Day Care
(Revised November 2011)
 

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Audit guide released by the IRS Choosing the business entity for business Paying and deducting salary  Record keeping Reporting requirements for salary payments  Requirements when hiring employees  Selling your residence used for daycare Standard meal and snack rates method

Before you make a final decision on your business entity, you need to talk to your lawyer.   The following  is a very general discussion of the various business entities;  the main purpose of this discussion concerns your out of pocket costs.

A) - Corporation as your business entity for daycare

1) the advantages are the following: 

.....corporate formation is relatively inexpensive - $100 to $500 generally

2) there are a number of disadvantages:

......the operating costs are high - there will be more tax filings and payroll tax returns involved. Your accountant will love the additional fees.

.....your income tax bill will probably be higher

.....if a child in your care is injured, you will probably be sued personally (and you may be liable personally)!

.....close attention to corporate formalities (i.e. keeping corporate minutes) is advisable.  There is a legal concept called "piercing the corporate veil"; if this occurs, you could be held personally liable.  If you decide to go with a corporation, you need to discuss the ground rules including corporate record keeping .
 

Conclusion:   Generally, I don't believe that  a corporation is a suitable business entity for a daycare due to the higher taxes and legal and accounting costs.  However, if the net income will probably exceed $30,000, operating as an S Corporation may result in some self employment tax savings.  You need to talk to a tax  professional.

B) Limited Liability Company (LLC) as your business entity for daycare 

1) LLCs have a number of advantages including:

......LLCs have all of the advantages of a sole proprietorship, because for tax purposes, the LLC is treated as a sole proprietorship in most cases.

.......LLCs offer the protection against creditors and lawsuits as do corporations; but again, you can still be sued personally (and you may have personal liablility)!

2) LLCs have one major disadvantage: They are expensive. The fees for an Illinois LLC go anywhere from $1,000 up to $2,500 and even higher!  

Conclusion:  I generally do not recommend LLCs for daycare businesses. The business may not last long enough to recoup the initial high cost.

C) Sole Proprietorship as your business entity:

1) There are a number of advantages:

.....there are virtually no setup costs - you already are a sole proprietorship!

.....your income tax bill will probably be less

.....there are fewer payroll and income tax returns involved, and 

.....you will probably pay your accountant less

2) There are also a number of disadvantages:

.....YOU are liable for all debts of the business, and

.....YOU could be sued

Conclusion: I recommend a sole proprietorship in most cases. However, you need to get liability insurance that includes legal fee coverage. 

The general liability coverage that is a requirement for state licensure is probably not adequate.  Several insurance companies that issue homeowners' policies (e.g. Allstate and American Family) also write riders for home daycare businesses.  A home daycare rider on your homeowners' insurance is probably the most economic solution.

The Redleaf Organization, www.redleafinstitute.org, is also a source for daycare insurance.

Finally,  if you are married and jointly own a house with your spouse, consider putting the house into tenancy in the entirety before starting your daycare business.   Ownership in the form of "tenancy in the entirety" should offer protection from creditors of the daycare business.  Ask your lawyer about this.

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Generally, salary that you pay to your employees is fully tax deductible against your daycare income. Salary payments to your own children are also fully deductible, as long as your children are bona fide employees and the payments are reasonable. If your children are under 18 years of age when you pay them the salary, the payments are exempt from all social security and payroll taxes. In addition, if the child’s income is less than $4,500, the salary payments may be free from Federal income taxes.

If your child is at least a junior in high school and is thinking of college, paying him or her a salary could have an adverse affect on obtaining financial aid.  If  you are a client,  call me.

There are a number of record keeping and reporting requirements for salary payments, even for salary paid to your own children. However, the tax savings are usually well worth the bookkeeping headaches.   For likely documentation you would need for an IRS audit, press here.

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1^st) Form I-9 - Employment Eligibility Verification: This form documents the fact that the employee is either a US citizen or legal alien with a work permit. Even though the penalty for not preparing this form is up to $1,000 per infraction, few daycare employers bother with their own children.

If you are hiring a non-relative, you should fill out the form and keep it in the employee’s personnel file along with copies of any related required documentation (e.g. social security card, voters registration card, green card, etc.).

