First Considerations in Starting a Family Child Care Busine…

First Considerations in STARTING A FAMILY CHILD CARE BUSINESS

First Considerations In STARTING A FAMILY CHILD CARE BUSINESS

is available for viewing and download from the Minnesota Department of Employment and Economic Development (DEED), Small Business Assistance Office. Office address: Great Northern Building, 12th Floor, 180 East 5th Street, St. Paul, MN 55101-1678. Telephone: 651-556-8425 or 800-310-8323 Fax: 651-296-5287 | Email: deed.mnsbao@state.mn.us Website: Small Business Assistance Office

Upon request, the information in this document can be made available in accessible formats for people with disabilities by calling 651-259-7476.

The Minnesota Department of Employment and Economic Development is an equal opportunity employer and service provider.

First Considerations in STARTING A FAMILY CHILD CARE BUSINESS

TABLE OF CONTENTS

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 SOME IMPORTANT INITIAL DEFINITIONS . . . . . . . . . . . . . . . . . 4 THE CHILD CARE MARKET AND CONSUMER CHOICE . . . . . . . . . 6 LICENSING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 COSTS AND THEIR TAX TREATMENT . . . . . . . . . . . . . . . . . . . 19 THE CHOICE OF BUSINESS STRUCTURE . . . . . . . . . . . . . . . . . 27 FINANCING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 CHILD CARE RESOURCES . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 COUNTY HUMAN AND SOCIAL SERVICE AGENCIES . . . . . . . . . . 59 MINNESOTA SMALL BUSINESS DEVELOPMENT CENTERS (SBDCs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 MINNESOTA RULES CHAPTER 9502, LICENSING OF DAY CARE FACILITIES . . . . . . . . . . . . . . . . . . 82 MINNESOTA STATUTES CHAPTER 245A. HUMAN SERVICES LICENSING . . . . . . . . . . . . . . . . . . . . . 111 MINNESOTA STATUTES CHAPTER 245C. HUMAN SERVICES BACKGROUND STUDIES . . . . . . . . . . . . . 225

INTRODUCTION The 2016 legislature directed the Minnesota Department of Employment and Economic Development (MnDEED) to develop and publish a manual on starting a child care business in Minnesota. That charge reflected three major economic facts. • Lack of quality, affordable child care is a significant barrier to the participation of women, single parents, low income parents, and rural parents in the workforce. That barrier then creates further spillover barriers to job creation, wealth creation, business expansion and retention, and new business location. In addition, lack of child care is a major factor in employee absenteeism with adverse effects on both employers and employees. • Lack of quality, affordable child care forces parents into what the Child Care Council of America in 2016 called the problem of “accommodation not choice.” Scarcity in child care does not now produce general substitutability of one provider for another, requiring parents to make accommodations to costs, schedules, children’s needs and other characteristics of a family’s demand for child care. Minnesota Department of Human Services data reported that twenty-nine percent of all parents, and thirty-five percent of low income parents, reported taking whatever child care they could get. Those percentages increased to over forty percent for minority and non-English speaking households. • The decision to enter the child care business is both a personal and a business decision where the potential provider often encounters high information costs for information needed to guide entry and operations decisions. Those costs can be particularly high for the forty-six percent of child care providers who operate as family child care providers.

In keeping with the January 2017 report and recommendations of the Legislative Task Force on Access to Affordable Child Care, this publication is directed at persons considering the formation and operation of a family day care business. Because the start-up of such a business involves the personal financial resources of the potential provider – sometimes exclusively so – this publication seeks to offer information that will guide the decision making on whether or not to enter this type of business. It looks at six areas that constitute significant barriers to entry and successful operations: • The child care market and the dynamic of consumer choice; • The requirement of licensure; • Start up and ongoing costs (and their mitigation via tax deductibility); • The limitations imposed for tax and financing purposes by the choice of organization structure; • The requirements and process for seeking working capital and other loans from commercial lenders; • The ongoing administrative requirements of tax and regulatory compliance.

A few things that this publication is not. • This publication is not a treatment of child care policy options or planning. Those topics are beyond the expertise of MnDEED and are left here reserved to the various public and private organizations that address them as their first priority. • This publication is not legal or tax advice. Potential child care providers should seek the assistance of appropriately licensed professionals. • This publication is not a textbook on how to conduct survey research, do population forecasting, or develop financial forecasts or financial documents. Nor does it seek to provide counsel on every topic associated with business start-up. MnDEED’s A Guide to Starting A Business In Minnesota, available free of charge in hard copy, or for downloading online, does offer a more encyclopedic treatment of topics. Likewise, Minnesota is rich in the number and kind of organizations that provide these kinds of technical assistance. A partial list of such organizations appears below on page 57-58. A complete list of county social and human service agencies appears below on pages 59-76. • This publication is not about curriculum design or the kinds and number of child development activities that a child care center can optimally offer. Those educational issues are beyond the scope of this publication and the expertise of MnDEED.

