your home, provide substantiation of the rent paid during the taxable years (insert the taxable years) and a copy of the rental agreement.
3. Provide copies of your federal income tax returns for the taxable years (insert the taxable years); prior federal and state tax audit reports for the taxable years (insert the taxable years); and any related tax returns (e.g., partnership returns, corporate returns, or employment tax returns) for the taxable years (insert the taxable Page 32 years)); and any Forms 1099 filed and/or received during the taxable years (insert the taxable years).
4. Provide journals, ledgers, records, and/or notebooks used to keep a record of your clients and the amount they paid (weekly, monthly, etc.) during the taxable years (insert the taxable years).
5. Provide all bank statements, business and personal, for the period beginning (insert first day of the period) and ending (insert last day of the period).
6. If you are a participant in a food program, provide copies of the reimbursement statements, name and address of the food sponsor, attendance and meal count record, and time record for reimbursements received during the taxable years (insert the taxable years).
7. Provide a copy of any benefit or retirement plan offered to your employees.
8. Provide substantiation in the form of canceled checks, receipts, statements, or invoices for expenses identified for examination.
9. Provide all business licenses, approvals, registrations, and certifications.
10. For the taxable years (insert the taxable years ), provide any contracts for services, rate schedules, policy statements, sign-in/out sheets or any other attendance records, emergency contact sheets and/or medical treatment forms for children in program for year of examination, permission slips for trips, and year end statements to parents, if any.
Exhibit B Internal Revenue Regulation 1.280A-2(i) Proposed Regulation 1.280A-2 Deductibility of expenses attributable to business use of a dwelling unit used as a residence (i) Limitation on deductions - (1) In general. The deductions allowable under chapter 1 of the Code for a taxable year with respect to the use of a dwelling unit for one of the purposes described in paragraphs (b) through (f) of this section shall not exceed the gross income derived from such use of the unit during the taxable year, as determined under subparagraph (2) of this paragraph. Subparagraphs (3) and (4) of this paragraph provide rules for determining the expenses allocable to the business use of a unit. Subparagraph (5) of this paragraph prescribes the order in which deductions are allowable.
(2) Gross income derived from use of unit. (i) Only income from qualifying business use to be taken into account. For purposes of section 280A and this section, the taxpayer shall take into account, in applying the limitation on deductions, only gross income from a business use described in section 280A(c). For example, a taxpayer who teaches at school may also be engaged in a retail sales business. If the taxpayer uses a home office on a regular basis as the principal place of business for the retail sales business (a use described in section 280A(c)(1)(A)) and makes no non-business use of the office, the taxpayer shall take the gross income from the use of the office for the retail sales business into account in applying the limitation on deductions. Even if the taxpayer also corrects student papers and prepares class presentations in the home office (not a use described in section 280A(c)), no portion of the taxpayer's gross income from teaching may be taken into account in applying the limitation on deductions.
Page 33 (ii) More than one location. If the taxpayer engages in a business in the dwelling unit and in one or more other locations, the taxpayer shall allocate the gross income from the business to the different locations on a reasonable basis. In making this determination, the taxpayer shall take into account the amount of time that the taxpayer engages in activity related to the business at each location, the capital investment related to the business at each location, and any other facts and circumstances that may be relevant.