Could in-home child-care providers keep their claimed business deductions when their records commingled business and personal expenses?

Plain-English summary

Virginia upheld the deduction adjustments because the child-care providers could not separate business costs from personal expenses. Virginia individual income tax begins with federal adjusted gross income, but the Department may look behind the federal return when there is clear evidence that reported amounts are inconsistent with federal law.

Ordinary and necessary business expenses must be directly connected with the trade or business and supported by sufficient records. The providers submitted invoices, bank statements, and child-care regulations, but their business and nonbusiness spending was commingled.

Because the records did not show which expenses were business-related, the Department could not verify the claimed deductions. The auditor instead used industry-average pricing methods established by the IRS, and Virginia upheld the 2007-2010 assessments.

Common questions

Q: Did child-care licensing requirements prove the deductions?
A: No. The rules did not identify which commingled costs were directly related to the business.

Q: Can Virginia adjust a deduction shown on a federal return?
A: Yes, when clear evidence shows the reported amount is inconsistent with the Internal Revenue Code.

Citations and references

• Va. Code §§ 58.1-219, 58.1-301, 58.1-310, and 58.1-322.
• IRC § 162.
• Treas. Reg. §§ 1.162-1 and 1.6001-1(a).
• Dilts v. United States, 845 F. Supp. 1505 (1994).

Subject

Taxpayers unable to furnish sufficient information to substantiate their deductions

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 12-132

Original ruling text

August 10, 2012

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek correction of the individual income tax assessments issued to * (the "Taxpayers") for the taxable years ended December 31, 2007 through 2010.

FACTS

The Department adjusted the Taxpayers' business deductions reported on their 2007 through 2010 Virginia income tax returns and issued assessments. The Taxpayers appeal the assessments, contending the adjustments are not based on state license standards for in-home child care providers and do not properly reflect the expenses incurred for implementing such standards.

DETERMINATION

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia "conforms" to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust FAGI where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Va. Code § 58.1-219.

Under IRC § 162, taxpayers are permitted to deduct all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Such expenses must be directly connected with or pertaining to the taxpayer's trade or business. See Treas. Reg. § 1.162-1 and Dilts v. U.S. , 845 F.Supp 1505 (1994).

The Taxpayers assert that the adjustments are not consistent with Virginia's child care licensing requirements. Further, in order to adhere to the child care standards, the Taxpayers were required to make upgrades to their residence and purchase additional child care equipment.

Under Treas. Reg. § 1.6001-1(a), taxpayers are required to maintain records sufficient to allow the IRS to determine their correct tax liability. In addition, Treas. Reg. §1.4461 (a) requires each taxpayer to maintain accounting records necessary to support entries on his return. Similarly, Va. Code § 58.1-310 provides:

Whenever in the opinion of the Department it is necessary to examine the federal income returns or any copy thereof of any individual, estate, trust, partnership or corporation in order to properly audit such returns, the Department or the commissioner of the revenue shall have the right to require such taxpayer to provide such return or a copy thereof and all statements, inventories, and schedules in support thereof.

The Taxpayers provided invoices, bank statements and a copy of the child care regulations to support the deductions claimed for the taxable years at issue. Because the business and non-business expenses were commingled, the Department has been unable to verify which expenses were directly related to the trade or business. As a result, the auditor computed the business deductions using industry average pricing methods established by the Internal Revenue Service. Because the Taxpayers have been unable to furnish sufficient information to substantiate their deductions, I must uphold the Department's assessments for the 2007 through 2010 taxable years.

An updated bill, with interest accrued to date, will be sent to the Taxpayers. No additional interest will accrue provided the outstanding balance is paid within 30 days from the date of the revised bill.

The Code of Virginia sections cited, along with other reference documents, are available on-line in the Tax Policy Library section of the Department's web site, located at www.tax.virginia.gov. If you have any questions regarding this determination, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-4979792718.D