SOME IMPORTANT INITIAL DEFINITIONS Although the terms “child care” and “day care” are often used interchangeably in general conversations, it is important to be aware that those terms and other related terms have specific definitions in Minnesota Statutes and in sections of Minnesota Rules implementing those statutes. Minnesota Statutes § 119B.011 defines “child care’ as the care of a child by someone other than a parent, a stepparent, legal guardian, eligible relative caregiver, or the spouses of any of the foregoing in or outside the child’s own home for gain or otherwise on a regular basis. Minnesota Rules 9503.0005 Subp. 7 defines a “child care program” as the systematic organization or arrangement of activities, personnel, materials, and equipment in a facility to promote the physical, intellectual, social, and emotional development of a child in the absence of the parent for a period of less than 24 hours a day. Minnesota Rules 9503.0015 (A) defines a “day program” as a child care program operated during normal waking hours (approximately 6 a.m. to 6 p.m.) where the program(1) operates for more than 30 days in any 12 month period, is not a program excluded from licensing under Minnesota Statutes § 245A.03 subd. 2 (for example, is not a sheltered workshop or a program operated by a public school) and (2) provides care to any child for more than 30 days in any 12 month period and 45 hours in any calendar month.

Minnesota Rules 9503.0005 Subp. 5 defines a “center” as a facility in which a child care program is operated when the facility is not excluded from licensing by Minnesota Statutes § 245A.03, subd. 2 and is not a family or group family day care home. Minnesota Rules 9502.0315 Subp. 9 defines “day care” as care of a child in a residence outside the child’s own home for gain or otherwise on a regular basis for any part of a 24 hour day. Subpart 11 of that same rule defines “family day care” as care for no more than 10 children at one time in which no more than 6 are under school age. The licensed capacity must include all children of any caregiver when the children are present in the residence. Subpart 13 of the rule defines “group family day care” as day care for no more than 14 children at any one time including all children of any caregiver when the children are present in the residence.

THE CHILD CARE MARKET AND CONSUMER CHOICE In looking at the potential market for child care, it is important to distinguish between “need” and “demand.” For child care, need is the expression of the total number of spaces required in a given time period. It is a driven by the total child population, either now or at some point in the future and is most often expressed as “a need for XXX child care spaces in the years X to Y.” Demand is that total segmented by the wants of the child care purchasing consumer. That is, the consumer will seek out child care based on things like location, price, staff, curriculum, developmental activities and the like. In some cases one want will be the driver of the consumer’s decision (for example, the location of the provider within a particular driving distance); in other cases it is the mix of these wants that drives the decision. It is the ability of the provider to meet these wants that creates value for the consumer such that the consumer will take action to acquire the services. In some cases, such as smaller family child care providers, the demand may be apparent from anecdotal comments of co-workers, friends or neighbors who are child care consumers. In other cases, social service organizations, schools, churches and the like may have completed, or be encouraged to complete, more extensive surveys or focus groups. Despite the fact that many publications on starting a child care business emphasize the importance of demographic data, it needs to be remembered that these will most often yield expressions of aggregate need rather than immediate or predictable demand for specific characteristics of service. When a potential child care provider desires to have more formal demand research (to accommodate, for example, a larger potential geographic market), the potential provider should seek the assistance of an organization knowledgeable about the design and interpretation of such surveys. This is particularly important if the potential provider expects to be using that data in a business or financing plan to be submitted to a bank or other commercial lender that will want to be assured of the quality and confidence level of any data supporting a funding request. There are multiple sources of possible errors and biases in survey market research.

