How to Survive a High-Risk Audit as a Childcare Provider

Childcare providers, whether they own a daycare center, are employed at a pre-school, are considered self-employed babysitters, live-in nannies, or provide childcare in some other capacity, can deal with severe consequences when it comes to tax liability. Childcare business tax returns provide a unique challenge to the IRS and other auditing agencies due to their potential to understate income as cash-intensive business, as many small daycare providers do not keep thorough records concerning their day-to-day transactions. For this reason, childcare providers may be more likely to be hit with an audit or criminal tax investigation when the numbers don’t add up.

Childcare providers can avoid high-risk audits, such as eggshell and reverse eggshell audits, by utilizing a dual licensed Tax Attorney and CPA trained in meeting childcare industry tax standards who can assist in developing and implementing proper bookkeeping and accounting procedures. However, provided your already being audited / investigated, you’ll need the assistance that only a dually licensed Tax Attorney and CPA can provide to avoid civil and/or criminal penalties and ongoing continued exposure.

Childcare Provider Business Types

Childcare Provider Businesses have historically faced so much enforcement action that the IRS has developed a guide—used by its auditors —which discusses the areas of child care provider business tax returns that likely to contain material misstatements based on the IRS’s previous historical experience auditing and investigating them in the past. The Child Care Provider Audit Technique Guide discusses various childcare business models at length and potential issues that are likely to occur when it comes to their history of reporting tax obligations.

A childcare provider’s typical tax liabilities will largely depend on the specific business type at issue. The Child Care Provider Audit Technique Guide recognizes three types: “Kith and Kin” providers, Family Daycare, In-Home Care, Babysitters, and “Others.” All types have unique tax reporting obligations that a childcare provider must understand to properly report their taxes and avoid a potential audit or criminal tax investigation.

“Kith and Kin” care generally occurs in a provider’s home when a parent stays at home to provide care to their own child[ren] while also providing additional care to other children to provide extra income. Kith and Kin care is regulated rather loosely, and many states do not have licensing requirements when it comes to these providers. While many childcare providers using this model may not be under the impression that the income obtained using this model—however minimal—is considered taxable. However, this is a common mistake. Kith and Kin setups must report their net taxable income and will be taxed accordingly.

Family Daycares usually occur outside the residence and in its own center or location. Generally, Family Daycares can be divided into many business types, including partnerships and corporations, with each center (when there is more than one) potentially set up as its own corporation or partnership. These providers usually have large commercial kitchens, playground equipment, swimming pools, etc. All states require that childcare centers be licensed, however, licensing requirements will vary by state. Childcare providers with their own daycare center(s) should consult their state and local taxing authority, as these centers may be required to keep and report attendance records and compile other data used in calculating their state and federal income tax obligations.

In-Home care providers, when they are considered maids, nannies, au pair, or governesses, are usually paid as a household employee rather than a daycare provider employee. While the in-home care provider will receive wages, they will not incur expenses as a childcare business provider would. Generally, the in-home care provider’s wages will be reported on a Schedule H attached to the Payor’s Form 1040. These providers are covered by Topic 756 – Employment Taxes on Household Employees. While most states do not regulate these in-home care providers, some states regulate nanny-placement agencies and other similar agencies. 

Babysitters are those caregivers who provide childcare on a regular basis, usually in the child[ren]’s home, when the child[ren]’s parents are out during the evening or a weekend. The income made by babysitters is considered taxable income. The Audit Technique guide broadly categorizes all other types as “Others” and does not address these other childcare business types directly. However, many other childcare providers can be categorized as school programs, church programs, and tax-exempt entities. These entities will need to consult their state and/or local childcare regulations to be in full compliance.

Common Childcare Business Tax Issues

Many childcare providers are tasked with providing meals to their child attendees, with many providers using the Child and Adult Care Food Program (CACFP). When the right approach isn’t used when it comes to CACFP paperwork, a minor miscalculation can impact the monthly reimbursement and could result in corrective action should an audit occur. For example, one snack per day per years is worth a $200 tax deduction.

Other mistakes than can impact a CACFP audit include expired eligibility paperwork, noncompliance with the required meal patterns, inaccurate meal counts, children not counted as present, and more. Mistakes such as these can be avoided with proper organization. When you’ve made a mistake concerning CACFP paperwork, the auditing agency will want to review your CACFP paper trail, including receipts, menus, eligibility lists, etc. Properly organizing the CACFP paperwork can have a substantial impact on the audit process and can reduce prolonged examination.

