Guide used for IRS for day care audits
(Revised November 2012)


In May of 2000, the IRS issued an audit guide for audits of child care providers. The guide focuses IRS auditors 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 us or your personal tax advisor.

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

Day Care Audit Guide - Table of Contents
    1. Gross Receipts
    2. Food Expenses
    3. Automobile Expenses
    4. Housing Expenses
    5. Other Expenses
    6. Independent Contractor vs. Employee Issues



Gross receipts

The IRS examiner will want to look at 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 to see your Federal food program reimbursement records. The 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 that may be used for an audit of a 2010 tax return:

Example

Assume the following facts:

  1. The Federal Food Program (FFP) reimbursed you at the rate of $1.58 per lunch and $.47 for two snacks per day, totaling $2.52 per day.
  2. For the year, the FFP paid you a total of $5,235.
  3. 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:

  • Total reimbursements ($5,235) divided by Daily reimbursement ($2.57) = 165 days times your daily per child charge($20)  = $41,550.

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.


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Food Expenses

Substantiation of food expenses has become easier. The IRS issues food per diem allowances that can be used for your food deduction. The deduction is calculated using the number and types of meals served to the daycare children 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.

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Automobile Expenses

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

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Housing expenses

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' purposes 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.

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Other expenses

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. Also, if your business schedule indicates a large deduction for toys, the IRS examiner may want to capitalize any large items. Finally, deductions for 'outside services' may be looked at for any payroll tax issues as well.

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I
ndependent contractor versus employee issues

The IRS examiner will probably be looking at your payments to any individuals working for you. If you treat them as 'independent contractors' and do not 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 as well. The IRS may argue that the individuals should have been treated as employees who are subject to income, FICA, 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 vs. 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. 
  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 may still 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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