• When identifying potential families to interview, are you contacting the right group of people? • Are these families in need of child care over the next few years, or do any of these families not need or no longer need child care? • Are these families representative of families who may need child care in the near future at your location (e.g. by neighborhood, by number of children, by age grouping of children, by area schools, by race/ethnicity)? • Are you including some types of families (e.g. with toddlers and pre- school children) but omitting other types of families (e.g. expecting a first child)? • Are you including more families living in neighborhoods within 2 miles, but not those within 3-5 miles of your location? • Were your families identified from only one or two sources (e.g. your church, your circle of friends and family), rather than a broader group? • When your sample is not representative of the full set of potential customers, you will miss certain groups of families who may need child care, thus underestimating potential clients, and/or overemphasize those who need child care, thus overestimating potential clients. • How many families are you interviewing? The more families – who are representative of families potentially needing child care services such as yours and at your location – you can interview, the better your data will be. • Not all families you identify will have time to respond to your call, survey, or request for an interview. You need to consider the non- responding families and their impact on your data. Do the non- respondents share particular characteristics? Can you contact the non-responding families again, and in a different way, to encourage them to respond? Simply increasing the number of families to contact may not be the appropriate solution. While in some cases

you can reasonably assume that non-responding families will respond in the same way as those who did respond, this is not always a safe assumption if the non-respondents are different in some demographic way from your respondents. • Are you asking the questions that will provide the information you need to determine potential need for your child care? Demand is, of course, not totally persistent. It changes with parents’ desires and wants as children leave, new children are added, or family social or economic status changes. Likewise, there is often a surprising delay between the provider’s initiation of efforts to meet demand through specific characteristics of service and the child care consumers’ action to purchase the service. This paradoxical situation where a provider seeks to meet a demonstrated and articulated want but gets no takers, or gets them only after a time, is a function of three important characteristics of child care consumer choice. • There is a natural inertia in consumer choice. People tend to stay with what they have even if they prefer something else. This is particularly true of any service business where the “product” is not tangible, cannot be stored, and creates no ownership interest for the consumer. • Even though many child care consumers stress that they “took what we could get”, such consumers are risk averse where changing providers is concerned. Child care is an “experience good” whose value can only be completely determined after the consumer has experienced the service. In such a case the consumer can be slow to give up an “OK” service for a potentially better one until the consumer is convinced by experience or otherwise (like advertising or word of mouth reputation) that the new service is indeed better at meeting the consumer’s demand. • There may be “switching costs” associated with changing providers. These can be explicit monetary costs of tuition or transportation, or they may be implicit costs of searching out a new provider, handling registration paperwork, dealing with the potential stress andpsychological costs for children and parents of changing providers. 8

It has been estimated that child care providers derive ninety percent of their income from tuition. In all areas of the state child care accounts for a significant percentage of the expenses in a family budget. In rural or low income areas where wages tend to be lower child care providers come up against this ability-to-pay constraint as a substantial barrier to entry and growth. That is, even in the face of scarcity, child care providers remain price takers with little ability to move their prices down or up: raise prices and the market fails; lower prices and the business fails. Taken together these factors of demand, price inflexibility, and consumer choice constraints mean that the child care market place does not perfectly resemble the traditional economic marketplace where consumers look to substitute one product or provider for another. It becomes important for a new entrant to the market to offer, right away, its best available mix of capacity, price, and program to attract and retain clients now and build reputation effects for later. Most importantly, the potential provider must ask if the effort involved in operating in such a market is worth the effort. The 2017 report of the Minnesota Legislative Task Force on Access to Affordable Child Care heard testimony that the average annual salary for family child care providers was around $24,566 for an average work week of fifty three hours per week with half of all providers making less than $8 per hour before taxes.

LICENSING

License required Unless exempt by law, child care centers, family day care residences, and group day care residences must be licensed. For family day care providers, the audience of this publication, that requirement appears at Minnesota Rules 9502.00335 Subp. 1. The stated purpose of such licensing is to ensure that minimum levels of care and service are given; and that the protection, proper care, health, safety, and development of the children are assured. Operating without a license, or without being one of the exempt categories of provider, is a misdemeanor. Minnesota Rules 9502.0325 Subp. 3 identifies the following day care situations as exempt from licensure: • day care provided by a relative to only related children; • day care provided to children from a single, unrelated family, for any length of time; • day care provided for a cumulative total of less than 30 days in any 12 month period. Minnesota Statutes § 119B.011 Subd. 16 refers to such providers as “legal unlicensed child care providers.” For a potential provider, the requirement of licensure has two important characteristics. • It operates as a barrier to entry by new providers. That barrier exists not only in terms of meeting the standards and requirements of licensing, but also in terms of potentially adverse consequences of delay in obtaining the license. That is, during the period of application and license pendency the market may change against the applicant in terms of potential clients or the entry of other new providers; or the applicant’s personal circumstances may change; or the availability and accessibility of outside funding may change. Both of these characteristics make it incumbent on a potential provider to