Kith and Kin providers, more than other childcare providers, due to likely minimal state and local regulation, incur unique tax obligations that should be discussed. Kith and Kin care providers are likely to omit hours spent in the home doing business activities when children are not present. These hours include hours spent cleaning, activity and meal preparation, and parent interviews. An inexperienced tax preparer is likely to tell you that you should not report these hours, but they are wrong. These are hours that can get childcare providers more money back on their return.

In addition, Kith and Kin providers might be able to receive a deduction based on rooms exclusively used in a household to conduct childcare business. When the exclusive room deduction applies to you, use it!

Kith and Kin providers need to calculate their time-space percentages, which is used to determine an item’s worth when it is used in business and personal purposes and how much can be deducted as a business expense. To calculate the time-space percentage, you’ll need to know your operating hours and the time spent engaging in other business activities and the rooms used exclusively to conduct your childcare business (both discussed above).

Finally, with respect to Kith and Kin providers, who are generally providing childcare services in their own home, it is important to consider home depreciation. However, this deduction cannot be calculated based on the land’s value, rather only on the building placed on the land.

With nuanced tax issues such as these, it is best to get ahead and avoid an audit by seeking advice on proper bookkeeping practices and tax preparation procedures. We utilize dually licensed Tax Attorneys and CPAs that can provide bookkeeping and accounting services, tax preparation services, and more, to help avoid tax audits and investigations that could result in harsh civil and/or criminal tax penalties.

The FTB, CDTFA, EDD

Childcare providers in California should be aware that they not only owe taxes to the Federal government, but also the state. The Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA), and the Employment Development Department (EDD) are all taxing entities a childcare provider in the state might encounter. Here are some tax issues that should be considered with respect to the FTB, CDFTA, and EDD:

The FTB recognizes the “gig economy,” and asserts that those using online applications to provide goods and services to others are engaged in gig economy activity, even when the task is considered a part-time business or when paid in cash. This situation is likely to apply to babysitters using online sites that connect them with parents seeking childcare services. Generally, these individuals are considered independent contractors and are required to make estimated tax payments. However, gig workers may also deduct appropriately related expenses. Accordingly, good record keeping is essential to minimize your taxable income.

Generally, those childcare providers only providing services and not selling goods are not likely to have to deal with the CDTFA, as money obtained through services is generally not taxable under CDTFA sales tax standards. However, a uniquely situated childcare business that sells goods used by children, such as toys, clothes, etc. and provides childcare services could be regulated by CDFTA. 

The EDD administers payroll tax regulations with respect to both businesses and individuals. While the IRS and EDD enforce similar regulatory provisions, they are distinct entities with their own employment tax requirements. Overwhelmingly, the predominant indicator that a childcare provider may be selected to undergo an audit by the EDD is when a childcare provider has made a mistake or misrepresentation when determining whether their worker is an employee or an independent contractor. Many times, childcare providers in the state are considered independent contractors and do not incur the same employment tax liabilities that a business would. For this reason, it is important to consult the EDD’s tax regulations or consult with an experienced Tax Attorney to help you determine whether you are an employee or an independent contractor and how to calculate your tax obligations accordingly. When you’re being audited based on an employee/independent contractor determination, we can assist you and guide you through the process.

Due to the complexity involved in FTB, CDTFA, and EDD audits, and the debilitating penalties that can result, it is crucial that you are represented by an experienced dually licensed Employment Tax Audit Attorney & CPA. The Tax Law Office of David W. Klasing routinely represents childcare providers and individual taxpayers in IRS tax audits, FTB tax audits, CDTFA sales tax audits, and EDD employment tax audits. , David W. Klasing, has provided audit representation spanning three decades, providing our legal team with invaluable insight into the IRS, FTB, CDFTA, and EDD civil and criminal tax investigative process.

Childcare Business Audits

With the many nuanced tax issues that childcare providers must deal with, a childcare business audit can occur due to various reasons, and it does not always mean that you are in trouble or that you’ve done something wrong. However, you’ll want to move quickly and take the necessary steps to determine what the problem is. It may be necessary to retain a dual licensed Tax Attorney & CPA to help you determine what went wrong and what you need to do to eliminate continued exposure. It is important to protect your business and minimize mistakes that can, at best, cost your business money, and at worst, cost you your liberty. Our experienced dual licensed Child Care Tax Attorneys & CPAs stand ready willing and able to help.