2^nd) New Hire Report: This form is used by the government to track down dead-beat dads. The form is required to be filed within 20 days of the hiring date of a new employee. There do not appear to be any exceptions, even if the new employee is your 5 year old son or daughter. The penalty for not filing this report ranges from $15 to $500.

We recommend that you file this form. Meeting the filing requirements is proof that you are treating your employees (e.g. your child) as bona fide employees.

3^rd) W-4 and IL - W-4: This is the form that employees use to declare the number of exemptions they are claiming for withholding tax purposes.

We recommend that you have all employees (including your child) fill out these forms before their first payroll and at the beginning of each year.

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1) There are specific quarterly and annual reporting requirements if you hire employees.

A) Quarterly requirements:
 

1) You will have to file Federal Form 941 - Quarterly Federal Payroll Tax Return.

If you pay wages, you have to file Form 941 even if you do not owe any payroll or withholding taxes.  For example, if you only pay salary to your children (who are under age 18), you have to file quarterly payroll tax returns even though you do not owe any taxes.

2) You may have to file Form UC-3 Illinois Unemployment Tax Return.

You do not have to file this form if all wages are to your under-18-years old children (and therefore exempt from tax).

3) You will have to file Form IL-941 - Illinois Quarterly Payroll Tax Return.

4) If your Federal quarterly liability exceeds $2,500 per quarter, you will need to make monthly tax deposits;  in some cases (e.g. at least $50,000 in quarterly taxes) you may need to make bi-weekly payroll tax deposits

5) If your Illinois quarterly liability exceeds $500 per quarter, you will need to make electronic tax deposits via the Illinois Department of Revenue website.

Note - if your annual Illinois withholding is less than $500 for the first year of business operations, most likely, you will need only file one Illinois quarterly payroll tax return in subsequent years.   You are allowed the reduced filing only after, the state notifies you.  

All quarterly tax returns are due by the end of the month following the end of the quarter. The specific dates are as follows:
 

 B) - Annual requirements:

1) You will have to give W-2s for all of your employees by January 31^st of the following year. We recommend preparation of W-2s for all employees, even for your own children.

2) You will have to file a Form IL-W-3, Illinois Annual Wage and Withholding Report, by January 31^st of the following year.

3) You may have to file Form 940, Federal Annual Unemployment Contribution Report, by January 31^st of the following year. You do not have to file this form if all wages are to your under-18-years-old children (and therefore exempt from tax).

4) You will have to file Federal Form W-3, Federal Annual Wage and Withholding Report, along with W-2s by February 28^th of the following year. 

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RECORD KEEPING

Prematurely throwing your records away can be very costly if you are subsequently notified about an IRS audit.  You will be financially ahead if you follow the guidelines discussed in this section.

7 year minimum for bank statements, canceled checks, deposit receipts, payment receipts, attendance reports, and bills. 

Discussion: The normal statute of limitations is 3 years from the later of the due date (including extended due dates due to extensions) or the actual date that the return is filed. However, the statute of limitations is extended to 6 years if there is an omission of more than 25% of gross income.

If your return contains a fraudulent item (and the IRS proves it), the statue of limitations is forever!

4 year minimum for payroll records. Generally, there is a 3 year statute of limitations that is similar to the general rule for statute of limitations affecting income tax returns.

Forever: Copies of income tax returns, IRS audit reports and related correspondence, as well as home purchase and improvement information.

If in doubt, keep the records.

First, when you pay expenses, use a check or a credit card; do not use cash if possible.

Second, open up a separate checking account for the daycare business. Follow the following rules:
 

a) Deposit all receipts (both checks and cash) into the daycare checking account.

b) If possible, write checks for all direct daycare expenses from this account.

c) On credit card bills, write the daycare portion of the bill from the daycare checking account.

d) To pay your personal expenses, transfer funds from the daycare account to your personal account.

e) The less you co-mingle items with your personal account, the easier the record keeping will be.

Note - some banks charge much higher fees for "business accounts".  We suggest that you either switch to another bank (or a S&L or a credit union), or open up a second  personal account for your business.
 