obtain and understand – before application – the statutes and rules relating to licensure and to ensure that standards and requirements can be met. A copy of the appropriate rules appears below on page 82-110 and a copy of the appropriate statute below on pages 111- 224 and 225-278. • Licensing is a measure only of the provider having met the defined standards. It is not an indicator to potential clients of the quality of offered programs, services, curriculum, or interactions with children. In a market where there are already operating incumbents, those incumbents may have a “reputation effect” advantage that any new entrant provider must overcome. The Licensing Process The Commissioner of the Minnesota Department of Human Services (DHS) has responsibility and authority for child care licensing but has delegated to counties – acting through their social services or human services agencies – the responsibility to perform major functions related to the licensure of family child care programs. Minnesota Rules 9543.0030 lists these to include: • Accepting and processing license applications; • Conducting inspections, studies, and evaluations of applicants and programs; • Recommending to the Commissioner of DHS the approval or denial of applications for licensure; • Processing requests for variance from rules; • Monitoring compliance with applicable rules; • Investigating allegations of license violations; • Issuing corrective orders; • Recommending forfeiture orders and negative licensing actions; • Enforcing orders of the Commissioner of DHS;

• Representing the Commissioner of DHS in contested case hearings conducted under Minnesota’s Administrative Procedure Act (Minnesota Statutes Chapter 14). While counties have such delegated responsibilities, and while licensing standards and requirements are fixed in statute or rule, there can be some variation among counties in the actual process for implementing licensing. For example, some counties rely on group orientation meetings for potential license applicants while others address potential applicants on a one-to-one basis. Regardless of the manner in which the individual counties implement their responsibilities, the licensing process will have a number of major elements: application, background study, physical environment study, training and operations requirements. Application . The county will provide all prospective applicants a summary of licensing requirements, a description of the agency’s licensing study process, the agency’s timeline for application processing, and the actual license application form. (Note that actual copies of the program rules are not provided until the county receives a completed signed application.) The application form will ask the applicant to identify the type of license applied for, the class of license (based on the licensed capacity of children), and the physical location of proposed services. Most family child care licenses are Class A with a licensed capacity of 10 children. Of those 10 only 6 can be under school age; and, of that 6 only 3 can be under 2 years old; and of those 3 only 2 can be under 12 months old. The application also asks for any previous license history and information on all children and adults living and/or working in the location. The names of three references, who will be contacted directly by the county, are required and—if the applicant was previously licensed—the name of the previous licensing agency from whom a reference will be directly requested. Applicants will be asked to provide their Federal Employer Identification Number (FEIN) and their Minnesota Tax Identification Number. Minnesota requires a Minnesota Tax Identification number for a business that is organized as a corporation or a limited liability

company electing to be taxed as a corporation and filing a tax return with the Minnesota Department of Revenue or which is an employer collecting and remitting withholding taxes on employee wages. For information on obtaining a Minnesota Tax Identification Number see the Minnesota Department of Revenue’s Business Registration The Internal Revenue Service requires a business that is organized as a corporation or a limited liability company electing to be taxed as a corporation and filing an income tax return with the Internal Revenue Service or which is an employer collecting and remitting federal withholding taxes on employee wages to have a FEIN. For information on obtaining a FEIN see How to Apply for an EIN Individual applicants must provide their Social Security Number on the application. Minnesota Statutes § 270C.72 requires the Minnesota Department of Human Services to provide the Minnesota Department of Revenue with the tax identification number(s) and Social Security Number of each license applicant. This information may be used to deny issuance of a license, or to revoke a license, if the applicant owes delinquent taxes, penalties or interest to the State of Minnesota A Certificate of Compliance; Minnesota Workers’ Compensation Law (A Minnesota Department of Labor and Industry Form) must be completed and be submitted with the application for the application to be complete. Minnesota workers’ compensation law requires all employers to purchase workers’ compensation insurance or become self-insured. For purposes of the law employers are defined as those who hire another, including minors, to perform services. Minnesota Statutes § 176 182 prohibits the Minnesota Department of Human Services from issuing a license until the applicant presents evidence of compliance with the law. Additional information is available from the Minnesota Department of Labor and Industry at Workers’ Compensation - Businesses Applicants must also complete the Background Study Notice and Consent Forms for the conduct of the background study described below. 13

