Child Daycare and Taxes

When discussing daycare for children so their parents can work, there are two primary areas of discussion: one from the viewpoint of the individual providing the daycare services and another from the parents using a daycare provider’s services. Tax law provides special benefits for both.

Article Highlights:

• Daycare Providers
• Simplified Food Deduction
• Special Rules for Business Use of the Provider’s Home
• Home Sale Consequences
• Other Expenses
• Other Daycare Provider Issues
• Daycare User Credit
• Employer Dependent Care Benefits
• Other Credit Criteria

When discussing daycare for children so their parents can work, there are two primary areas of discussion: one from the viewpoint of the individual providing the daycare services and another from the parents using a daycare provider’s services. Tax law provides special benefits for both.

DAYCARE PROVIDERS

Daycare providers are generally self-employed individuals who provide care in their home, and like other self-employed individuals conducting a business, they are allowed to deduct business expenses, including the following:

• Business Use of a Vehicle – Examples of business-related use of a personal vehicle by a daycare provider include taking the kids to the park, on field trips, or the movies. Also eligible are miles used to purchase supplies and other business-related travel. What’s deductible is the standard mileage rate of 58 cents per business mile (2019) or the prorated business portion of the actual operating expenses for the vehicle. In either case, a contemporaneously prepared log detailing the business trips should be maintained.
  
• Food – Daycare providers can deduct the cost of meals provided to the children (not including meals for their own children). The simplest method, which does not require documenting food purchases, is to use the simplified meal deduction. This does not preclude a care provider from using the actual expenses if the actual cost is higher and the provider is willing to document the expenses without including food purchased for his or her own family’s use. The simplified meal deduction amounts for 2019 are illustrated in the table below.
  
  

  Year	States	Breakfast	Lunch	Dinner	Snack
  2019	Contiguous States Alaska Hawaii	$1.31 $2.09 $1.53	$2.46 $3.99 $2.88	$2.46 $3.99 $2.88	$0.73 $1.19 $0.86

  
  The rates do not include the cost of nonfood supplies (e.g., utensils), which may be deducted separately. The number of meals per day per child is limited to of the amounts below. (The table uses the amounts based upon the rates for contiguous states and will be higher for Alaska and Hawaii.)
  
  

  Meal	Rate	2019 Allowance
  One Breakfast	$1.31	$1.31
  One Lunch	$2.46	$2.46
  One Dinner	$2.46	$2.46
  Three Snacks	$0.73	$2.19
  2019 Daily Maximum Per Child		$8.42

  
  If the provider receives some form of reimbursement or subsidy, then the provider may deduct only the part of the simplified rate that exceeds the reimbursed amount.
  
• Business Use of the Home – Self-employed individuals may take a business deduction for the business use of a portion of their home if that portion is used exclusively for business. Daycare facilities are not subject to the exclusive use requirement that applies to other home offices. However, that special rule only applies to providers who:
  
  1. Are licensed, certified, registered or approved as a daycare care provider under state law;
  
  2. Have a pending application for licensing, certification, registration, or approval under state law as a daycare provider that has not been denied; or
  
  3. Is exempt from licensing, certification, registration, or approval under state law.
  
  Any daycare provider not meeting one of these three requirements is still subject to the exclusive use rules, which will generally preclude them from the deduction unless they use some portion of the home exclusively for daycare purposes, such as a bedroom or a storage area. The daycare facility exception does not apply if the services performed are primarily educational or instructional in nature (e.g., musical instruction). However, the exception does apply if the services are primarily custodial and if the educational, development, or enrichment activities are only incidental to the custodial services. The services must be provided for individuals age 65 or older, children, or individuals who are physically or mentally incapable of caring for themselves.
  
  When calculating the percentage of business use of the home, both the space used to operate the daycare business and the amount of time that the space is used to provide day care, including preparation and cleaning time, are factors.
  
