2000 Redleaf National Institute ISBN

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2 2000 Redleaf National Institute ISBN ABOUT REDLEAF NATIONAL INSTITUTE Redleaf National Institute is the national center for the business of family child care. It offers a variety of services to help caregivers succeed in their business. Call , rni@redleafinstitute.org, or visit their Web site at to get help with: Questions about record keeping, taxes, or other business matters Information about workshops for new providers Names of tax preparers in your state Tom Copeland is the director of Redleaf National Institute. He is the nation s leading authority on family child care business issues and the author of several books. His address is tom@redleafinstitute.org. Redleaf National Institute and Redleaf Press are divisions of Resources for Child Caring (RCC), a 29-yearold private nonprofit agency that strives to improve the lives of children by strengthening and supporting the people who care for them. BECOME A MEMBER Redleaf National Institute also offers a membership program for child care providers. Members receive many benefits, including discounts on Redleaf Press books, a business newsletter, access to insurance, a tollfree number to ask business-related questions, and much more. For further information, contact the Institute at DISCLAIMER The author and Redleaf Press are not rendering legal, accounting, or other professional services. If expert tax assistance or legal assistance is required, consult a qualified professional.

3 Introduction No family child care provider wants to be audited by the Internal Revenue Service (IRS). It s a scary prospect that most of us would do just about anything to avoid. But instead of worrying about whether or not you will be audited, you should focus on keeping the proper records for your business. If your records are complete and organized, you will have nothing to fear in an audit. This booklet will help you prepare to deal with an IRS audit. It answers these basic questions: What are my chances of being audited? Page 2 How long should I save my records? Page 2 How are providers chosen for an audit? Page 3 Are there different types of audits? Page 4 What areas in family child care are most often audited? Page 5 How do I get ready for my audit? Page 7 How do I defend myself in an audit? Page 9 What are my rights if I disagree with my auditor? Page 10 How can I get help if I am audited? Page 12 Where can I find a tax professional? Page 13 Where can I get further information? Page 15 If you are audited, you should consider two new resources. In the spring of 2000, the IRS 1

4 published the Child Care Providers Audit Techniques Guide. This Audit Guide was written to help IRS auditors do a better job of auditing family child care providers. Every provider who is audited should acquire a copy of this publication. It is posted on the Redleaf National Institute Web site, at The site also contains copies of IRS Rulings and Tax Court cases concerning family child care. In early 2001, Redleaf Press will publish the Family Child Care Audit Manual, which will contain detailed information about how to defend yourself against an IRS audit. Copies of the Manual may be purchased by calling What Are My Chances of Being Audited? The IRS audits less than 2% of all taxpayers. Family child care providers, like other selfemployed businesses, have a slightly higher chance of being audited. In general, the IRS can audit you up to three years after you file your tax return. If you underestimate your income by more than 25%, however, the IRS can audit you six years after filing your return. If you commit fraud or fail to file a tax return, there is no time limit on an IRS audit. How Long Should I Save My Records? You should save your business records for at least three years after filing your tax return. 2

5 To be safe, save them for at least four years. Save receipts associated with items you are depreciating (furniture, appliances, and large play equipment) for the life of the depreciation, plus three years. Furniture, appliances, and play equipment are depreciated over 7 years. Therefore, you should save receipts for these items for at least 10 years. Save records associated with buying, selling, and making improvements on your home for at least 7 years after selling your home. For more information about depreciation and other tax-related subjects, see the Family Child Care Record-Keeping Guide from Redleaf Press. How Are Providers Chosen for an Audit? The precise reason why the IRS audits someone is a closely guarded secret. IRS computers give every tax return a score. The higher the score, the more likely you will be audited. The scores are based on many variables, and you cannot find out the score on your tax return. Sometimes providers are chosen for an audit because of a series of tax issues, rather than just one issue. In many cases, providers are audited simply at random. We do know that the following circumstances may increase the chances of an audit: Your return shows one or more expense lines that seem high compared to your income. An income of $15,000 with $4,000 of car expenses might draw IRS attention because this looks like the provider has spent a very high proportion of 3