Background Study. Background studies are conducted to ensure that those providing licensed child care, or having access to children in licensed child care, do not have a history that may adversely affect the children in care. Minnesota Statutes § 245C.03 requires a background study for the following in family child care: the license applicant(s) and license holder(s); caregivers (provider, substitute, helper, or another adult giving care in the residence); individuals age 13 or older living in the household where the child care will be provided; and individuals who may have unsupervised access when there is reasonable cause. The county’s conduct of the background study will include a review of criminal history information maintained by the Minnesota Bureau of Criminal Apprehension, records of substantial maltreatment of a child or vulnerable adult or other records maintained by the juvenile courts, the county attorney, the county sheriff, local chiefs of police, the Federal Bureau of Investigation, and the National Criminal Records Repository. Minnesota Statutes § 245C.09 provides that an applicant’s failure or refusal to cooperate with the background study is considered probable cause to disqualify a subject, deny a license application, or suspend or revoke an existing license or registration. Minnesota Statute § 245C.15 identifies acts which disqualify a person from providing child care services in a licensed child care setting and also identifies the time period for the disqualification (7 years, 19 years, 15 years, or permanent disqualification depending on the severity of the offense). Examples include child abuse or neglect, spousal abuse, murder, criminal sexual contact, assault, false representation, medical assistance fraud. If the background study results in a disqualification, the Minnesota Department of Human Services may grant a “set aside” or a “variance” which will allow the disqualified person to participate. If the Minnesota Department of Human Services determines, after request by the disqualified person, that the person does not present a risk of harm to children in care, it will grant a “set aside.” If a set aside is not granted, a variance may be granted based on the license holder’s explanation of how the license holder will mitigate any risk of harm. Such a variance often has conditions. For further information see Minnesota Statutes Chapter 245C. 14

The Licensing Study Minnesota Rules 9592.0335 provides for the county to conduct a licensing study to determine compliance with all the requirements of Minnesota Rules Chapter 9502. This inspection will involve: • Compliance with the very detailed requirements of Minnesota Rules 9502.0425 relating to the physical environment in which child care will be delivered. • Compliance with the very detailed of requirements of Minnesota Rules 9502.0435 relating to sanitation and health. Both physical issues like pest control, storage of rubbish, bedding, diapers, storage of hazardous materials and service delivery issues like hand washing by providers and children, care of ill children, administration of medicines, and preparation for emergencies are covered. • Discussion with the applicant of training requirements of Minnesota Statutes § 245A.50. That section requires that individuals working in licensed child care settings take pre-service training before caring for children and/or licensure. Pre-service training ensures providers have the knowledge and skills necessary to provide a healthy and safe environment for the children in care. The family child care license holder must ensure that every staff person and volunteer is given orientation training and successfully completes the training before starting assigned duties. The following training requirements must be completed by a newly licensed child care provider or by a child care provider who has not held an active child care license in Minnesota in the previous 12 months. o Child Growth and Development and Behavior Guidance (Developmentally Appropriate Behavior Guidance). The license holder and each adult caregiver who provide care in the licensed setting for more than 30 days in any 12 month period is required to have at least four hours of child growth and development training in understanding how children acquire language and develop physically, cognitively, emotionally and socially and behavior guidance training in the understanding of functions related to child behavior and strategies for managing challenging situations prior to initial licensure. Child growth 15

and development and behavior guidance training must be completed annually. Current education may substitute for course requirements. o First Aid and CPR. At least one staff member who is present in the home must have been trained in first aid. First aid training must be repeated every two years. At least one caregiver must be present in the home who has been trained in CPR, including CPR techniques for infants and children, and in the treatment of obstructed airways. CPR training must be provided by an approved CPR instructor and must be repeated every two years. o Sudden Unexpected Infant Death and Abusive Head Trauma. This two hour training must be completed at least once every two years. o Child Passenger Restraint Training. Persons who place the child/ children in a passenger restraint system must be trained in using the proper use of child restraint systems and the proper installation of a car or booster seat. Training must be provided by approved trainers through the Minnesota Department of Public Safety. This training must be repeated at least once every five years. o Supervising for Safety. At least six hours of approved training on supervising for safety must be completed, including supervision basics, supervision outdoors, equipment and materials, illness, injuries, and disaster preparedness. At least two hours of training must be repeated annually. Family child care license holders must complete 16 hours of training each year. While many of the on-going training requirements are specified, providers have the flexibility to take some of the annually required hours of training on a variety of different topics. • Collection from the applicant of the fee for an inspection by the Minnesota State Fire Marshal. (The Fire Marshal will schedule the inspection directly with the applicant). Note that Minnesota Rules 9502.0335 requires a Fire Marshal inspection for all new applicants

