A family child care provider writes:

> I have some questions about the possibility of expanding my existing business and wondered if you could advise me on the tax implications. I am contemplating purchasing another house and having my current teacher live in the house we currently own. The idea is that she would get a large license and meet the requirements to run the program we have currently established. We would hire an assistant to work with her and all state and city requirements would be met. I would then work to establish a second location at the newly purchased residence.

Under this scenario, can I pay my current teacher for her teaching skills and have my business pay the mortgage, utilities and all other operating expenses? Can my business then deduct all the home-related expenses based on the time/space percentage for the established location, as well as separately deducting such expenses based on the time/space percentage at the new location? Would it be in my best interest to establish a corporation to operate both households, rather than continuing as a sole proprietor?

You ask good questions. I have heard variations of this idea from other providers and it does present some difficult tax issues.

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From a tax point of view, you can certainly treat your teacher as an employee and compensate her through wages and possibly other benefits. I caution you to be very certain you are operating within local laws, however. California social services and/or city business license rules may require the business owner to live in the home.

The biggest tax issue is that once you move out of the home yourself, you can no longer write off the home expenses (mortgage interest, etc.) using a time/space percentage. In other words, the business use of home rules will no longer apply. If your employee were the business owner, she could claim such expenses by paying you rent. The home office deduction applies only to the business owner's actual residence.

You could treat the home as part business property and part residential rental. You would have to designate certain floor space as 100% day care business space, which your teacher could not use during off hours. Your teacher would pay rent on her designated living space. You could deduct the home expenses associated with the 100% day care space directly on your business Schedule C and deduct the home expenses associated with the teacher's living space on a rental Schedule E, where you would also have to report your rental income as taxable. Without doing research, I don't know if there would be any way to deduct home expenses for the shared space in the home, such as the kitchen, etc.

If you don't want your teacher to pay rent, you could perhaps treat the entire house as a business property. This amounts to providing your teacher with free lodging, however. The fair market rental value of the teacher's residence space in the house would probably be considered a taxable employee benefit.

Incorporation causes even more problems in the area of deducting the home expenses. This is because the corporation does not own the home and cannot use the home office deduction or the time/space percentage.

These are my initial thoughts on your business expansion proposal. More research would be required before we could really decide how best to structure this two-house scenario. My fear is that the City of Fremont will disallow any arrangement other than simply renting the existing home outright to your teacher, with her as the business owner.

Last updated on 20 May 2010

Posted on 2010-05-20 19:16:49