Tax Strategies & Credits
Child Daycare and Taxes: Complex for Clients and Providers
For working people who have children or who are responsible for the care of aged or disabled loved ones, daycare provides an invaluable and necessary service: it allows them to leave their home in order to earn a living and contribute to their households. Though daycare may feel like a convenience, or in the best circumstances like an extension of family, it is actually a business transaction and therefore has real tax impacts for both those using the service and those providing it.
Let's take a look at the tax rules and benefits as they apply to both sides of the interaction.
Daycare Client
There are significant tax credits available for those who use daycare to facilitate their ability (and their spouse's ability if married) to be employed. When that is the case, the costs of daycare for a child, stepchild, foster child, sibling, stepsibling, or descendant of any of these who is under 13 and who lives in their home for over half the year, are considered an employment related expense. There is a requirement that the individual not provide more than half of their own support for the year, and couples who are married must both work and must file jointly. There is an exception that allows the credit when one spouse is either disabled or a full-time student.
There are limitations to how much of the cost of daycare is allowed to be taken as a qualifying expense. Taxpayers cannot get a credit that amounts to more than their working income, and when the taxpayers seeking the credit are a married couple, the amount that can be taken is restricted to whichever spouse's income is lower.
In the exception cited above, where one spouse is either disabled or a full-time student and has no income, the calculation of the allowable credit is made based on their having a monthly income of either $250 where the couple has one qualifying child or $500 when the couple has more than one qualifying child in daycare, effectively eliminating the income limitation in these cases, as the overall limit in all cases per household is $3,000 for one child and $6,000 for more than one qualifying child.
Many taxpayers express concern over how to take the credit when costs for daycare expenses differ between attendees. The tax law permits the maximum credit to be divided unequally between qualified children, so even if one child's qualifying daycare expense is $1,500 and the other is $4,500, the full $6,000 credit can be taken. Calculation of the amount that a family is permitted to take is based on a percentage of qualifying expenses, as summarized in the table below. The number is based on the taxpayer's adjusted gross income, and in most cases is calculated at 20%.
AGI Adjusted Applicable Percentage
Example: Sarah and Michael are both employed. Sarah works part-time during the same hours that their 10-year-old son Jake goes to school and earns $10,000 in that job. Though this means that during the school year the couple has no qualifying childcare expenses because daycare isn't needed to address the needs of their son, during the time that he is off for summer the couple needs daycare so she can continue working. They send Jake to a day camp that costs $4,000. With the expense limitation for a single child set at $3,000, that is the maximum amount that their credit can be based upon. That places them in the category of being able to take a 20% credit on $3,000 or a $600 childcare credit.
After calculating their credit, taxpayers are able to use it on a dollar for dollar basis; so in the example above, the childcare credit would allow Sarah and Michael to subtract $600 from the taxes that they owe. It is important to note that this credit is only to be applied to income tax and alternative minimum tax liability and can't be used to reduce the amount owed for self-employment tax or taxes linked to the Affordable Care Act. If the credit takes the couple's tax liability to less than zero, they do not get a refund.
When Employers Provide Dependent Care Benefits
Employees whose employers offer dependent care assistance programs as job perks have many questions about how this benefit impacts their ability to take the childcare credit. Taxpayers need to determine whether their earned income (for those who are married, the lower-paid spouse's income) or $5,000 ($2,500 for those filing married but separate) is lower, then exclude that amount from their income. Rather than being treated as income, the benefit reduces the expense limits in place ($3,000 for one child, $6,000 for more than one child) for daycare expenses. If an employee receives more than the limit in reimbursement for daycare, the overage gets taxed and can't be used to cut the amount of the credit's qualified expenses.
Other Important Details to Consider:
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In-home daycare – Taxpayers who have daycare providers in their home are not able to use these expenses towards a childcare credit. The daycare provider needs to be treated and reported as a household employee.
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Child's age – Once a child turns 13, the credit is no longer available. If the child ages out of qualifying during the tax year, the credit gets calculated on a pro-rated basis based on the time when they did qualify, up until their 13th birthday.
