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 Special tax benefits are available for those providing daycare services for children and the parents who pay for those services. This article looks at the various tax deductions daycare providers may use and the childcare tax credit that the parents may claim. 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 to the movies. Also eligible is mileage to purchase supplies and for other business-related travel. What’s deductible is the standard mileage rate (58.5 cents per business mile in 2022, up from 56 cents per mile in 2021) 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). Using a simplified method for the deduction does not require documenting food purchases. 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 2021 are illustrated in the table below. Year States Breakfast Lunch Dinner Snack 2021 Contiguous States $1.39 $2.61 $2.61 0.78 2021 Alaska $2.22 $4.24 $4.24 $1.26 2021 Hawaii $1.62 $3.06 $3.06 $.091 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 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 2021 Allowance One Breakfast $1.39 $1.39 One Lunch $2.61 $2.61 One Dinner $2.61 $2.61 Three Snacks $0.78 $2.32 2021 Daily Maximum Per Child $8.95 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 prevent them from claiming 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 aged 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 the home expenses, including interest, real property 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 operation, 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 $147,000 (2022) of profit from the business and a 2.9% Medicare tax on all the profits. Plus, 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. Qualified Business Income Deduction - Most business owners are allowed a deduction equal to 20% of their qualified business income (QBI). This deduction is most commonly known as the pass-through income deduction because it applies to income from business pass-through entities such as partnerships and S-corporations but also includes income from sole proprietorships reporting on Schedule C of Form 1040. It is sometimes referred to as the Section 199A deduction. The computation can be quite complicated and includes limitations on the deduction at the entity level and then again when the deductions from all entities of the taxpayer are combined and is further subject to a limitation based on the taxpayer’s taxable income. While the deduction doesn’t reduce the amount of the business income on which self-employment tax is paid, it does lower the individual’s income that is subject to income tax. In many cases, this deduction can be very beneficial for a taxpayer operating a daycare business. 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 for an individual operating a daycare business not to give out their SSN to their clients and instead obtain and use an EIN (even if they don’t have employees). DAYCARE USER If you use the services of daycare providers you may qualify for a tax credit if the expense is an “employment-related” expense, i.e., it must enable you or your spouse, if married, to work or look for 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 your 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.