Commentary on the IRS Child Care Provider Audit Technique Guide
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Commentary on the IRS Child Care Provider Audit Technique Guide

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Commentary on the IRS Child Care Provider Audit Technique Guide By Tom Copeland, JD Introduction On April 17, 2009 the IRS published a revised edition of the Child Care Provider Audit Technique Guide. Read the Guide [www.irs.gov/businesses/small/article/0,,id=206004,00.html]. This Guide was written to help instruct IRS auditors how to conduct an audit examination of family child care providers. It also identifies the unique tax issues and business practices of family child care providers. In 2000 the IRS published the first edition of Child Care Provider Audit Technique Guide. This Guide is part of the IRS Market Segment Specialization Program, a series of IRS Guides that focus on particular business industries. This second edition of the Guide is a major improvement on the first edition. It offers a greatly expanded explanation of key tax issues and clarifies a number of points in ways that are favorable to family child care providers. Notable changes include: An expanded section highlighting the importance the IRS places on looking for unreported income in this field. The clearest explanation in any IRS publication of how to report Food Program reimbursements as income. A new section on the use of the standard meal allowance rule for claiming food expenses. An expanded section on how to allocate expenses for items used for both business and personal purposes. A detailed discussion of how to calculate the business use of home percentage. ...

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Commentary on the IRS Child Care Provider Audit Technique Guide By Tom Copeland, JD Introduction On April 17, 2009 the IRS published a revised edition of the Child Care Provider Audit Technique Guide . Read the Guide  [www.irs.gov/businesses/small/article/0,,id=206004,00.html]. This Guide was written to help instruct IRS auditors how to conduct an audit examination of family child care providers. It also identifies the unique tax issues and business practices of family child care providers. In 2000 the IRS published the first edition of Child Care Provider Audit Technique Guide . This Guide is part of the IRS Market Segment Specialization Program, a series of IRS Guides that focus on particular business industries. This second edition of the Guide is a major improvement on the first edition. It offers a greatly expanded explanation of key tax issues and clarifies a number of points in ways that are favorable to family child care providers. Notable changes include:  An expanded section highlighting the importance the IRS places on looking for unreported income in this field.  The clearest explanation in any IRS publication of how to report Food Program reimbursements as income.  A new section on the use of the standard meal allowance rule for claiming food expenses.  An expanded section on how to allocate expenses for items used for both business and personal purposes.  A detailed discussion of how to calculate the business use of home percentage. This section includes, for the first time, a statement that the area of a basement and garage should be included in the total square footage of the home when calculating this percentage.  A recognition that items purchased before the business began and then later used in the business can be depreciated under the normal rules of depreciation. This commentary on the IRS Child Care Provider Audit Guide is designed to help a family child care provider who is being audited or a tax professional who is representing a provider in an audit. It highlights, explains, and expands upon the key points made in the Guide to help the reader better able to anticipate what the
auditor will do and better prepare for the audit. I strongly recommend that the reader review the Guide and my commentary before meeting with an auditor. At the invitation of the IRS I made a series of recommendations for how the second edition of the Guide could be improved. The IRS did incorporate many of my suggestions. I will continue to offer suggestions to the IRS on how to improve future editions of the Guide . If you have experiences with IRS audits or have your own recommendations for other changes in the Guide , please contact me and I will pass them on to the IRS. I may be reached at 800-359-3817 (x321) or tcopeland@nafcc.org . If you are a member of the National Association for Family Child Care I can offer some free assistance with your audit. If you are a tax professional I can answer your questions and offer free advice. I would very much like to hear from those who have been or are currently being audited or are providing professional audit assistance so that I can continue to be a resource to the family child care field. Commentary “Kith and Kin” (Care Provided by Relatives, Friends and Neighbors)  These caregivers (also called exempt providers or informal caregivers) are often not aware of their responsibility to report their income and expenses. The Guide says, These providers often believe that this income is not taxable and, therefore, need not be reported. However, this could result in both taxable income and self- employment tax. ” In fact, all such income should be reported on Schedule C. For many of these providers it may come as a shock to discover that they owe 15.3% of their net profit in Social Security and Medicare taxes. All kith and kin providers are required to follow the same IRS rules regarding reporting income and expenses as licensed family child care providers. IRS Publication 587 Business Use of Your Home makes it clear that providers who are exempt from state licensing rules are entitled to claim the same house expenses on Form 8829. Many kith and kin providers are not keeping business receipts and are likely paying too much in taxes. In addition, when these providers sell their home they will have to pay tax on the depreciation they were entitled to claim, even if they didn’ t claim it. Kith and kin providers who don’ t show a profit are not eligible to claim house depreciation and thus won’ t owe tax on the depreciation when they do sell their home.  Family Day Care “ This type of child care is provided in the home of the provider, is nonmedical and is usually for less than 24 hours, ” says the Guide . In the previous version of the Guide it said, “ and is for less than 24 hours. ” There are some providers tha t work 24 hours a day