6 business income on that one business expense. If the same provider reports $50,000 of income, there is much less reason to be suspicious. Occasionally, the IRS will give special attention to a particular type of business and audit a lot of tax returns in that business. This may happen to family child care providers in a particular region of the country. The IRS believes that it is unusual for providers to claim a loss in their business and is more likely to look closely at those providers who do. Providers are entitled to claim losses if their expenses are reasonable and they are trying to make a profit. If you claim losses repeatedly, you should be prepared to defend yourself with good records. Are There Different Types of Audits? There are three types of audits: correspondence audit, office audit, and field audit. In a correspondence audit, the IRS requests that you mail specific records or receipts instead of meeting with an auditor. Usually the issue is a simple one that is easily resolved. In an office audit, the IRS auditor asks you to bring your records to an IRS office, where the auditor can look at one issue or many. The most thorough examination is a field audit, in which the IRS comes to your home and is likely to look at all aspects of your business. A field audit is very rare. 4

7 What Areas in Family Child Care Are Most Often Audited? The IRS Audit Guide identifies the following areas as the most commonly audited: Income Food Program reimbursements Food expenses Time-Space percentage Large expenses Supplies The IRS auditor looks at two basic things: whether you reported all of your income, and whether you are entitled to claim your business deductions. The list of commonly audited areas above reflects this. To protect yourself, follow these key rules. INCOME The IRS Audit Guide tells auditors to verify income by asking providers to produce these records: rate schedules, ledger cards, notebooks, attendance lists, business and personal bank deposit statements, contracts and agreements, food reimbursement statements, and meal count records. You should be keeping careful track of all of these income records to show exactly how much you received from each parent, from the Food Program, and from government agencies. The IRS Audit Guide spells out a formula to estimate how much a provider earned from parents based on the amount she or he received from the Food Program. If you are audited, you should be prepared to answer any questions raised by the 5

8 application of this formula to your tax return. Read this portion of the IRS Audit Guide with care. See a complete copy of the Guide at or in the Family Child Care Audit Manual (available 2001). Give parents a receipt at the end of the year showing how much they paid you. Have them sign it, and keep a copy for yourself. Report all of your Food Program reimbursements on your tax return (excluding any reimbursements for your own children). Identify the source of all deposits (business and personal) into all your checking and savings accounts by making a notation on your deposit slip or your check register. DEDUCTIONS The IRS Audit Guide tells auditors to ask for evidence to support business deductions. Such evidence includes receipts, canceled checks, credit card statements, written records, calendar notations, and other documents. Specifically, the Guide urges auditors to ask for a floor plan of the home (to show the square footage of business use); mortgage interest and property tax statements; copies of tax returns for prior and subsequent years; and a business license, registration, or certification. You should keep careful records of all business deductions. The IRS Audit Guide makes it clear that workers hired to help with child care are employees, not independent contractors. In order to claim the expenses for employees of your business, you should write a job description, withhold the proper federal and state payroll taxes, and obtain workers compensation insurance (consult the rules for your state). 6

9 Every business expense should have a record, which may be a receipt, canceled check, written record, notation on a calendar, photograph, or credit card statement. On each receipt, note the method of payment (cash, check number, or credit card). Save all records of house-related expenses, such as utility bills, light bulbs, and household cleaning supplies. Save records of all business and personal food expenses. Carefully track the hours you work in your home for your business, including hours that children are not present but you are cleaning, preparing activities, making business phone calls, doing Internet research, and so on. Review your records each month to make sure you are keeping current with your record keeping. The IRS Audit Guide describes the record keeping habits of most providers as inadequate. The fact that you have good records of your income and expenses will be your best defense during an audit. How Do I Get Ready for My Audit? Don t go to the audit by yourself. You can ask a friend, spouse, your tax preparer, or anyone you want to accompany you. Only an enrolled agent, certified public accountant, or attorney can represent you before the IRS. Some tax professionals prefer to meet with the IRS alone and will not ask you to attend. We recommend using a tax professional if you can afford one. For help finding a tax professional, see the resources listed at the end of this booklet. 7

