Tax Advantages of Starting a Daycare in Your Home

You are in the childcare business. Now what? You must decide a number of pressing questions. How to organize my business? What forms do I need to keep track of? What logs of information do I need to keep? Why does this all seem so confusing? What planet do accountants and IRS agents come from anyways?

Take a deep breath and we will try to create some simple rules to add some sanity to the confusion. I'm going to start with a couple of advantages to running a child care center from your personal home and will address some of the tricks to record keeping in its own special chapter.

Why is child care a business like no other? You are allowed to follow your own special rules not allowed by any other business run out of your home.

See the IRS is not all bad. Oh my, I did just say that?

You are allowed to count all the areas in your home used regularly for your business and not just those used exclusively for childcare when determining the space in the home that you can deduct. You are the only business that is allowed this treatment.

Here comes the real meat and potatoes, the forms and code sections. (Ugh.)

The most important calculation that you need to understand is a formula called the Time-Space Calculation. This is the calculation that allows you to make your personal expenses that no one else can deduct, as business expenses. In order to do this the IRS demands that you report these expenses separately on form 8829.

First we need to determine the space component of the calculation. Step one is to draw a floor plan of your home. Notice I said floor plan not blueprint. We are trying to determine the square-footage of your rooms a percentage of your home and are not trying to rebuild the home! Each room is labeled one of three titles: 100% Personal, 100% business, shared. The IRS has ruled that for a room to be counted as shared it must only be used regularly for business, not exclusively. Each year you will need to verify the space component with a new floor plan of the home.

The second component of the calculation is the time component. This seems pretty straight forward. At first you may just count the hours when children are present but you would be missing out on all the other time spent in you home working on your business. These hours include time spent preparing for the day, record keeping, and appointments with parents, and cleaning up from the day. Once you have determined the space percentage and the time spent percentage you simply multiply the two percentages together and you are set to go.

Okay. Now what?

Direct vs. Indirect Expenses

The easiest way to define direct business expenses is to call them expenses that you simply wouldn't have if you hadn't decided to start a daycare. Advertising, Liability Insurance, Toys, Art Supplies, etc. all fall into this category.

Indirect expenses are defined as those shared by you as an individual and your business. Rent, Mortgage Interest, Real Estate Taxes, Utilities, Household supplies, Home Owners Insurance, Repairs and Maintenance, etc. fall into this category. The indirect expenses are put through the time-space calculation and the direct expenses are put directly to the business tax return.

The last wrinkle that you need to deal with is to determine what a capital asset is verses an expense. Assets are things that you own that will last longer than one year. For example, your house, car, furniture, stove, refrigerator, microwave, are all assets. These items must be depreciated, expensed over a period of time, not expensed in the current year.

You then need to determine if the item is shared or directly used by the business. Your house is used jointly. A daycare van used specifically for child transportation is a day care specific capital expense. The jointly used assets must be depreciated and applied to the time space calculation. This manual does not allow enough time for an in-depth discussion of depreciation rules. Hopefully, however, you have a general idea that there are different expenses and assets for your business which need to be accounted for.

Startup Costs

Startup costs are the expenses associated with starting a business, both direct and capital, made prior to the actual start of operations. These costs are treated differently than normal expenses. The IRS does not want to see two years of startup expenses and no income on your income tax return. Therefore you are allowed to expense the first $5,000 of expenses in your first year of operation and any expenses over that amount are capitalized and amortized (divided equally) over sixty months. Examples of startup costs are Legal and professional fees, supplies, toys, day care furniture, license fees, education classes, etc. Capital costs might be room additions to bring the house in compliance, fence in the back play area and the like.

Choice of Business Entity

The type of entity that you choose to operate your business can have significant ramifications in the future. Record keeping stays an important component regardless of which entity you choose. We will address that in its own special chapter. A word about insurance would be appropriate at this time. You should always maintain insurance on your business no matter which entity you choose. I will make the assumption that you are starting your business for the long term. With that assumption your business will need to be protected and as such will need liability insurance, just like your home needs home owners insurance. You are attempting to protect the source of your future income from loss.

Now back to the subject at hand.

The moment you as an individual start to engage in providing a service or providing a product to others you are engaging in a business. This business can be regulated or unregulated; the IRS does not care for tax purposes. Your state licensing board obviously does care and you should follow all appropriate rules in your state.

Sole Proprietor

The default type of organization is the sole proprietor. This is the easiest to form, (no cost) but could be the costliest in the long run. The sole proprietor is fully liable for the debts and obligations of the business. The argument that I hear from clients is I truly don't have own anything right now, why should I be concerned? If you are taken to court and a judgment is rendered against your business, it will be applied against all your current personal and business assets now and in the future.

Secondly, the net income of your business is treated as a wage. You are both the employee and the employer. Most employees are unaware that the employer matches an equal amount of their social security tax. This amounts to 7.65% from the employee and 7.65% from the employer totaling 15.3% on the first $90,000 of wage (adjusted annually upwards). This tax is assessed over and above any federal and state taxes.

Single Member Limited Liability Company.

As the name suggests, this is a form of an entity that will limit you from the full liability of the sole proprietorship. The costs are nominal $130.00 in the state of Wisconsin plus the attorney fees if you require assistance. The taxes are exactly the same as the sole proprietor, so the only difference is the peace of mind of the limited liability.

Partnership

Partnerships are two or more people organized to operate a business. There is no limited liability and all partners are held responsible for the action of each partner. If you do decide to organize a partnership you can also use the multi member limited liability company and your liability will limited to the extent of business assets and your investment in the company.

Corporation

A corporation is considered an individual entity, and as such, needs to file its own income tax returns. You, as the owner, will receive a wage for working in the corporation and rent for the use of your property. Additionally, you will need to follow the rules of your state and should consult an attorney. Make sure you are receiving the benefits of liability protection and numerous other tax strategies that are available. Consult your accountant or attorney to verify that you are following rules and guidelines in your specific state.

Subchapter S Corporation

The major difference between a regular corporation and an S-corporation is the way in which it is taxed.

The S-corporation's profits are distributed to the owners, one or more, and are taxed to each shareholder as ordinary income.

As you can see, there are many choices when deciding to operate your business. Not every business is the same and therefore each business must be examined to see which form of business entity is right for you. If you are unsure, seek professional guidance and explore which option is right for you.

(c) CG Groth 2007