who are still entitled to claim all “ ordinary and necessary” expenses. At my suggestion, this change was made. Child Care Centers This Guide is not addressed at child care centers and should not be consulted if you are a child care center. In-Home Care If you are a nanny or au pair who is caring for a child in the child’ s home, the IRS considers you to be an employee of the parent (unless you work for a nanny agency). This Guide is not written for you. Status This section identifies the most important areas that an auditor is likely to examine in an audit. The IRS recognizes that many providers are not adequately reporting their income or expenses and keep inadequate records. This is also my experience. As a result, the IRS will likely be suspicious of a provider’ s records. Providers who do have good records will likely surprise the auditor and make a favorable impression. Therefore, providers should do everything they can to organize their records before meeting with an auditor, even if this means reconstructing lost records. One of the issues most often audited is “ supplies and miscellaneous expenses (may include personal expenses). ” Providers can expect an auditor to look closely at these expenses to see if they are personal or business. To show that these are business expenses, be careful to save the receipts for all household supplies that are used by your family as well as your business. Don’ t claim 100% of one type of expense (paper towels, laundry soap, etc.) unless you can show receipts for personal use of these same items. If you didn’ t save all of these receipts, look to see if you have cancelled checks, credit or debit card statements for purchases at the stores where you bought these items. This can be used to show that you did buy a lot more of these types of items than you deducted. If you have better records in tax years subsequent to the years under audit, show these records as evidence that your business deduction is reasonable. In the first edition of the Guide  it said, “ A net loss is unusual expect at the corporate level. ” I wrote to the author that in fact it is not unusual for a provider to show a loss, particularly in her first year or two of business. Fortunately, this sentence was taken out, thus giving some hope for providers who do show a loss to defend this position in an audit. Showing losses several years in a row does, however, increase a provider’ s chances of being audited. I asked for clarification on how a provider could avoid showing a loss when caring for only a few subsidized children but the Guide does not address this issue. Introduction 
The Guide refers to the different business entities that providers might operate under: sole proprietor, partnership, corporation or LLC. The partnership and corporate tax return is more complicated to file. A sole proprietor and a single person LLC fills out their tax return in exactly the same manner. In general, providers are better off operating as a sole proprietor. If you are considering operating as anything other than a sole proprietor you should carefully consider a number of factors, including the tax and limited personal liability issues. I strongly advise you to consult with both a tax professional and an attorney before making this decision. For a detailed discussion of the business structure options, see my Family Child Care Legal & Insurance Guide , published by Redleaf Press. Interview This is an entirely new section of the Guide . The large number of questions included here that auditors are recommended to ask providers during an audit interview is a reflection of how important the IRS considers the reporting of income in family child care. In other words, the IRS will be initially suspicious that a provider has not properly reported all her income on her tax return and will ask these probing questions in an attempt to uncover unreported income that can then be taxed. The Guide focuses on the many different rate terms that may be listed in the contract or policies: illness, vacation, late pickup, overnight, transportation, diaper fees, holding fees, etc. The auditor will be looking at this to see if the provider got paid additional amounts beyond the regular child care rate. Because parent fees are the main source of income, providers should take steps to keep careful records that can back up the income reported on her tax return. Here are some suggestions for how to do this: Report on your tax return all income from parents, the Food Program, subsidy program, and grants.  Keep records showing the source of all deposits into your checking or savings accounts (both business and personal). Indicate on a deposit slip, check register, software program, or other record where the money came from (husband’ s paycheck, business deposit, transfer from savings, etc.). The IRS likes to look at bank deposits and compare them to what you reported as income. If you cannot identify where all the money came from for each deposit the IRS will assume the unidentified deposit is business income.  Give parents an end-of-year receipt of the total amount the parent paid you for the year and ask them to sign a copy for you to keep in your files.  If you receive, cash from parents and do not deposit all of it in a bank account, make a note on a ledger or your calendar of how much you did deposit of these cash payments.  