for licensure with a licensed capacity of more than ten as well as for applicants using mobile homes, those using solid fuel heating, those in multiple occupancy buildings. As a practical matter, counties now require such an inspection from all applicants. If, in the judgment of the county agency representative a potentially hazardous condition may be present, due to a violation of Minnesota Rules 9502.0315 to 9502.0445, the applicant shall obtain an inspection from a fire marshal or other public health and safety official to verify the absence of hazard and to report to the agency. In effect this means that the applicant must correct any deficiencies and have that verified to the agency by re-inspection, or a variance must be approved under Minnesota Rules 9502.0335 Subp. 8. The applicant has 60 days to make any corrective changes and contact the agency for re-inspection. • Discussion of insurance coverage and the requirements of Minnesota Statutes § 245A.152 and Minnesota Rules 9502.0355 Subp. 4. The statute requires that parents be informed prior to admission of the child either: - That the provider carries liability insurance, in which case the provider must make the certificate of insurance, including its date of expiration, available for inspection. On expiration the provider must then notify the parents either that coverage has lapsed or that it has been renewed and – if renewed – give the new expiration date. Or, - That the provider does not have liability insurance. This notice is to be provided annually and parents must be notified of any change in insurance status. Written affidavits signed by parents must be maintained demonstrating their acknowledgement of lack of insurance or changes regarding insurance status. The rule provides that where the provider has liability insurance for bodily injury it must be in the amount of at least $100,000 per person and $250,000 per occurrence.

Note that Minnesota Statutes § 65A.30 makes clear that there shall be no coverage under a day care provider’s homeowner’s insurance for loses or damages arising out of the operation of day care services unless specifically covered in a policy or covered by a rider for business coverage attached to a policy. In addition a potential provider should discuss with a licensed insurance agent the need for other kinds of insurance coverage like: - Business Automobile Insurance covering damage to property or bodily injury caused by the operation of a vehicle in conduct of the child care business, such as during field trips; - Business Interruption Insurance covering income loss if the business is damaged by a natural or man-caused disaster and must stop conducting business in order to make repairs; - Crime and Fidelity Insurance covering situations where the business is a victim of events like robbery or employee theft; - Workers’ Compensation Insurance (required by Minnesota law) covering injuries to employees; - Umbrella Insurance Policies providing extra coverage if the cost of a covered event (such as death or major injuries to multiple parties) exceeds the coverage limits of other insurance policies.

COSTS AND THEIR TAX TREATMENT In considering any potential decision to start and operate a child care business it is useful to look early at the kinds of costs which can be sustained and their potential deductibility from business income taxes as together these two aspects of cost will affect both the entry decision and the realities of going concern operations. There are two important federal tax code sections that both help to identify costs and also to identify the potential deductibility of those costs against income taxes owed from the business’ activity. Section 195 of the Internal Revenue Code provides for deductibility of “startup expenditures” which it defines [Section 195(c)] as “any amount paid or incurred in connection with investigating the creation or acquisition of an active trade or business, or creating an active business, or any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, and which, if paid or incurred in connection with the operation of an existing active business (in the same field as the trade or business)…would be allowable as a deduction for the taxable year in which paid or incurred.” Examples of such expenditures include: licensing fees, cost of business formation and registration, inspection fees, supplies, and pre-opening payroll expenses. Starting a child care business can be capital intensive requiring substantial outlays of money up-front. This is particularly true if physical construction or rehabilitation of a home is required. In making an entry decision one should remember that such costs are “sunk costs” that cannot be recouped (at least not totally) if you decline to go forward with the business or later exit the business. Section 162 allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year for carrying on any trade or business.” That section identifies as “ordinary and necessary expenses” salaries and compensation, travel costs in the conduct of the business, rent for property used in the business in which the taxpayer has no equity. The Treasury Regulations expand the list to include

supplies, repairs, advertising, insurance costs. Larger material goods and equipment are usually depreciated over a period of years determined by statute or rule unless the taxpayer elects to use Section 179 to expense them in the year in which the capital asset was put into service in which case a deduction is allowed for that taxable year not to exceed the amount the taxpayer received from the business during that taxable year up to an upper limit of $500,000. Some of the costs most frequently encountered are: Wages and Benefits The cost of wages paid to employees are deductible as ordinary and necessary expenses in the running of the business. Also deductible are the major classes of fringe benefits provided to employees like health insurance, life insurance, long term care insurance, and educational assistance. Family members of the business owner may work as employees provided that actual bona fide services are performed. Wages paid are subject to the employment tax (see below). If the business is organized as a “C” or “S” corporation then payments to the owner for services are deductible as wages and are subject to the employment tax. The owner may also deduct the cost of health insurance for the owner, the owner’s spouse, and the owner’s dependents. If the business is organized as a sole proprietorship or LLC, payments to the owner are classed as draws or distributions and are not tax deductible. The owner may, however, deduct the costs of health insurance for the owner, the owner’s spouse, and owner’s dependents. For both an LLC and a sole proprietorship, the owner will be subject to the employment tax. The Use of Independent Contractors The business should be very cautious about engaging anyone to work as an independent contractor who is paid a contract fee not wages and who provides his or her own benefits. In recent years, the Internal Revenue Service and the Minnesota Department of Revenue have both expressed