10 Take time to organize your records before you meet with the auditor. The appearance of records can help in getting the auditor to accept your numbers. Recheck the totals for your income and expenses on your business tax forms. Attach an adding machine printout that shows the totals for each line. This will speed up the audit process and make the auditor s job much easier. If you are audited for more than one year, keep separate records for each year. Don t bring in any records that the auditor has not specifically asked you to bring. You don t want the auditor to see any more of your records than necessary. You can always send copies of additional records later. If you don t have a receipt for a particular expense, try to reconstruct a record using a photograph, canceled check, calendar notation, or oral testimony. Be prepared to answer questions about expenses for which you have no receipts. Review your records to see if you have receipts or other documentation for business expenses not originally claimed on your tax return. Did you forget to claim your car loan interest (even if you used the standard mileage method)? Did you claim all the hours you worked in your home on business activities after the children were gone? It s not too late to bring in new records to claim additional deductions at the time of the audit. 8

11 How Do I Defend Myself in an Audit? When you meet with the auditor, follow these basic rules: If you find that you made a mistake, don t be ashamed to admit it and move on. No one expects you to be perfect. Only answer questions that are asked; don t volunteer information. Any information you give the auditor can be used against you. It is acceptable to respond to questions with one of the following answers: yes, no, I don t remember, or I ll check my records and get back to you. Don t let the auditor keep any original records. Because originals can get lost, ask the auditor to make copies. Maintain a cooperative attitude. Although an audit can be stressful, be polite and keep your cool. If you feel yourself losing control, ask to take a brief break to calm down. If the auditor disallows a deduction, follow these tips: Just because the auditor says something is true doesn t make it so. Ask for written authority for the auditor s position, such as a citation from the Internal Revenue Code, a Tax Court decision, a Revenue Ruling, or an IRS publication. If the auditor can t produce written support, you have a much stronger position. If the auditor denies your deduction and says it is because you don t have a receipt, ask, What kind of records can I produce for you to accept this deduction? You are not required to have a receipt in order to claim a deduction. Other 9

12 written records and oral testimony can be used to show that you have an adequate record. If the auditor won t tell you exactly what type of records you must show to prove your case, appeal this point to his or her supervisor. Don t let the auditor try to tell you how to run your business. If the auditor says, Why don t you do some of your cleaning while the children are sleeping? you should respond, Because I want to take a break like any other worker. You are entitled to all the ordinary and necessary expenses for your business. What Are My Rights If I Disagree with My Auditor? After gathering information, your auditor will write up an Examination Report for you to sign. This report will list the additional taxes and interest owed. Or it may show that you are entitled to a refund! You have 30 days to appeal this determination. If you have more evidence to present, you can have this deadline extended. Do not sign this report unless you understand what it says and you agree with it. Ask questions if you don t understand how the auditor arrived at the numbers on the report. If you do not agree with the auditor s position, ask the auditor to explain your right to appeal. You may want to ask the auditor s supervisor to review your case. Sometimes the supervisor will be more reasonable than the auditor. Some providers prefer to bypass the supervisor and go directly to an appeal. If you wish to contest the Examination Report in any way, you should refuse to sign it. 10

13 The first step in the appeals process is to request that your case be reviewed by an appeals officer. You can do this by telling your auditor that you want to appeal, or you can write a simple letter stating that you disagree with the Examination Report. Your case will be forwarded to an Appeals Office that is separate from the auditor s office. There are no filing fees to appeal your case. You are entitled to see a copy of most of the information in your IRS auditor s file. This includes the auditor s notes of his or her meetings with you and other work papers. You can obtain a copy of your file by using the Freedom of Information Act (FOIA). Send a letter to the FOIA Disclosure Officer at your IRS district office. Ask your auditor for the address of the district office. You will meet informally with the Appeals Officer in an attempt to settle your case. Your auditor will not be present. You can bring anyone you want to your appeal hearing, and you can present any additional evidence or records. The Appeals Officer is likely to lean more favorably to your position than your auditor if you are presenting a reasonable argument and the auditor did not provide any written support for his or her position. If you lose at the appeals hearing, you can appeal your case to Tax Court. Tax Court is held in larger cities around the country, and there is a $60 filing fee. Before you appear in court, the IRS will again contact you and attempt to settle your case. You can represent yourself in court or use a tax professional. 11