Common indicators that tax evasion has occurred with respect to childcare businesses include unpaid income tax liabilities, purposely characterizing employees as independent contractors even where they are deemed employees by law, illegally claiming excessive unsubstantiated deductions or tax credits or concealing business income. When these and other badges of fraud are discovered in your tax returns, the chances that you will be selected to undergo an audit or criminal tax investigation are high.

Once a childcare provider has been selected to be audited, the childcare provider can expect to be asked numerous, lengthy questions by the auditing agent to establish that the income has been accurately reported and that there is substantiation available to corroborate the income and deductions reported. A childcare provider can expect to be asked, among other things, about how taxable income was determined, income recording systems & procedures, to provide contracts with a sample of the children’s parents, rate schedules, attendance policies, vacation time, sick leave, registration charges, whether year-end statements are provided to parents, whether the provider utilizes sign-in and sign-out sheets, and whether the provider provides meals, transportation, and supplies.

When the numbers don’t add up and the childcare provider doesn’t have adequate records to validate the numbers reported in their tax returns, the auditing agency will attempt to estimate or reconstruct their records through various means, including receipts, existing contracts, and government records, such as subsidy programs. When the records can’t be estimated or reconstructed to their satisfaction, the IRS and other auditing agencies are required to make assumptions that can weigh heavenly against the audited taxpayer. The worst-case civil scenario we have commonly seen is treating every deposit as taxable income and disallowing every claimed expense as nondeductible & personal.

Unfortunately, so many childcare businesses have filed tax returns in the past that included indicators of fraud that the IRS wrote an audit guide on the subject. They’ve seen it all and are trained to distinguish between mere negligence and genuine criminal income tax evasion. Intentional misrepresentations increase your exposure to high-risk audits that are likely to result in a conviction, particularly when you don’t have an experienced dual licensed Tax Attorney & CPA’s assistance to minimize your civil and criminal tax liability and protect your interests.

Eggshell Audits

The industry term “eggshell audit” evolved to describe high-risk scenarios and fact patterns that could result in civil fraud penalties and criminal tax exposure for the audited / investigated taxpayer. Imagine that you’ve made intentional misrepresentations on previous tax returns and you’re now being audited or investigated on your current returns. While you know that you’ve lied on your tax returns, but the auditing agent has yet to discover your history of lying. Naturally, you’re going to be “walking on eggshells,” worried that your lies will be uncovered. Hence, the term “eggshell audit.”

An eggshell audit rarely results because of the mindless errors that are inherent in any tax return. Minor preparation errors, reasonable accounting errors underlying the return, etc., won’t likely be viewed as the taxpayer having made intentional representations when errors such as this are discovered.

What is considered an intentional and material misrepresentation is determined on a case-by-case basis and will be highly dependent on the childcare provider’s unique facts and circumstances. Ultimately, a material & intentional misstatement will be one that is deemed indicative of tax evasion rather than mere negligence. Intentional conduct is a prerequisite to a criminal tax conviction.

When they IRS or another California auditing agency has not yet discovered intentional misrepresentations or indicators that tax evasion has taken place, a voluntary disclosure may be available, limiting civil tax exposure and eliminating the chances that a criminal tax prosecution will ever occur. When you’re already under audit or investigation, a voluntary disclosure is not available and you’ll need a dually licensed Attorney and CPA to survive the audit or a criminal tax investigation.

Note: As long as a taxpayer that has willfully committed tax crimes (potentially including non-filed foreign information returns coupled with affirmative evasion of U.S. income tax on offshore income) self-reports the tax fraud (including a pattern of non-filed returns) through a domestic or offshore voluntary disclosurebefore the IRS has started an audit or criminal tax investigation / prosecution, the taxpayer can ordinarily be successfully brought back into tax compliance and receive a nearly guaranteed pass on criminal tax prosecution and simultaneously often receive a break on the civil penalties that would otherwise apply. 

It is imperative that you hire an experienced and reputable criminal tax defense attorney to take you through the voluntary disclosure process. Only an Attorney has the Attorney Client Privilege and Work Product Privileges that will prevent the very professional that you hire from being potentially being forced to become a witness against you, especially where they prepared the returns that need to be amended, in a subsequent criminal tax audit, investigation or prosecution.