The IRS will initially assume that a child is enrolled in your program for 52 weeks a year at your full time rate. They will look at your contract to identify your rates. For example, if your rate is $150 a week the IRS will assume you earned $7,800 a year to care for one child. You need to keep attendance records that show when a child was not present (sick day, vacation, holiday, etc.) and if the child was part-time for all or part of the year.   If your rates change in the middle of the year, or you do not charge the parent your full rate (because of a family layoff or illness), keep records to show that you did not receive your full-time rate for this child for part or all of the year.  Here is an example: You care for a child for 52 weeks and the child is on the Food Program. However, because of a layoff in the child’ s family, you decide to charge the family half your regular rate for three months. The IRS will look at your Food Program records and attendance records to see that the child is present for the entire year. They will then assume that you were paid your full rate for the year. You need to show with your parent payment records that the parent did pay less for those three months.  If your contract says that you charge for a late pick-up fee, or for overnight care, or early drop off, or for transporting the child, and so on, be sure that if you do not charge for any of these fees your records show this. In other words, if your attendance records show that the child was picked up at 7pm and your contract says the pick-up time is 6:30, with a $1 a minute late fee, the IRS will assume that you earned an extra $30 each day that this happens. If you are not charging parents for these late pick-ups put a note in your attendance records (“ No late fee charged” ).   Reconstruction Methods to Verify Income or Reconstruct Income  In this section of the Guide the IRS is again stressing the importance of looking closely at the records of providers to make sure that all income was reported. Auditors may rely less on bank deposit statements when auditing a “ Kith and Kin” provider because parents are more likely to pay in cash. The Guide indicates that the auditor may want to contact parent clients directly to verify how much they paid their provider. The Guide gives a new example of a how an auditor might try to verify income using sign-in/out sheets and rate schedules. In this example the provider reported $38,400 of income based on her bank deposit records. But when the auditor looked at attendance records and multiplied the days the children were in care with the stated rate of $250 a week, the income totaled $61,250. This provider is in trouble because it looks like she underreported her income. How would a provider respond to this situation? The provider might make the case that parents didn’ t actually pay the stated rate consistently throughout the year for a variety of reasons. To support this position the
provider should ask parents to write letters indicating how much they did pay that was less than $250 a week for part or all of the year. The Guide updates an example of how to reconstruct income using a food reimbursement formula. The provider charges an average weekly fee of $200 per child and serves a lunch and two snacks per day, per child. The provider received $6,501 from the Food Program. The Guide tells the auditor to use the $6,501 amount to calculate how many child days this represents and to multiply it by the average weekly fee. Using this formula in this example, the auditor concludes that the provider must have earned $83,000. If this provider is told that she earned $83,000 and this amount is much more than she actually earned, how can she argue that this formula may not accurately reflect her income:  Some of the parents may not have paid her full weekly rate for 52 weeks.  Some part-time children may have eaten the same number of meals as a full-time child.  The number of meals that were served may have varied during the year.  The rates for some children may have gone down during the year (for example, when an infant became a toddler).  The provider may have offered temporary free care to some children who were on the Food Program because of financial problems.  The provider didn’ t charge on a weekly ba sis to all families.  A parent left, owing money. There may be other reasons why this formula may not work in every case. Providers and tax professionals may want to check their tax return to see if they will have difficulty defending their reported income if this formula was applied to them. If not, write a note to yourself explaining the discrepancy. This note will be very important if you are ever audited. In addition, keep complete records of parent payments, children’ s attendance, and the number of meals served (including unreimbursed meals). Food Program Reimbursements (CACFP) This new section in the Guide offers an explanation of how the Food Program operates. The Guide  encourages providers to report Food Program reimbursements under “ Other Income” on  Schedule C. It also recognizes that reimbursements for a provider’ s own child is not taxable income. For a complete discussion of how to report Food Program reimbursements see below under “ Food Expense. ”  Other Income