14 We strongly recommend that providers use the appeal process if they believe they can win a dispute, because the process offers opportunities to have the case reviewed by IRS agents who are likely to be more reasonable than some auditors in accepting the provider s position. How Can I Get Help If I Am Audited? Contact Redleaf National Institute: 450 North Syndicate, Suite 5 St. Paul, MN phone: fax: rni@redleafinstitute.org Web site: Redleaf National Institute staff can help answer your audit questions without charge. Our Web site has a Tax Preparer Directory with lists of tax preparers who have experience in family child care, organized by state. It also contains information about IRS audits, including citations to Tax Court cases, Revenue Rulings, and other articles that may be useful when doing tax research for an audit. The Institute has a new membership program that, for a fee, offers many exciting benefits for providers, including discounts on Redleaf Press publications, toll-free telephone assistance, a business newsletter, and access to insurance. In addition, members who are audited can receive additional assistance, including extended telephone consultation, tax research, and limited 12

15 audit representation. For further information about membership, go to our Web site or call Jeff at , extension 678. Where Can I Find a Tax Professional? In order to represent you before the IRS, a tax preparer must either be an enrolled agent (EA), a certified public accountant (CPA), or an attorney. Enrolled agents are licensed by the U.S. Treasury Department and have passed an IRS exam. A CPA has a college degree, work experience with a CPA firm, and a passing score on an exam. For a list of enrolled agents in your state, see the National Association for Enrolled Agents Web site at or call For names of CPAs, go to the Web site of the National Society of Accountants at or call The National Association of Tax Practitioners Web site at also contains a stateby-state listing of tax preparers, some of whom are enrolled agents. The association can also be reached at You can also find a tax professional by asking for references from other providers in your area or from your local child care resource and referral agency, Food Program sponsor, or family child care association. 13

16 QUESTIONS TO ASK A TAX PROFESSIONAL Not all tax professionals will be able to handle your tax audit effectively. You want to find someone who is experienced in handling family child care tax returns. Here are some questions to ask: What type of training do you take each year to keep current with changing tax laws? What experience have you had with representing people audited by the IRS? How many of those were family child care providers? What were the results of the audits? What are your fees? Do you charge for telephone calls? tax research? time spent at the audit? Ask for an estimate up front. Also ask yourself if you feel comfortable with the tax professional. Is the person easy to reach and to talk to? You will probably maintain a better relationship if you share a similar philosophy about the audit. If you are very conservative in claiming deductions (you don t claim any that might be questionable), look for someone who understands this and will follow your wishes. Likewise, if you are more assertive in claiming deductions, find someone who shares your views. Remember, all fees paid to a tax professional to defend you in an audit are 100% tax deductible! 14

17 Where Can I Get Further Information? INTERNAL REVENUE SERVICE Call the IRS ( ) with any questions about IRS tax laws or audit procedures. If you are not sure if the person you are speaking to on the phone is giving you the correct information, ask in what IRS publication the answer can be found. The following IRS publications may be helpful: IRS Publication 1 Your Rights as a Taxpayer IRS Child Care Providers Audit Techniques Guide Call the IRS to have these publications mailed to you. You can also download them from the IRS Web site at The IRS Taxpayer Advocate Program ( ) may be able to help you if you are experiencing delays, suffering a significant hardship, or having difficulty resolving a dispute. This program may be able to help you deal with the IRS and make sure your rights are preserved. REDLEAF PRESS Redleaf Press publishes the following books that can help you prepare for an audit: The Family Child Care Record-Keeping Guide lists over 1,000 allowable deductions and contains several chapters about how to deal with tax preparers and audits. 15

18 The annual Calendar-Keeper and Calendar- Keeper Software both include monthly charts to record child attendance, parent payments, and business expenses. The software allows you to print out numerous tax reports to help you organize all your records. The annual Family Child Care Tax Workbook includes detailed directions for filing your tax return and references to recent IRS Tax Court cases. The Family Child Care Business Receipt Book helps track individual parent payments. The Mileage-Keeper helps track business mileage records. The Family Child Care Inventory-Keeper is an easy-to-use log that allows you to track your furniture, appliances, and other business property. The Family Child Care Audit Manual contains a step-by-step strategy for defending yourself in an IRS audit. It includes a complete copy of the IRS Child Care Providers Audit Techniques Guide, copies of IRS publications dealing with audits, Tax Court cases, and other audit resources. Available in early For further information, call or visit our Web site at Thanks to tax preparers Don Gilbo and Lorry Sorgman, EA, for help with this booklet. 16

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