  
  Example – Edna uses her living room, kitchen, and bathroom ten hours a day, five days a week to provide licensed daycare services. The home is 2,400 square feet, and the living room, kitchen and bathroom are a combined 1,400 square feet. The exclusive use requirement doesn’t apply. Edna’s percentage use of her home for business is determined as follows:
  
  

  
  
  Once the percentage is determined, all of the home expenses, including interest, taxes, home insurance, maintenance, utilities, and depreciation, are summed up and multiplied by the percentage to determine the deduction for the business use of the home. If the home is rented, the rent expense replaces the interest, taxes, and depreciation. After determining the deduction, it is further limited to the gross income from the daycare, and if limited by the gross income, there is a specific order in which the home expenses can be used (not discussed in this article).
  
  Claiming the business use of the home deduction will also impact any future sale of the home. For taxpayers who own and use their home for two years out of the five years prior to the sale, they can generally exclude up to $250,000 ($500,000 if married filing jointly) of any resulting gain. However, any depreciation claimed or that could have been claimed after May 15, 1997, cannot be excluded and, as a result, will be taxable to the extent of any gain from the sale.
  
  
  Example: A care provider is entitled to claim $1,000 per year of home depreciation, and she operates that business for ten years, claiming a total of $10,000 in depreciation. Whenever she ultimately sells her home, the $10,000 cannot be included in the excluded gain and will always be treated as a taxable capital gain, to the extent of any home sale gain.
  
• Other Expenses – Other expenses include just about any expense that has to do with operating the daycare facility, including, for example:
  o Advertising
  o Business banking account fees
  o Daycare licensing
  o Daycare organization membership expenses
  o Seminars and education related to operating a daycare center
  o Business insurance
  o Games and toys
  o Supplies, diapers, wipes, and cleaning supplies
  o Phone service
  o Prorated Internet service
  o Field trip expenses
  o Payroll for employees

Additional important tax issues apply to daycare providers:

Self-Employment Tax – Like all self-employed taxpayers, daycare providers must pay self-employment tax, which is made up of the Social Security tax of 12.4% on the first $132,900 (2019) of profit from the business and a 2.9% Medicare tax on all of the profits. In addition, there is an additional 0.9% Medicare tax on the extent to which the profits exceed $200,000 for single taxpayers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately. In addition, half of the self-employment tax can be deducted from gross income.

Retirement Plan Contributions – Profits from a daycare business qualify for IRA contributions and self-employed retirement plans, allowing daycare providers to put away substantial amounts for their future retirement.

Medical Insurance Above-the-Line Deduction – While most taxpayers must itemize their deductions in order to deduct the cost of their medical insurance, self-employed taxpayers – including daycare providers, to the extent of the profits from their business – can deduct the premiums from their adjusted gross income and avoid the 10% medical expense haircut when itemizing deductions.

Employer Identification Number – Most daycare clients can claim a tax credit for the cost of daycare. However, to do so, they must include either the daycare provider’s Social Security number (SSN) or an employer identification number (EIN) on their tax returns. It is a best practice in this age of ID theft not to use the SSN and instead obtain an EIN.

DAYCARE USER

Individuals who use the services of daycare providers may qualify for a tax credit if the expense is an “employment-related” expense, i.e., it must enable a taxpayer or spouse, if married, to work, and it must be for the care of a child, stepchild, foster child, brother, sister, or stepsibling (or a descendant of any of these) who is under 13, lives in the taxpayer’s home for more than half the year, and does not provide more than half of his or her own support for the year. Married couples must file jointly, and both spouses must work (or one spouse must be a full-time student or disabled) to claim the credit.

The qualifying expenses are limited to the income from working and, in the case of a married couple, are limited to the lower of the taxpayer’s or the spouse’s income from working. However, under certain conditions, when one spouse has no actual income from working and that spouse is a full-time student or disabled, that spouse is considered to have a monthly income of $250 (if the couple has one qualifying child) or $500 (for two or more qualifying children). This means the income limitation is essentially removed for a spouse who is a student or disabled all year.

The qualifying expenses can’t exceed $3,000 per year for those who have only one qualifying child, while the limit increases to $6,000 per year for those with two or more qualifying persons.

If there are two children, the care expenses need not be divided equally. For example, if the taxpayer paid $2,500 in qualified expenses for the care of one child and $3,500 for the care of another child, the $6,000 can be used to determine the credit. The credit is computed as a percentage of qualifying expenses – in most cases, 20%. See the table below for the credit percentages based on the taxpayer’s adjusted gross income.

