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.

Tax Implications of the Unlicensed Daycare Provider

One of my areas of specialty is in-home daycare operations, and it's something I haven't blogged about much.  One of the questions about in-home daycare operations is what the tax consequences are to an unlicensed daycare provider.

Different states have different licensing requirements for daycare providers.  In Iowa, an in-home provider can care for up to 5 children without being registered or licensed.  A provider caring for 6 children must be registered, and a provider caring for 7 or more children must be licensed.  (Read more at the DHS website.)

For tax purposes, your in-home daycare is considered a business whether you or not you are registered or licensed.  Income should be reported as business income; legitimate business expenses can be claimed as a deduction against business income.

The tricky part for the unlicensed/unregistered is figuring out whether they can take the deduction for "business use of the home."  This deduction allows a taxpayer to partially deduct expenses associated with the house, such as utilities and mortgage interest.  Only daycare operators who are licensed or registered with the state -- or who are not required to be licensed or registered -- can take the deduction for business use of the home.

So in Iowa, a provider caring for less than 6 children CAN take the deduction for business use of their home, because they aren't required to be registered or licensed.  But if a provider cares for 6 or more children and is not registered or licensed, then no deduction is allowed for business use of their home.  Of course, aside from the tax deduction issue, there could also be problems with the DHS!