Moreover, only an Attorney can enter you into a voluntary disclosure without engaging in the unauthorized practice of law (a crime in itself). Only an Attorney trained in Criminal Tax Defense fully understands the risks and rewards involved in voluntary disclosures and how to protect you if you do not qualify for a voluntary disclosure.

As uniquely qualified and extensively experienced Criminal Tax Defense Tax Attorneys, KovelCPAs and EAs, our firm provides a one stop shop to efficiently achieve the optimal and predictable results that simultaneously protect your liberty and your net worth. See our Testimonials to see what our clients have to say about us!

It is important to recognize the signs when a civil audit is likely heading towards a criminal tax investigation, which a reputable and experienced Criminal Tax Defense Attorney is trained to spot. Commonly recognized indicators that a criminal investigation is potentially looming include:

• The civil audit is mysteriously suspended, while the audit is clandestinely handed off to a federal or California criminal tax investigator without notice to the taxpayer.
• The federal or California auditor suddenly becomes unreachable.
• The auditing agent collects voluminous and excessive documentation and makes copious amounts of copy requests.
• The taxpayer is summoned to provide records and make an appearance.
• More than one auditor, their manager, or the IRS’s legal counsel and court reporter attend a taxpayer interview.
• The auditing agent makes undisclosed contact with third parties.

Eggshell audits are considered sensitive and require the discretion that only an experienced and reputable criminal tax defense attorney can provide. This is not the time to play fast and loose with the IRS or State of California Auditor. With such extensive and burdensome civil tax penalties and criminal tax consequences at stake, childcare providers would be well-advised to retain an experienced dual licensed Tax Attorney & CPA anytime they have knowingly made intentional representations, even when an audit is not currently pending or ongoing.

Reverse Eggshell Audits

Unlike a regular eggshell audit, where the taxpayer has potentially incriminating evidence that the auditing agent hasn’t discovered, a reverse eggshell audit occurs when there are two parallel investigations taking place simultaneously: one civil and one criminal. Essentially, the criminal investigation is disguised by the civil one. Ordinarily, during a civil audit, the auditing agent is not on notice that the taxpayer has engaged in any criminal tax conduct. However, in a reverse eggshell audit, the taxpayer and their potential representatives are the ones without notice concerning the auditor’s true intentions.

Fundamentally, a tax auditor’s purpose is to ensure that taxpayers are compliant with applicable laws and regulations. However, this doesn’t mean that auditors are void in using deceptive tactics when necessary to ensure compliance. The auditing agency has no duty to provide you with notice that the evidence they’re gathering in the civil investigation can be used against the taxpayer in a criminal tax investigation. Absent direct deceit, trickery, and misrepresentations, the auditing agency can use any means necessary to complete their investigation.

The evidence obtained via these morally questionable tactics can result in heavy consequences to unsuspecting taxpayers. For this reason, reverse eggshell audits are dangerous territory. By disguising the criminal investigation as a civil one, the taxpayer is ostensibly denied the protections that a criminal tax attorney could otherwise provide them. However, once it is discovered, or merely suspected, that a reverse eggshell audit is occurring, a dually licensed Criminal Tax Defense Attorney and CPA can intervene at any stage in the process and attempt to mitigate any civil or criminal tax liability.

The Tax Law Offices of David W. Klasing has decades of experience providing high-risk audit representation, including representation concerning eggshell audits and reverse eggshell audits to childcare providers located within the state of California and across the U.S. as to federal audits or criminal tax investigations. With more than twenty years’ experience working with daycare centers, babysitters, nannies, and other childcare providers, our award-winning dual licensed Tax Attorneys & CPAs are uniquely equipped to protect your net worth and your liberty.

Eggshell and Reverse Eggshell Audit Consequences

There is a severe risk that an inadequately represented taxpayer can overprovide evidence that can be used against them later during a criminal tax proceeding. Because the reverse eggshell audit disguises the criminal tax investigation with the civil one, many taxpayers will not realize they have a constitutional right to decline to provide any evidence that could incriminate them prior to it being too late. Because there is no 5^th Amendment right in a civil setting, and because taxpayers are legally bound to answer all inquiries made by an auditor candidly, many taxpayers will unknowingly provide the auditor with incriminating evidence that can be used against them in a subsequent criminal tax proceeding.