concern about the misclassification of employees as independent contractors with adverse effects on collection of employment and unemployment taxes and on lack of income tax withholding at both state and federal level. The Internal Revenue Service generally applies a “right to control” test to determine employee or independent contractor status. If the business owner has the right to control the method and manner of performance and the means of accomplishing the result, the worker is most likely an employee. This control breaks down into three pieces: behavioral control, financial control, and the relationship between the parties. Behavioral Control • Instructions. A worker who is required to comply with another person’s instructions about when, where, and how he or she is to work is ordinarily an employee. • Training. Training a worker to perform services in a particular manner generally indicates employee status. Financial Control • Payment of business and/or traveling expenses. If the employer pays the worker’s business and/or traveling expenses, this factor weighs heavily in favor of an employer-employee relationship. Independent contractors are more likely to have unreimbursed business expenses. • Payment for services. An employee is generally compensated with a regular wage amount for an hourly, weekly, or other period of time. An independent contractor is often paid a flat fee or on a time and materials basis for a job. • Investment. If the employer furnishes significant tools, materials, and other equipment, this tends to show the existence of an employment relationship. An independent contractor typically has a significant investment in the facilities and tools he or she uses in performing services for someone else.

• Realization of profit or loss. The worker’s ability to realize a profit or suffer a loss is indicative of independent contractor status. In other words, if the worker is subject to real risk of economic loss due to significant investments or bona fide liabilities for expenses, this factor indicates that the worker is an independent contractor. • Availability of services. An independent contractor is generally free to seek out business opportunities. If a worker’s services are available to the general public on a regular and consistent basis, this factor weighs in favor of independent contractor status. It is possible, however, that an individual who performs services for more than one person or company may be an employee of each of those persons or companies. Type of Relationship • Benefits. The provision of benefits such as insurance, a pension plan, paid time off vacation pay, and sick pay indicate an employer- employee relationship. • Agreements. Written contracts describing the relationship the parties intend to create will assist in defining the relationship as an employer-employee relationship or an independent contractor arrangement. • Permanency of relationship. If a worker is engaged with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence of an employer-employee relationship. • Key aspect of business. If a worker provides services that are a key aspect of regular business activity, it is more likely the company will have the right to direct and control the worker’s activities. Provision of key aspects of business services suggests an employer-employee relationship. The U.S. Department of Labor and the Minnesota Department of Labor use a different set of factors to address employee or independent contractor status for operation of minimum wage payments and the applicability of the Federal Fair Labor Standards Act. Those factors focus on the “economic realities” between the parties. 22

• Is the work an integral part of the employer’s business? If yes, employee status is indicated. • Does the worker’s managerial skill affect the worker’s opportunity for profit or loss? If not, employee status is indicated. • How does the worker’s investment in his or her business compare with the employer’s investment? If the worker’s investment is minimal compared with the employer’s investment, employee status is indicated. • Does the work performed require special skills and initiative? If not, employee status is indicated. • Is the relationship between the employer and worker permanent or indefinite? If yes, employee status is indicated. • What is the nature and degree of the employer’s control over the worker? If control is asserted, employee status is indicated. In addition, the Minnesota Department of Labor has developed additional factors to be used in determining independent contractor status. • An employer’s right to discharge a worker indicates employee status. • A worker making his or her services available to the general public on a continuing basis indicates independent contractor status. • Compensation on a job basis rather than by hour, week, or month indicates independent contractor status. • Where a worker is in a position to realize a profit or loss as a result of services rendered, independent contractor status is indicated. • The worker’s right to terminate the working relationship at will without incurring liability for non-completion indicates employee status. • A substantial investment by a person in facilities used in performing services for another indicates independent contractor status.