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Day camp expenses – The child and dependent care credit can be used to offset the costs of placing children under 13 years of age (or any age if disabled) into a day camp if the expense allows them to work during the summer when school is not in session. This does not apply to summer school or tutoring expenses or to the costs of overnight camp.
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School expenses – The only school expenses that are considered to qualify are those for a child below kindergarten level.
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When both parents work in a single unincorporated business – In situations where spouses work together in a single unincorporated business, it is important that they divide the business income into income for both of them in order to qualify for the childcare credit. Those who only report the income under one spouse's name as income will lose their ability to take the child and dependent care credit.
Daycare Provider
Those who provide daycare services in their own homes are generally considered to be self-employed. They are entitled to deduct business expenses in the same way that other self-employed individuals are, but because the expenses for their business are unique there are details that may require special explanations. For example:
Business Use of the Home
People who are self-employed and who work out of their home are able to deduct a portion of their home expenses as a business expense. The calculation for those who run daycares out of their home are calculated differently than most businesses: while home offices are subject to an exclusive use requirement, this is not applicable to daycare providers as long as they meet one of three requirements. Those requirements are:
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They are licensed, certified, registered or approved as a daycare care provider under state law;
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They have a pending application for licensing, certification, registration, or approval under state law as a daycare provider that has not been denied; or
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They are exempt from licensing, certification, registration, or approval under state law.
If none of these requirements apply, then a daycare provider who operates their business out of their home will need to limit their application of the deduction. (The exception is if they do have an area of their home that is exclusively used for their business.) This might be a finished basement set aside for care, or a pantry that is set aside for supplies. This exception is specifically for services that are primarily custodial.
If a daycare provider is offering services for children, those who are physically or mentally incapable of caring for themselves, or for individuals 65 or older, the exemption is applicable. It is allowable for educational, developmental, and enrichment activities to be offered as part of the care offered. However, if the primary purpose of the business is to provide instructional or educational services, the business will not qualify for the exception even if they meet one of the requirements above.
To identify the correct percentage to allocate to business use of the home for a daycare business, the taxpayer needs to figure out both what parts of the home are used for the business and how much time is spent using it for the daycare rather than as a home space. This calculation is not limited to when the clients are present; it also can include the time that the space is used to maintain, prepare, or clean the space.
The number that you end up with as a percentage is then applied to the total of all of the expenses that contribute to the operation and maintenance of your home. These expenses include utilities and home insurance, mortgage interest and taxes. Depreciation can also be included in this sum, then multiplied by the percentage to come up with the number that can be deducted for the daycare's home business expenses. If the business operator rents rather than purchases, then the calculation is still applicable; the owner simply substitutes rent for mortgage interest or depreciation and taxes.
Keep in mind that businesses are not permitted to take a deduction greater than their gross income, and this also applies to daycare operations. If the deduction exceeds gross income, the expenses should be calculated again using the IRS' prescribed order of expenses (not included here).
You also need to remember that if you do use the business use of home deduction and live in and use your home for two out of five of the years immediately prior to selling your home, you are able to eliminate up to $250,000 (or $500,000 for married couples filing jointly) of any gain that you realize on the sale, but you can't exclude any depreciation you've claimed (or could have claimed) after May 15, 1997. This translates into that depreciation being taxable if you have in fact realized a gain.
Example: A daycare operator who has operated his business out of his home for ten years is entitled to claim $1,000 per year of home depreciation, or $10,000 in total. At the end of that ten years when he decides to move and sell his home, he can't include the $10,000 in depreciation from his excluded gain. The depreciation will always be treated as a taxable capital gain, to the extent of any home sale gain.
Meals
Most daycare providers include meals served to those in their care as part of their service, and the cost of those meals can be deducted as a business expense. There is a simplified meal deduction calculation that avoids the need to keep records or provide proof of food expenses, though if the actual cost of meals is higher and the daycare provider wishes to use actual expenses, they can. If this option is chosen, it is important to keep in mind that meals for the provider's own family members cannot be included.
