Rev. Rul. 77-279

Advice has been requested as to the Federal income tax consequences and the Federal employment or self-employment tax consequences in connection with day care services performed by taxpayers under the circumstances described below.

Situation 1. Under the auspices of a charitable organization formed to provide day care for needy children, an individual takes care of such children in the individual's home during the working hours of the children's parents. The individual has complied with the state's licensing requirements for day care services. The charitable organization rather than the individual designates the children assigned to the individual. The individual furnishes a hot lunch and morning and afternoon snacks daily for the children and provides suitable furniture, toys, and activities for them. The individual receives no payment of any kind from the parents, but the organization gives the individual $13 per week per child to repay the estimated amount of out-of-pocket expenses in connection with the day care services rendered. These payments do not exceed actual expenses. The organization makes periodic inspections to insure that the children assigned to the individual are receiving proper care. The organization has the authority to remove the children from the care of the individual if proper care is not provided.

The parents of children enrolled in the program have no voice in the selection of the individual who cares for the children. They pay the organization, according to their ability, for the cost of administering and providing the day care services, such payments ranging from $2 to $21 per week per child. The organization is recognized by the Internal Revenue Service as one that is exempt from Federal income tax under section 501(c)(3) of the Internal Revenue Code of 1954 and one to which contributions are deductible under section 170(c).

Situation 2. An individual takes care of a child whose parents work during the day, as discussed in Rev. Rul. 56-70, 1956-1 C.B. 460. The parents leave the child at the individual's home in the morning before going to work and call for the child in the evening upon returning from work. The parents rely upon the individual's judgment in caring for the child and issue no instructions other than relative to diet, health and rest, and occasionally relative to special foods, medicines, etc., that the child may require from time to time. The individual is told whom to contact in case of emergency. The individual personally determines the amount of attention the child requires, the types of meals to be served, and the manner in which to cope with any situation likely to arise in rendering child care services. The individual is free to perform household chores at any time during which the child does not require personal attention, such as, while the child is taking an afternoon nap. The individual receives a fixed weekly fee from the parents for these services. However, the individual is not held out to the public as engaging in day care work, and is not required to obtain a license for such work under state law.

Section 61(a) of the Code and the Income Tax Regulations thereunder provide that, except as otherwise provided by law, gross income means all income from whatever source derived.

Section 162(a) of the Code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Under this provision an employee or a self-employed individual may deduct the ordinary and necessary expenses of carrying on a trade or business. If the trade or business does not consist of the performance of services by the taxpayer as an employee, such deduction is an allowable deduction from gross income in computing adjusted gross income under section 62(1). However, if the trade or business consists of the performance of services by the taxpayer as an employee, the deduction is allowable only if the taxpayer itemizes deductions or if the expenses fall into one of the categories set forth in section 62(2).

Section 170 of the Code provides that subject to certain limitations a deduction shall be allowed for any charitable contribution (as defined in section 170(c)) payment of which is made within the taxable year. Section 1.170A-1(g) of the Income Tax Regulations provides, in part, that unreimbursed out-of-pocket expenditures made incident to the rendition of services to a charitable organization may constitute a deductible contribution.

The Federal employment taxes of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages (Chapters 21, 23, and 24, respectively, subtitle C of the Code) are imposed on the wages paid to an employee by an employer. An individual is an employee for Federal employment tax purposes if the individual has the status of employee under the usual common law rules applicable in determining whether an employer-employee relationship exists. Guides for determining whether an employer-employee relationship exists are found in three substantially similar sections of the employment tax regulations, namely sections 31.3121(d)-1(c), 31.3306(i)-1, and 31.3401(c)-1. These sections state that generally, the relationship of employer and employee exists when the person for whom the services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so.

Section 1401 of the Code imposes taxes on the self-employment income of an individual derived from any trade or business carried on by such individual.

The individual rendering child care services in Situation 1 does not have a profit motive and is not, in fact, making a profit. The charitable organization rather than the individual designates the children assigned to the individual. The organization has a purpose of providing day care services for needy children and of locating individuals to provide such day care services. The organization has a continuing responsibility to supervise the care provided by an individual after the assignment of children to the individual's home and the organization does, in fact, supervise the care provided by the individual. Also, the organization has the authority to remove children from the care of an individual who does not provide proper care. Therefore, the individual in Situation 1 is rendering gratuitous services to the charitable organization in providing day care services for needy children.

Consequently, the expenses incurred by the individual in Situation 1 in providing day care services are directly connected with and solely attributable to the rendition of gratuitous services to the charitable organization. These expenses are incurred on behalf of and for the use of the charitable organization. Thus, the payments from the charitable organization represent reimbursements or advances for such expenses incurred on behalf of the organization by the individual. In addition, there is no employment relationship between the organization and the individual, and the individual is not engaged in an independent trade or business.

Accordingly, in Situation 1:

(a) The payments received from the charitable organization are not includible in the gross income of the individual as long as the payments do not exceed the expenses incurred by the individual in caring for the children.

(b) The individual's expenditures in providing day care services are not deductible business expenses under section 162 of the Code.

(c) The individual is entitled to a charitable contribution deduction within the limitations of section 170 for any unreimbursed out-of-pocket expenses incurred in providing day care.

(d) The payments received from the charitable organization are not subject to employment taxes or self-employment taxes.

See Rev. Rul. 77-280, page 14, this Bulletin, Situations 1 and 2, for a discussion of similar payments to foster parents.

The individual rendering child care services in Situation 2 does have a profit motive. The individual receives a weekly fee for services from the parents of the child. Thus, the individual is engaged in a trade or business. Under the facts of this case, however, there does not exist a sufficient right of control on the part of the parents to establish, for employment tax purposes, the relationship of employer and employee between the parents and the individual who cares for the child. Thus, the individual is not engaged to perform services as an employee, but is engaged in an independent trade or business.

The individual receives a fixed weekly fee for services rendered. There is no agreement between the individual and the parents of the child that a portion of each payment is intended as a reimbursement of expenses incurred in caring for the child.

Accordingly, in Situation 2:

(a) The entire amount of each payment received by the individual from the parents of the child is includible in the individual's gross income.

(b) The ordinary and necessary expenses incurred by the individual in carrying on this trade or business are deductible business expenses under section 162 of the Code, subject to the limitations of section 280A. Further, such expenses may be deducted from gross income to arrive at adjusted gross income under section 62(1).

(c) The payments received by the individual are gross income derived from a trade or business for purposes of the self-employment tax imposed by section 1401.

Rev. Rul. 56-70 is superseded since its contents are amplified and included in this ruling.