AGI Adjusted Applicable Percentage

AGI Over	But Not Over	Applicable Percent	AGI Over	But Not Over	Applicable Percent
0	15,000	35	29,000	31,000	27
15,000	17,000	34	31,000	33,000	26
17,000	19,000	33	33,000	35,000	25
19,000	21,000	32	35,000	37,000	24
21,000	23,000	31	37,000	39,000	23
23,000	25,000	30	39,000	41,000	22
25,000	27,000	29	41,000	43,000	21
27,000	29,000	28	43,000	No Limit	20

Example: Al and Janice both work, with combined earned income in excess of $50,000 for the year. Janice has a part-time job, from which she earns $10,000 for the year. Her work hours coincide with the school hours of their 11-year-old daughter, Susan, so while school is in session, Al and Janice incur no childcare expenses for Susan. However, during the summer vacation period, they place Susan in a day camp program that costs $4,000. Since the expense limitation for one child is $3,000, their childcare credit would be $600 (20% of $3,000).

The credit reduces a taxpayer’s tax bill dollar for dollar. Thus, in the above example, Al and Janice would pay $600 less in taxes by virtue of the credit. However, the credit can only offset income tax and alternative minimum tax liability, and any excess is not refundable. The credit cannot be used to reduce self-employment tax, if a taxpayer is self-employed, or the taxes imposed by the Affordable Care Act.

Employer Dependent Care Benefits – Some employers provide dependent care assistance programs to help their employees with the cost of daycare. Payments under these plans used by employees to pay dependent care expenses are excludable from employees’ income, up to the lower of:

1. The employee’s earned income (for married employees, this is the earned income of the lower-paid spouse) or
   
2. $5,000 ($2,500 for married filing separate).

Because reimbursement up to these limits is excludable from income, the benefits the employee receives are treated as reimbursement for daycare expenses that reduce the expense limits of $3,000 for one child and $6,000 for two or more children. Reimbursement in excess of these limits is taxable to the employee and does not reduce qualified expenses for the credit.

Other Credit Criteria:

• Age of the Child – If the qualifying child turned 13 during the year, count only the care expenses paid for the child for the part of the year when he or she was under age 13.
  
• Day Camps – Many working parents must arrange for care for their children under 13 years of age (or any age if disabled) during school vacation periods. A popular solution - with a tax benefit - is a day camp program. The cost of day camp can count as an expense toward the child and dependent care credit. But be careful: expenses for overnight camps do not qualify. Also, not eligible are expenses paid for summer school or tutoring programs.
  
• Both Parents Working in an Unincorporated Business – When both spouses of a married couple are jointly involved in an unincorporated business, it is fairly common, but incorrect, for all of that business’s income to be reported as just one spouse’s income. As a result, they lose the benefits of the childcare credit, which requires both spouses to have income from working.
  
• School Expenses – Only school expenses for a child below the kindergarten level are considered qualifying expenses for this credit.
  
• In-Home Care Providers – If the daycare is provided in a taxpayer’s home, the daycare provider is considered a household employee.

This has been an overview of the various tax issues related to daycare from the perspectives of both the provider and the recipient of daycare services. However, as in everything taxes, many more rules and issues exist than could be included in this article. So, for information about how states deal with the issue and questions about how the daycare will impact your taxes, please give this office a call or visit our website.

Is It Better to Have a Tax Credit or a Deduction?

People often say that an expense is “a tax write-off”; most everyone interprets this to mean that the expense will have a tax benefit. Generally, such a benefit takes the form of either a deduction or a credit; these benefits’ effects are quite different, however, and each type has various categories. As a result, the tax implications may not be as expected. This is especially true when the write-off claim comes from a salesperson who is touting the tax benefits of a product or service, as such individuals often leave out key details. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.

