Are you a day care provider considering incorporating your business for increased liability protection? If so, please review the following two-part discussion of this topic by Tom Copeland. Once you do, I think you see that the increased costs to you, and especially the loss of your home-related expenses as a deduction on Form 8829, Expenses for Business Use of Your Home, are huge drawbacks. If you decide to proceed with incorporation, get the advice of a tax professional and a legal professional well versed in the business of family child care. Note that I do not recommend setting up a family child care business as a partnership either.
A Limited Liability Company (LLC) is another business entity available to child care providers, though the amount of such additional liability protection provided by an LLC is unclear, as Tom explains below. Still, I believe an LLC is a better and simpler option than incorporating, as long as it's set up to have only a single member. Do not make your spouse or anyone else a member. That way you can remain a sole proprietor for income tax purposes.
Spouses looking for the best way to operate a home child care together will find that it is cheapest and simplest to have one spouse act as the owner and hire the other spouse. This arrangement may even make it possible to deduct your entire family's medical costs as a business expense by setting up a medical reimbursement plan as an employee benefit.
For a more recent discussion of incorporation, see Tom Copeland's article entitled Should You Incorporate Your Family Child Care Business?
Tom Copeland Tax Preparer Update
TO INCORPORATE OR NOT?
I attended a roundtable meeting this week sponsored by the IRS and spoke with an attorney who assists with businesses who want to incorporate. He told me that all family child care providers should be incorporated, a sentiment that I have heard repeated by other attorneys.
Is this good advice?
Providers do get some personal liability protection if they incorporate, but incorporation does not protect business assets. In a typical situation, a provider might have a Time-Space Percentage of 40%, which means that 40% of their home is not protected if they incorporate. (The same would go for all household furniture and appliances.) When I pointed this out, the lawyer responded that a provider could have their corporation pay the provider rent and thus shield their home from a lawsuit.
This answer brings up a problem I see in the general discussion of whether or not it makes sense for a provider to incorporate. Lawyers understand the legal implications of incorporating, but not necessarily the tax consequences. Tax professionals understand the tax consequences of incorporating, but not necessarily the legal issues.
In this case, the lawyer doesn't realize that it will cost the provider more money if her corporation pays her rent. Let's look at an example.
Let's say that a provider who is a sole proprietor has $30,000 of Schedule C income and $15,000 of Schedule C deductions (food, toys, supplies, etc.). She is also entitled to deduct $5,000 of house related expenses on her Form 8829. Her total business expenses are therefore $20,000, and her Schedule C profit is $10,000. If she is in the 30% tax bracket (15% federal income tax and 15% Social Security tax), her taxes are $3,000 and her take home pay is $7,000.
Now, what happens if she incorporates and the corporation pays $5,000 rent to her and deducts this rent as a business expense? The corporation still has $20,000 of expenses, and if all the profit is reported by the provider as income, the provider still ends up with $7,000 at the end of the year. But now she must report $5,000 as income on Schedule E and pay 15% federal income tax (or $750) on this amount. So it has cost the provider $750 to pay herself rent.
Note: The provider can't claim any home office deductions as an employee of the corporation if she is not using any rooms on an "exclusive" basis for her landlord business. Only family child care providers can use the "regular use" test when deducting expenses for using their home in a business. If the provider was using one or more rooms in her home exclusively for her business, then she would be limited to deducting only the business portion of her mortgage interest and property taxes. Such home office expenses would be taken as a miscellaneous itemized deduction on Schedule A. [Note from Alison: Tom admits this is incorrect in Part Two below. Even home-related expenses for exclusive-use rooms are lost.]
In this example, we have left out the possible tax benefits of incorporating and shielding some of the income from Social Security taxes. But these tax benefits are not automatic and carry with them their own costs (higher tax preparation fees for a corporation). Incorporating also carries other costs (fees to incorporate, possible annual corporate fees, workers' compensation, etc.).
In summary, whether to incorporate or not is a complicated question that needs the input from both a lawyer and a tax professional.
Tom Copeland Tax Preparer Update
TO INCORPORATE OR NOT? PART 2
Following my last month's email update on incorporation, I received several comments from tax professionals that I want to respond to:
Tom Jemison, an Enrolled Agent in California, wrote, "I think the home office deductions are even worse than what you spelled out. If an employer (the corporation) pays rent for a portion of an employee's (provider's) residence, the employee is not allowed the corresponding deduction for business use of the home - period [IRC 280(A)(c)(6)]. That means not even for an exclusive use area. This comes up a lot for small non-provider corps."
This is true, and my previous email was not accurate on this point. When an employee rents her home to her employer, the employee (family child care provider) cannot claim any home office deduction on Schedule E (or Form 8829), even if the provider is using one or more rooms in her home exclusively for business. The homeowner can still claim mortgage interest and property taxes on Schedule A. The only time a person can claim home office expenses on Schedule E is when the homeowner is renting her home to someone who is not her employer.
Tom also pointed out that there is a tax benefit for a C-Corporation paying rent to a family child care provider employee. Although there is no home office deduction benefit, there is the tax benefit of moving income to a Schedule E where no payroll taxes are paid. This benefit may be offset some by the lower Social Security earnings for a provider.
Several tax professionals commented that family child care providers could set up a single person LLC (Limited Liability Company) to reduce their personal liability. The advantages of an LLC are that the provider can still file Form 8829 and claim all of the regular home office expenses in the same way that a sole proprietor can. In fact, the tax return of a single person LLC looks no different than a sole proprietor. Therefore, there would be no need for the corporation to pay rent to the provider.
However, although it's probably the least complicated of all corporation entities, there are some drawbacks of a single person LLC. Most states charge annual fees for an LLC; a lawyer should be consulted to set up an LLC properly; the business formalities of an LLC must be followed; and business and personal records must be kept separate.
The biggest benefit of an LLC is the potential for additional personal liability protection. After consulting with other lawyers on this point, I am somewhat skeptical that this is true to the extent that providers may think. The LLC is a relatively new business entity, and we don't have much in the way of court rulings to determine how well it will protect the owner. The part of the home that is used for business purposes would not be protected from a lawsuit; the same is true for furniture and appliances used in the business. Because many providers struggle to keep business records in a professional manner, I am also concerned that those who form an LLC would fail to follow all of the record keeping requirements of an LLC and therefore would risk losing the corporate protection in a lawsuit.
My advice is for providers to purchase a lot of professional business liability insurance (at least $1 million per occurrence and $2 million aggregate). Although an LLC may indeed provide some additional personal liability protection, I don't believe it is a simple solution to this problem.
Last updated: 26 September 2011