Third, keep a daily log of the time the home is used for daycare as follows:
 

1) time period each day that children are on the premises, including the time when the first child arrives and the last child leaves

2) time period each day used for preparation and cleanup

3) time period each day used for bookkeeping and other administrative functions, e.g. calling parents, meal planning, surfing the Internet for daycare web sites, and of course calling your accountant with tax questions. You may decide after the end of the year to include these hours in your "dwelling time percentage". 

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Automobile expenses - you should keep a log in your vehicle and record the purpose and mileage of each trip. If your driving habits remain fairly constant throughout the year, you can keep a log for a few months and base the entire year’s auto use on the results for the logged months. The easiest way to deduct auto expenses is by using the per diem method. Under this method, you are automatically allowed a specific deduction (presently 37.5 cents per mile) for each business mile driven in your automobile.

What auto miles are deductible "business miles" and which miles are not? The primary purpose of the auto trip governs whether or not the mileage constitutes business mileage. In the case of daycare, if the primary purpose for the particular auto miles is daycare related, all of the particular miles are deductible.

Example 1: You drive 20 miles to the grocery store and back home primarily to buy daycare food. Even if part of the grocery shopping was personal, the entire 20 mile trip is treated as business miles.

Example 2: The primary purpose of the trip is personal. In this case, none of those miles are deductible.

Example 3: You leave one client and drive 20 miles to see another of your clients.  On the way, you make a stop at a store to pick up some personal items.  Assuming that the primary purpose of the trip was business motivated, all of the miles driven are considered business miles.

Keeping receipts for gas: Generally, gas receipts are not necessary. Instead of deducting actual expenses, you can usually deduct your business auto at the rate of 31 cents per mile.  This is called the mileage method.

Keeping receipts for repairs: You need to keep these receipts. If you are examined, the IRS auditor will want to look at your repair bills, even if you use the mileage method. Repair bills usually list odometer readings and the IRS auditor will want to verify the fact that you did indeed drive all of those miles you claim that you drove.  Therefore, always keep your auto repair bills, even if you know that you will be using the mileage method to deduct your auto expense.

Food expenses - the types of documentation are listed in the order of best to worst
 

a) Actual receipts for both daycare and personal food purchases is the best documentation.

b) Estimates based upon the sum of food program reimbursements and the cost of meals and snacks not reimbursed by any food program.

c) Estimates based upon actual expenses for a representative period of time - usually for a period of at least two months

d) Using the standard meal and snack rates provided by the IRS.  To go to this topic, press here.

d) If there are no records at all and you are examined by the IRS, crying and self pity may help. You have nothing to lose!

Food expenses - which ones are deductible?
 

a) Food expenses reimbursed by a food program are deductible for tax purposes if the reimbursements are included in your income. From a practical point, if the food program reimburses you for your own child’s food, that food is also deductible in this situation.

b) Food for the daycare children (not reimbursed) is generally fully tax deductible.

c) Food for your own children (not reimbursed) may be deductible - if they are required to help with the daycare chores during the meal period. There is a recent court decision involving a Las Vegas Casino allowing for a deduction for tax free meals provided to certain employees. We believe that the rationale could apply to many daycare providers who have employees (including their own children).

d) Food for the daycare owner (not reimbursed) is not a deductible expense for your daycare business.

Salary expenses - IRS auditors generally do not closely examine salary payments paid to non-relatives. They correctly assume that you would not have paid out the salary in the first place if the services were not performed. However, IRS auditors are likely to challenge your deduction for salary paid to your own children unless you maintain records documenting their services to your daycare business.

If you have non-relatives working for you, the following records should be sufficient:
 

a) canceled checks
b) payroll reports and W-2s

If you have your own children working for you (and you are paying them salary) you need the following additional records:
 

a) detail of computation of gross salary (e.g. # hours and hourly rate)
b) daily time reports should be prepared and kept
c) schedule of daily duties should be prepared and kept
 

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Selling your residence

If you operate a home daycare business and you decide to sell your residence, it is possible that part of the selling price could be subject to income taxes, even if the selling price is less than the cost of your residence.  However, in this situation, the amount of gain you will probably have to report will probably be very small compared to the deductions you have taken on your tax return.