Article Highlights:

• Itemized Deductions
• Above-the-Line Deductions
• Business Deductions
• Asset-Sale Deductions
• Refundable Credits
• Nonrefundable Credits
• Carryover Credits
• Business Tax Credits

People often say that an expense is “a tax write-off”; most everyone interprets this to mean that the expense will have a tax benefit. Generally, such a benefit takes the form of either a deduction or a credit; these benefits’ effects are quite different, however, and each type has various categories. As a result, the tax implications may not be as expected. This is especially true when the write-off claim comes from a salesperson who is touting the tax benefits of a product or service, as such individuals often leave out key details. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.

Tax Deductions – In one way or another, tax deductions reduce the taxable portion of an individual’s income, which thus reduces the tax on that income.

Itemized Deductions – When taxpayers think of deductions, they typically think of the itemized deductions that are claimed on Schedule A. This is the only way to deduct personal expenses such as medical costs, state and local tax payments, investment and home-mortgage interest, charitable contributions, disaster-casualty losses, and various rarely encountered expenses. In some cases, itemized deductions are limited. For instance, medical expenses are only deductible to the extent they exceed 10% of the taxpayer’s adjusted gross income (AGI). Similarly, state and local tax payments (including those for income, sales, and property taxes) are capped at $10,000. On top of that, itemization only reduces taxable income to the extent that the total of the itemized deductions exceeds the standard deduction. When the sum does not exceed the standard deduction, the itemized deductible expenses provide no tax benefits at all.

Above-the-Line Deductions – Certain deductions actually reduce income. These are commonly called above-the-line deductions because, when applied, they reduce the income figure that is used to calculate AGI. Thus, their benefits apply regardless of whether the taxpayer uses itemized deductions. Above-the-line deductions include educators’ expenses; contributions to health savings accounts, traditional IRAs, and certain qualified retirement plans; deductible alimony payments; and student-loan interest. Most of these deductions have annual maximums.

Business Deductions – Taxpayers who operate noncorporate businesses can deduct from their business income any expenses that they incur when operating their businesses. These deductions (which cover advertising fees, employee wages, office-supply costs, etc.) are used to reduce profits, which in turn reduces taxable income and, ultimately, income tax. In addition, most self-employed taxpayers pay Social Security and Medicare taxes on their net business income, so any reduction in their business profits also reduces their Medicare taxes and possibly their Social Security taxes.

Asset-Sale Deductions – An individual who sells an asset is allowed to deduct that asset’s cost from the sale price to determine the taxable profit. Good recordkeeping is helpful here because the original expense may have been incurred years prior, even though it is only deductible when the asset is sold. For example, any improvements that an individual makes to a home over years of ownership are not deductible until the home is sold. At that point, the individual can reduce the taxable gain from the sale by counting the improvements as part of the home’s cost.

       Tax Credits – Tax credits come in several varieties, and the amount of benefit can vary:

Refundable Credits – A refundable credit offsets current tax liability; it is so called because any amount of unused credit is refunded to the taxpayer. Refundable credits include the Earned Income Tax Credit, the Additional Child Tax Credit, and the Premium Tax Credit (net of any advances received), as well as the American Opportunity Tax Credit (an education credit that is 40% refundable). As a matter of general interest, these credits are subject to significant filing fraud because of their refundability. The IRS also considers prepayments such as income-tax withholding and estimated tax payments to be refundable credits.

Nonrefundable Credits – A nonrefundable credit only offsets tax liability; any unused amount is lost (unless it can be carried over to another year; see below). Over time, Congress has become more generous with credits; most credits that are not refundable now carry over for a given period. Nonrefundable credits include the Saver’s Credit, the Lifetime Learning Credit, and the personal portion of the Electric Vehicle Credit.

Carryover Credits – For some nonrefundable credits, any unused current-year credit can be carried over to the next tax year (or for a longer period) until the carryover amount is used up. These credits include the Adoption Credit (which can carry over for up to five years) and the Home-Solar Credit (which carries over through at least 2021; tax law is unclear on whether it will expire then).

Business-Tax Credits – Numerous business-tax credits are available; however, they are grouped into the General Business-Tax Credit, which is nonrefundable but which carries forward for twenty years and back for one year. (This allows a business owner to amend the prior year’s return so as to claim the credit.) This category includes the business portion of the Electric Vehicle Credit.

If you have questions related to how you might benefit from tax credits or deductions, please call this office or visit our website.