Unlicensed Daycare Providers Part 2 - Tax Court Ruling

In this blog post, I talked about the tax consequences of being an unlicensed, in-home daycare provider.  As mentioned in that post, the unlicensed provider may or may not be able to take the deduction for "business use of the home," depending on state law.  If state law requires a provider to be licensed or registered but the provider is not licensed, then the deduction is not allowed.  (In Iowa, an unlicensed provider can care for up to 5 children, and thus would be able to take the deduction.  If the provider added a 6th child and did not register with the state, then the deduction would NOT be allowed.)

A provider from Illinois found out that the IRS does audit daycare providers, and the disallowance of the deduction for business use of the home can be costly.  (Side note:  the IRS has published an Audit Technique Guide for its auditors to use when auditing daycares - and yes, I have read that guide from cover-to-cover.) 

The case involved an unlicensed provider in Illinois who took sizeable deductions relating to business use of her home as a daycare.  Based on Illinois law, she was required to be licensed.  Because she was unlicensed when she was supposed to be licensed, the deductions -- more than $20,000 for 2004, and $22,000 for 2005 -- were disallowed.

Last month, the case went to the Tax Court, where the provider tried to argue that she thought she was exempt from licensing requirements, and that because the state had not filed a complaint against her for being unlicensed, the IRS had no right to disallow the deductions.  The Tax Court disagreed, saying that the IRS can disallow a deduction taken by a provider whether or not the state has taken any action against the provider.

The provider also tried to argue that because she had taken the deduction in other years without it being questioned by the IRS, the deduction should be upheld in the years in question.  The Tax Court also disagreed with that, pointing out that each tax year is considered separately.

The total cost to the provider will be more than $16,000 in taxes, plus penalties. 

As always, a daycare provider with any questions about the tax reporting for their operation should contact a tax professional.