Tax Court Punishes Child Care Provider Operating Illegally

Lori Malchow-Bartlett thought she was exempt from Illinois child care regulations when she started providing child care services in her home. But she wasn't - and after an IRS audit she ended up owing over $16,000 in back taxes. See IRS Tax Court Memo. 2010-271.

Illinois child care regulations state that family child care providers must be licensed if they care for more than three children. This number includes the child care provider's own children. Child care providers who care for children from one household are exempt from licensing.

Since Lori cared for five or six children each year and these children were from different households she was not exempt from state licensing regulations. Therefore, she was operating illegally. As a result there were serious tax consequences for her.

IRS regulations (Section 280A (c)(4)(B)) state that for a child care provider to be able to deduct expenses associated with her home she must "have applied for, been granted, or be exempt from having a license, certification, registration, or approval as a day care center or as a family or group day care home under state law."

Child care providers who are licensed or are exempt from licensing are entitled to claim house expenses: property tax, mortgage interest, rent, utilities, house insurance, house repairs, and house depreciation. Although Lori claimed these expenses on her tax return the Tax Court properly ruled that she was not entitled to do so. As a result they denied her over $20,000 in business expenses for each of two years. If she had been licensed or only cared for three children she would have been exempt from licensing rules and would have been entitled to claim these expenses.

Lori tried to argue that since the IRS did not disallow similar deductions she claimed in earlier years she should be allowed to claim them now. The Court ruled that this did not matter since she was not audited for the earlier tax years and tax years are considered separately.

She also argued that no one had made a formal complaint against her for  providing child care services without a required state license. The Court ruled that IRS rules do not require this before business expenses can be denied.

Lori was able to avoid paying a 20 percent penalty for substantially underpayment of her taxes because she testified that she thought she was exempt from licensing rules. The judge said she had reasonable cause and acted in good when she claimed her business deductions. In my opinion, the judge appeared to be very generous in not enforcing this penalty on her.

Lessons

If you are not licensed or are not exempt from your state child care licensing rules you should not try to claim expenses associated with your home. However, you could still deduct other business expenses such as food, toys, supplies, car expenses, depreciation on furniture and appliances, etc.

It's no excuse that you don't know what your state's child care regulations are.

I urge all child care providers who are required to be licensed to get licensed.

The National Resource Center for Health and Safety in Child Care and Early Education posts the child care regulations in your state. You may also contact your local Child Care Resource and Referral agency or your local child care licensing office.

Image credit: https://winnie.com/place/community-child-care-center-saint-paul

For more information, see my book Family Child Care Record Keeping Guide.