If you will have a large gain on the sale of your residence, and the sale occures after 2008, part or all of the gain may be taxable. Legislation passed in 2009 may affect the amount of gain you are requried to report on your tax return.

Residence sales before 2009

Generally, you can exclude up to $250,000 of gain on the sale of your principal residence.  In many cases, if you file a joint income tax return, the exclusion goes up to $500,000.  For years through 2008, this exclusion generally applied as long as the residence was used as the principal residence for at least 2 out of the 5 years before the sale.  If the property was subject to business use, part or all of any gain is subject to tax.  The $250,000/500,000 exclusion does not apply to any business use of a residence.  Operating a home daycare business means that the residence has been used for business use.   Prior to years 2009, generally the only gain needed to be reported as income was any depreciation on the residence related to the daycare use, from May 6, 1997 up to the date of sale.  

In January of 2003, the Internal Revenue Service issued final regulations concerning the $250,000/500.000 exclusion on the gain from a sale of a principal residence. These regulations make it relatively easy for most daycare operators to meet the rules to exclude a substantial portion of any gain (up to the $250,000/500,000 limits).  In most cases, the only gain that will have to be reported relates to depreciation deductions on the residence that are listed on your tax returns for the periods starting on May 6, 1997 until the date of sale.  The rules on this topic are very complex; you need to talk to your tax advisor.

Residence sales after 2008

For sales occuring after 2008, the rules may be quite different; part or all of the gain on the sale of the residence may be taxable regardless of the $250,000/500,000 exclusion discussed above.  Legislation passed in 2009,  requires any non-residential use during the 5 year period up to the residence sale is used to reduce the $250,000/500,000 exclusion.  Since the IRS has not yet issued any regulations on this change,  it is too early to determine how this change will affect a sale of a residence used in a daycare business.

Before making any decisions to sell your residence, either call me or send me a secured Email by pressing here.

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In May of 2000, the Internal Revenue Service issued an audit guide for for audits of child care providers.  The guide focuses IRS audtitors on the areas where the IRS feels the largest tax deficiencies can be obtained .  If your return is selected for audit, the items stressed in the audit guide will probably be examined.

We have prepared this audit guide summary to assist you in your record keeping. This guide is not a primer on "do it yourself IRS audits". If you get a notice of an IRS examination, contact a tax professional.

Assuming that you operate a daycare center and your tax return is selected for an IRS audit, the following 6 areas will definitely be questioned:
 

Gross receipts

The IRS examiner will want all of your bank accounts. If your deposits exceed the amount of income reported on your tax return, you can expect questions concerning unreported income.

The IRS examiner will also want your Federal food program reimbursement records. The IRS examiner will compare the gross income that you report on your tax return to the hypothetical income produced from the number of child day meals being reimbursed. The following is an example of the type of formula the IRS examiner may use:

Example: The Federal Food Program (FFP) reimburses you at the rate of $1.58 for each lunch and $.47 for each snack, totaling $2.52 per day. For the year, the FFP paid you a total of $5,235.Your customary daily charge per child is $20 per day. Based upon this information, the IRS examiner will compute a tentative gross income of $41,550, computed as follows:
 

If the gross income you reported on your tax return was substantially less than $41,450, you will have some explaining to do. If the discrepancy is substantial, you could have some serious (including criminal) tax problems.

Substantiation of food expenses has become easier.  IRS will issue food per diem allowances on deducting food expenses  based upon the number of daycare children served and the meals served each day.  These food per diem allowances will not require proof of actual expenses. These per diem allowances operate the same as the mileage method used for automobile expenses.   If  you choose to use the IRS optional standard meal and snack rate allowances, you will still need to provide records on the meals.  You will need daily records on who received meals and what meals were provided.

The IRS examiner will be on the lookout for erroneous tax deductions of food purchased for the family. To prove that you are deducting food expenses for your daycare operation, you will need to produce your grocery bills for both your daycare food and your family food .

While the IRS document states that food purchased for the family is a nondeductible personal expense, there is some recent case law that could allow for a deduction of food consumed by family members if they are employees of the daycare business.