The Guide addresses for the first time a situation where a provider gets a forgivable loan and says that when the loan is forgiven it is taxable income on Schedule C. There are a number of loan programs for family child care providers operating across the country and some of them are forgivable after the passage of time. For example, if a $1,000 loan is forgivable 20% a year for 5 years, then the provider should be reporting $200 as income each year. Expense Issues This entire section is new to the Guide and is extremely helpful in many respects. It acknowledges that providers use many items for their business that have both business and personal purposes (fixed assets, toys, supplies, appliances, vehicle expenses). It recognizes that some property might be used “ substantially” while in other ca ses it might be “ minimally” used. It directs the auditor 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. ”  The Guide then gives two examples of lawn expenses and laundry facilities and says that the proper way to allocate the business portion of these expenses is to use the “ business usage of the home percentage. ” (IRS Tax Court case Neilson v. Commissioner, 94-1, 1990 allowed a provider to claim lawn care expenses for her business.) Note: In an early draft of the Guide it said that providers should calculate an actual business use of the laundry facilities. At my request this language was changed. These statements may seem obvious to providers or experienced tax professionals, but they are the first time the IRS has given such explicit directions to auditors on how to handle family child care expenses. I have seen audits where the auditor claimed, in principal, that providers couldn’ t claim deductions f or items that were also used personally. I have seen other auditors who did allow some deductions for general household expenses (such as lawn care and laundry) but were very uncomfortable with the idea and had to be talked into it. The sweeping statement in this section “ there are many such examples in this industry of expenses incurred for both business and personal purposes” should encourage providers to claim a portion of all allowable household expenses and feel confident that this claim will be upheld in an audit. In addition, the advice to use the Time-Space Percentage (business usage of the home percentage) is also extremely helpful in clarifying how to allocate shared business and personal expenses. Substantiation Requirements of IRC Section 274(a) and IRC Regulation 1.274-5T This is another new section for the Guide . The language is not specific with regards to family child care, but rather summarizes the law dealing with the requirement that
taxpayers must substantiate their expenses with “ adequate records. ” This is not new. However, placement in this Guide suggests that the IRS wants auditors to be stricter in accepting business records from providers. The Guide points out that the Cohan rule is superseded by subsequent IRS regulations for certain types of expenses. These expenses include: travel, car, gift, and listed property. In the Cohan case the taxpayer didn’ t have adequate records to claim business expenses but the court allowed him to make a close approximation of his expenses rather than disallowing them entirely. Here the Guide is implying that providers could lose an entire deduction without adequate records and that the unsupported testimony of a provider is not an adequate record. This seems like it may be more difficult for providers to have their deductions accepted if they don’ t have adequate records and that the test for what is an adequate record may be more difficult to meet. Clearly, providers who have no records and are putting deductions on their tax return that are only guesse s should not do so. Providers who are audited and find that they can’ t back up their deductions still can try to make their case by uncovering receipts, cancelled checks, credit/debit card statements, parent statements, photographs and other records. Simpl y arguing that the deduction is “ reasonable” without backup is not going to be allowed if the auditor follows this Guide . Listed Property Listed property includes vehicles, computers, cameras, camcorders, cell phones and property used for entertainment, amusement or recreation. This could include televisions, VCR and DVD players as well as stereos and record players. The consequence of this designation is that taxpayers must have an “ adequate record” to substantiate the business use of such items. Commonly, IRS auditors like to see a log showing business use. As a practical matter, this is virtually unheard of in the family child care field. Providers are not tracking their daily use of their home computer, cell phone or televisions. It’ s unlikely that they ever will because of its impracticality. I have always argued that providers should use their Time-Space Percentage to determine the business portion of such expenses and have usually won on this point in IRS audits. The Guide may make it harder to argue this position. In the previous Guide a number of items were identified that were excluded from the stricter record-keeping requirement of listed property. These items were: computer, camcorder, VCR, television, stereo, piano and guitar. Presumably these items will now need to meet the stricter record keeping standard. Note that computers and entertainment items 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. ” The only time this would be the case for a family child care provider is if she had the computer in an exclusive use room or she operated her business in a building that was not her home (thus the space would also be exclusively used in her business).