However, while overproviding details is dangerous, so is underproviding. When you invoke your constitutional rights under the 5^th Amendment right against self-incrimination, this will be seen as incriminating and may get your case sent to the IRS or appropriate California Criminal Investigation Division. Accordingly, there really is no “winning” when it comes to reverse eggshell audits. Because reverse eggshell audits are so deceptive in nature, it is necessary to obtain an experienced dually licensed Tax Attorney & CPA at the outset to avoid the extreme consequences that can result. A dually licensed Tax Attorney and CPA is uniquely equipped to represent you and protect your interests when a reverse eggshell audit is at issue.

Remember, although you may be tempted to approach your original tax preparer to attempt to cover up your intentional misrepresentations and make your wrongs right, there is no accountant-client privilege, meaning that your tax preparer can be required—via a Court’s contempt power to divulge any incriminating evidence they have that could be used against you in a criminal tax prosecution. Moreover, they would most likely willingly divulge any incriminating evidence against you if assisted them with preserving their own reputation.

When your books have been cooked and your required to participate in an audit interview where tough questions that you cannot provide answer to will be asked, you will want an attorney present—and to invoke your attorney-client privilege—to avoid answering questions that could eliciting an incriminating response.

Childcare Business Audit Appeals

When a civil audit concludes, the auditing agency, whether it be the IRS, FTB, CDTFA, or EDD, will send a notice outlining their conclusions, describing what additional tax, civil penalties and interest will result. However, you have a right to contest the auditing agency’s conclusions. You can contest these conclusions—with an experienced dual licensed Tax Attorney & CPA’s assistance—through an appeal.

The appeals process involves filing a tax court petition or protest letter outlining why the auditing agency reached the wrong decision with both a legal and a factual basis to support your stance. You will need an a persuasive tax litigation attorney with a long record of appeals success to guide you through this sensitive, complex process, which involves understanding tax statutes, constitutional rights, evidentiary standards, court rules, and deadlines. 

The Takeaway

With childcare providers usually running cash-intensive businesses that have unique tax reporting obligations, and the IRS and California auditing agencies on high alert when auditing or investigating childcare business tax returns, it’s best to be prepared and hire an experienced dually licensed Tax Attorney and CPA who has extensive childcare provider industry related knowledge and can assist you with getting your income tax, sales tax and employment tax returns in compliance with California and Federal filing requirement prior to an eventual audit.

However, when you’ve made negligent errors or intentional misrepresentations on your returns that cannot be supported under an audit by the IRS California taxing authority, you should seek a dually licensed Tax Attorney CPA’s immediate assistance to mitigate the results of a high-risk audit to avoid severe civil and criminal penalties, where a criminal tax investigation leads to prison time.

Whether you have general questions about childcare business tax returns and how to get in compliance with applicable federal or California tax regulations, how to prepare to undergo an audit, or how to challenge an audit’s outcome, the Tax Law Office of David W. Klasing can provide you answers while ensuring your constitutional rights are protected at every step along the way. To schedule a reduced-rate initial consultation, concerning a childcare provider tax audit or a related matter, contact us online, or call us at 800-681-1295.

If you have failed to file a tax return for one or more years or have taken a position on a tax return that could not be supported upon an IRS or state tax authority audit, eggshell audit, reverse eggshell audit, or criminal tax investigation, it is in your best interest to contact an experienced tax defense attorney to determine your best route back into federal or state tax compliance without facing criminal prosecution.

Regardless of your business or estate needs, the professionals at the Tax Law Offices of David W. Klasing are here for you. We are open for business and our team will help ensure that your business is too. Contact the Law Offices of David W. Klasing today to discuss your business with one of our professionals.

In addition to our main office in Irvine, the Tax Law Offices of David W. Klasing has unstaffed (conference room only) satellite offices in Los Angeles, San Bernardino, Santa Barbara, Panorama City, Oxnard, San Diego, Bakersfield, San Jose, San Francisco, Oakland, Carlsbad and Sacramento.

Our office technology allows clients to meet virtually via GoToMeeting. With end-to-end encryption, strong passwords, and top-rated reliability, no one is messing with your meeting. To schedule a reduced rate initial consultation via GoToMeeting follow this link. Call our office and request a GoToMeeting if you are an existing client. 

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• Why hire David W. Klasing to represent me in an audit

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• I didn’t know I committed tax fraud. Can I get off?
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