The chart below provides the information on the 2019 deduction amounts using the simplified meal deduction:
Meal deduction amounts are recognized as being separate from the expense for utensils and other nonfood supplies that are required in order to properly feed those being cared for. Those expenses can be deducted separately based on actual expenses. The chart below reflects the number of meals that can be expensed per child per day. Alaska and Hawaii's figures are higher than those reflected for the continuous states.
Care providers who the government or other agency provides with reimbursement or a subsidy for the cost of meals need to make an adjustment to the amount that they can deduct per meal using the simplified meal plan, as the amount of the reimbursement needs to be subtracted from the simplified rate and only the unreimbursed amount can be deducted.
Business Use of a Vehicle
Daycare providers use their personal vehicle for many reasons. They may take those in their care on educational or entertainment trips, or to a playground or park for exercise and fresh air. They also use their vehicle to attend conferences, purchase supplies, have meetings and for other legitimate business purposes. This usage is deductible at the standard mileage rate of 58 cents per business mile, though daycare operators may also choose to track their actual operating expenses for their personal vehicle and then prorate the percentage that it is used for business to calculate their actual expense. No matter which method is chosen, the owner will need to keep a log of all trips so that everything is properly documented.
Other Expenses
Daycare operators have many other expenses which they are able to deduct in the same way that other businesses do. Some are general business expenses, and some are specific to their operation, but all can be deducted. Examples include:
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Advertising
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Business banking account fees
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Business insurance
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Daycare licensing
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Daycare organization membership expenses
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Field trip expenses
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Games and toys
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Payroll for employees
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Phone service
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Prorated Internet service
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Seminars and education related to operating a daycare center
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Supplies, diapers, wipes, and cleaning supplies
Daycare providers also need to be aware of other tax issues that apply to business owners of all types. These include:
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Employer Identification Number – An employer identification number (EIN) is similar to a Social Security Number (SSN) for tax purposes, but since daycare clients will need to provide the daycare's tax ID information in order to get their childcare tax credit, it is a very good idea to apply for an EIN rather than using your own SSN.
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Self-employment tax – When you work for yourself, you have to pay self-employment tax in the same way that employers have to take payroll deductions from employees to pay for Social Security and Medicare taxes. For 2019, self-employed individuals are required to pay 12.4% on the first $132,900 of profit from their business for Social Security and a 2.9% Medicare tax on the same profits, though half of these taxes can then be deducted from gross income. Businesses owned by single taxpayers whose profits exceed $200,000, $250,000 for married filing jointly, and $125,000 for married filing separately are also required to pay an added 0.9% tax for Medicare.
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Medical insurance above-the-line deduction – One of the advantages of being a self-employed taxpayer is that you can deduct your medical insurance premiums from adjusted gross income without needing to meet the 10% cutoff that other taxpayers have to meet in order to itemize their deductions.
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Retirement plan contributions – As a daycare business operator, you are able to put some of your daycare business profits into a self-employed retirement plan or an IRA to save for your future.
It is safe to say that few people who decide to run a daycare ever thought they'd need an in-depth understanding of tax rules, and the same is true for parents who simply want a safe and nurturing place to leave their children. If you need assistance on taking the credits and deductions to which you are entitled, contact a tax professional to learn more.
Jon Osborn, EA writes for TaxBuzz, a tax news and advice website. Reach his office at [email protected].
Steward Financial
Jon Osborn is a tax preparer based in San Dimas, California. His company, Steward Financial Services, offers a broad range of tax preparation, accounting and business consulting for small businesses. He loves to work with clients who are looking for answers to complex tax and business planning issues. He has owned several small businesses and worked with over one hundred small business owners. He helps his individual and business tax clients find the best ways to spend their money in order to minimize IRS tax. Small businesses looking to grow, sell or just increase cash flow are one of Jon's specialties.
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