Depreciation This is a greatly expanded section in the new Guide that is very helpful in clarifying two issues. First, in a discussion of how to determine the business use percentage it explicitly says that providers can use their Time-Space Percentage for furniture and furnishings. Second, the Guide clearly states that providers may depreciate items purchased before their business began that were originally exclusively personal use and then later put into business use. It says, “ The fact that t he 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. ”  This last statement is significant in that it recognizes that providers can depreciate hundreds of items in their home that were purchased before their business began. I have always encouraged providers to do an inventory of household items and start claiming depreciation deductions when their business begins. Providers can also use IRS Form 3115 Application for Change in Accounting Method to recapture previously unclaimed depreciation if they have not already depreciated such items. Providers who are audited and have not previously depreciated all of their household items should take the opportunity to claim any allowable depreciation. In addition they should file Form 3115 to help offset any tax deficiencies found in the audit. It is unlikely that providers will have receipts or other records of these items that were purchased before their business began. They should take pictures of their property and estimate their value at the time their business began. A reasonable estimate of this value should be accepted. The old Guide offered little help on understanding how to depreciate items in a family child care busi ness. It said, “ Assets that are converted from personal to business use should use fair market value at the time of conversion as a basis for depreciation. ” This left it unclear whether such assets had to be converted from 100% personal use to 100% business use. I wrote to the author of the Guide that I had seen many audits where the auditor would not allow depreciation deductions for assets because they were originally 100% personal use, or because the provider had to purchase the items anyway (i.e. for personal use), or because the items no longer had any value when first used in the business because their useful life had expired. Fortunately, the author of the new Guide  accepted my recommendations that this issue be addressed and such faulty thinking should now disappear. Vehicle (Car and Truck) Expense At my request, the Guide eliminated language that implied that trips for the benefit of a child at the request of a parent “ would not generally be the responsibility of the child care provider. ” Other lan guage instructing the auditor to look at the car insurance policy to verify the business use of the car was also deleted.