The IRS examiner will be looking for documentation concerning the number of business automobile miles that you claimed on your tax return. If your business miles include auto trips that are both business and personal, you will need proof that the primary purpose of the trip was business. Your best documentation for proving business automobile mileage is your diary (assuming that you keep one).

Expect the IRS examiner to ask for repair bills (to verify total auto mileage driven) and your automobile insurance policy (to verity the business percentage).

The IRS examiner will probably ask for documentation concerning the square footage of your residence and the portion used for the daycare business. The IRS audit guide suggests obtaining the house plans or blue prints.

You will also need to substantiate the number of hours that your residence is used for "daycare" each day. Your daily schedule concerning normal business hours and other hours spent on preparing and cleaning should be helpful in substantiating the business hours of your daycare operation.

This area is a catchall for any large deductions on your business schedule. For example, if you pay and deduct salaries to your children, you may have to produce records proving that your children are bona-fide employees who actually perform services for your daycare operation. Second, if your business schedule indicates a large deduction for toys, the IRS examiner may want to capitalize any large items.

Deductions for "outside services" may be looked at for any payroll tax issues. The IRS audit guide devotes 1 ½ pages to steps that the IRS examiner should take to determine if the recipient should be classified as an "employee" who is subject to payroll taxes rather than an "independent contractor" who is exempt from payroll taxes. 

The IRS examiner will probably be looking at your payments to any individuals working for you.  If you treat them as "independent contractors" and don't withhold any taxes on their compensation, you could be hit with a large tax deficiency.  Assuming that your "independent contractors" are reclassified as "employees", you could be liable for the withholding taxes you should have withheld and employer payroll taxes. The IRS may argue that the individuals should have been treated as employees who are subject to income and FICA tax withholding and payroll taxes.  The deficiency will include the income and FICA tax withholding  that should have been withheld from the paychecks. 

The rules concerning independent contractor v. employee status are complicated; The IRS audit guide on daycare devotes over three pages to this topic.  However, as an oversimplification, under the rules an individual should be treated as an employee if the following three factors are met:

       1) the individual works on your premises,
       2) the individual uses your equipment, and
       3) you have the right to control when and how they work

If the above three tests are met, and you are not treating the individual as an employee, you still may be able to reduce your exposure to payroll taxes.  Under certain circumstances, timely reporting of the individual's compensation on Form 1099 will either reduce or eliminate the payroll tax liability.   Since the rules are complicated, you will need to either talk to us or another  tax professional. 

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  Standard meal rates for day care providers

In late 2003, the IRS issued a procedure (Revenue Procedure 2003-196) listing the standard meal rates that daycare providers can use to determine their deduction for food expenses using standard rates for meals and snacks.  The 2004 rates are slightly higher than the 2003 rates.  If you do not keep all of your food purchase records, this procedure could provide you with a larger tax deduction .  If you keep good records, you can choose a deduction based upon your actual costs and the IRS provided standard rates.

If you don’t keep good records on the cost of meals you provide to your day care children, a new IRS procedure may be for you.  You can now determine your meals deduction on your income tax return by using a prescribed standard allowance.  The standard allowance method can be used by both licensed and unlicensed day care facilities.

The standard allowance amounts appear to be quite conservative.  In most cases, your actual expenses will be much higher. Assuming that you keep accurate records on your meal expense, the standard allowance could affect you.  Possibly (but not likely) , your tax deduction using the standard allowance is higher than your actual costs.  If this occurs, you are entitled to take the higher deduction.

For year 2011 and 2012 tax returns, the standard allowances are the following:

You can take a maximum of one breakfast, lunch, dinner, and three shacks per eligible child per day. The above allowances are for the cost of food and beverages. Paper, cleaning supplies and other costs are not included in the allowance.  Therefore, you can deduct the standard allowance plus your paper and other supply cost.

If you use the standard meal and snack rate method, you still have to keep records on the types and number of meals served to the eligible children in your daycare business.  The records need to include the names of eligible children, dates they attended, and types of meals served (e.g. snack, lunch, dinner).  The IRS procedure also includes a log that day care providers can use to keep tract of the meals.  Press here to download this log.

If you are interested in this topic, you should either talk to your tax professional or contact of of us  (708) 647-1045.  Clients can also contact us via secure email by pressing here.

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