The old Guide said, “ If a trip involves multiple locations, then only the mileage to/ from the business-only destination is deductible. ” I asked for a clarification on what this meant and the Guide gives an example that says that if there is a business destination and a personal destination in one trip that only the round trip miles to and from the business destination are deductible. The Guide  also expands the discussion of car expenses to state that “ there must be a profit motive present and the expense must be ordinary and necessary. ” The discussion that follows indicates that the auditor may question mileage deductions that occur after normal child care hours or involve some, but not all of the children in care. Providers should protect themselves by keeping careful records of business trips. Such records could include permission forms, calendar notations, and parent contracts that spell out transportation policies. Since car expenses will be subject to the stricter record keeping requirements of listed property, providers can expect closer scrutiny at an audit. Travel, Meals, Entertainment The Guide expands its discussion of deducting meal costs away from home by citing the regulations on this issue. Meal expenses away from home are subject to the 50% deduction limitation, while food served to the children in care are not. The cost of meals to entertain parent clients would be deductible (subject to the 50% limitation) but whether or not other meals are deductible depends on whether the expense is ordinary and necessary and if there is a profit motive present. In other words, a provider who spends $1,000 on meals for prospective clients and shows a $2,000 annual profit would have a hard time showing that this expense was undertaken with a profit motive. I had asked the authors to clarify whether providers could deduct meals when two providers ate lunch together to discuss business issues but they did not address my request. The Guide instructs auditors to look closely at meals in which the other person present has a “ close personal or family relationship with the provider. ” Obviously, if a provider is taking her husband out to dinner to discuss business issues this will get a close scrutiny. Interestingly, however, the Guide  goes on to say, “ This should not be the sole reason to disqualify the expense. ” Providers who do deduct meals served to family members should keep careful records, including receipts, names of persons at the meal, as well as a description of the business topics discussed. In addition, the annual deduction for such meals should reasonable in light of the overall business profit. Food Expense This new section offers the best explanation found in any IRS publication of how to report Food Program reimbursement payments. There continues to be false information circulating in the family child care field stating that reimbursements from the Food Program do not need to be reported as income on Schedule C. Even some Food Program sponsors continue to spread this misinformation thus creating the false impression in the minds of some providers that reimbursements from the Food Program are not taxable income.
The 2000 Guide  said, “ Federal food program reimbursements… are normally not taxable income if the food expenses are offset against this income. ” This description of offsetting, or netting, of income is also found in IRS Publication 587 Business Use of Your Home: “ Reimbursements y ou receive from a sponsor under the Child and Adult Care Food Program of the Department of Agriculture are taxable only to the extent they exceed your expenses for food for eligible children. ” IRS Publication 525 also contributes to the confusion when it s ays, “ If you operate a daycare service and receive payments under the Child and Adult Care Food Program administered by the Department of Agriculture that are not for your services the payments generally are not included in your income ” .  If a provider followed this advice and spent $5,000 on food and received $4,000 from the Food Program, she would report $0 as income and $1,000 as a food expense on Schedule C. In my experience, however, IRS auditors never wanted to see a netting of food expenses. Instead they wanted to see the reimbursements reported as income and the food expenses reported as expenses. In this section of the Guide we now have the clearest statement yet that the IRS prefers to see all the reimbursements reported as income and all the food expenses reported as expenses on Schedule C. It describes this as the “ recommended method. ” It does say that providers can use the netting method, but then says, “ the netting method is not a preferred method since an Examiner will always be looking for the food reimbursement amounts. ” This is a major step forward in clarifying this issue.  I wrote several times to the author of this new Guide explaining how confusing and unhelpful the netting method was and I am happy to see this new language. In an earlier edition of the Guide  it said, “ Most food reimbursement payments are reported on a Form 1099. ” In fact, this is not the case. Most Food Program sponsors do not issue Form 1099. A 1993 letter from Michael R. Gallagher, Chief, Technical Publications Branch of the IRS stated that sponsors were not required to issue Form 1099 under IRC section 6041. I’ m also happy to see this language eliminated. I will now urge the IRS to clarify the language of Publications 587 and 525 to comply with the language in the Guide . I have seen a number of auditors over the years try to limit a provider’ s food deduction to the amount she received in reimbursements from the Food Program. Although the Guide does not directly address this issue, its instructions do not put any limit on food expenses (other than ordinary and necessary). Since the first edition of the Guide was released the IRS issued Revenue Procedure 2003-22 that introduced the standard meal allowance rule. The Guide summarizes this Procedure but adds nothing new. Providers should note that they can deduct up to six food servings per day, per child while they can only get reimbursed a maximum of three servings from the Food Program. Some providers mistakenly believe they can’ t deduct more than three servings a day. To use the standard meal allowance rule the Procedure requires providers to keep careful records: name of each child, dates and hours of