• If the employer is responsible for the work behavior, negligence and personal behavior of a worker in contact with customers and the public during times that services are performed, employee status of the worker is indicated. • If the services provided are necessary to the fundamental business purpose for which the organization exists, an employment relationship is indicated. Large Material Goods and Computer Software An operating child care business may find it necessary to purchase larger items of equipment like office furniture, office equipment, refrigerators, televisions, computers and computer software, child size furniture, indoor and outdoor recreational equipment like swing set or climbing gyms. Historically, such larger equipment purchases were required to be depreciated over a period of years according to an Internal Revenue Service schedule with only a percentage of the cost of acquisition being deductible in the year in which the equipment was placed into service. For tax years beginning in 2016, Section 179 of the Internal Revenue Code allows a deduction of the full cost of such equipment (up to a total of $500,000) in the year in which the equipment is placed into service provided that the total amount spent for equipment in that year does not exceed $2,010,000 (after which the amount deductible is reduced on a dollar for dollar basis by the amount that the cost of all equipment exceeds $2,010,000). Both the cap and the investment limitation will be adjusted annually for inflation. To be eligible for the Section 179 deduction software must meet some specific requirements: • It must be readily available for purchase by the general public. • It must be subject to a non-exclusive license. • It must not be a substantially modified version of earlier software.

These three conditions in effect mean that payments for the creation of custom software are not deductible. In addition, three other requirements apply: • It must be purchased by the business. • It must be used for the business’ income producing activity. • It must have an expected useful life of more than one year. Using the Section 179 deduction requires the taxpayer to make an election to use Section 179 (rather than regular depreciation schedules) by completing and submitting with its tax return IRS Form 4562. A separate election must be made for each taxable year in which a Section 179 expense deduction is claimed. Some kinds of property and equipment do not qualify for the deduction: • Real property (land, buildings, permanent structures and equipment that are part of the buildings or structures). • Equipment that is purchased from yourself or a related party. • Air conditioning and heating equipment that is permanently affixed to a structure (i.e. central air conditioning). For tax years beginning after January 1, 2016, portable air conditioning units (e.g. window units) are deductible. Other Ongoing Costs Many other ongoing costs are deductible under IRC Section 162 as ordinary and necessary expenses. In general Section 162 deductibility appplies to: • Insurance costs (for example, casualty insurance, general business liability insurance, workers’ compensation insurance for any employees). • Bank charges for maintenance of business accounts. • Advertising costs in any media.

• Cost of establishment, maintenance and use of a telephone line or internet service line. • Cost of food for children in care (not including the owner’s children if they are at the facility). • Cost of food for employees (generally limited to 50 percent of cost). • Cost of services related to access to or use of the location (for example, landscaping or lawn care in areas used by children). • Toys and equipment (Note that the category of toys and equipment can involve substantial expense since it includes items required by regulation to provide activity for the physical, intellectual, emotional, and social development of the child. Depending on the age of the child the requirement extends to things like high chairs, playpens, cribs, cots, sofas, objects and toys to allow the child to see, touch, feel, hear, and taste). • Cleaning and office supplies. For operations located in the home, full deductibility is only available for that percentage of cost associated with the “direct cost” of the “business use” of the home for delivery of child care services. For purposes of that calculation a direct expense is one that is incurred exclusively for the benefit of the business operation and an indirect expense is one that benefits both the business and the home. Indirect expenses must be allocated using the business use percentage. For example, the business use percentage limitation would apply to the deductibility of the cost of rent or mortgage payment and the cost of utilities since only part of the home is used for business use while the cost involves the entire home. The business use percentage is calculated by multiplying the “space percentage” of use (the area of the home regularly used for business divided by the total area of the home) by the “time percentage” of use (the number of hours the home was used for the child care business divided by 8,760—the number of hours in a year). The result is the allowable percentage of deduction for an indirect expense.

THE CHOICE OF BUSINESS STRUCTURE When deciding to start a child care business, a potential provider must choose a legal structure for the business. That choice will affect many different aspects of the business and its operations including tax treatment, liability, expenses, financing, and growth potential. The major structures available for organizing a business are: a sole proprietorship; a corporation; a limited liability company. In Minnesota today, the most popular form of business structure for a small business is a limited liability company, followed by a sole proprietorship and corporation. Few small businesses outside the delivery of professional services are organized as partnerships. Below is a general overview of these different structures. MnDEED’s publication A Guide To Starting A Business In Minnesota contains a more substantial treatment of the tax and non-tax consequences of the choice of business structure. Whichever structure is chosen, the initial choice is not permanent; it can be changed as the business grows or to facilitate specific business activities like raising capital. Sole Proprietorship A sole proprietorship is the easiest business structure to form if there is only one owner. With that structure, the owner and the business are not treated as separate entities for legal and tax purposes: the owner is the business. In Minnesota no legal formalities or filings are required to create a sole proprietorship. If, however, the business is being conducted under a business name that is different from the owner’s full first and last name—as, for example, “Blue Sky Child Care” rather than “Jon Jones Child Care” – a Certificate of Assumed Name must be filed with the Secretary of State’s office. Information on completing this filing is available at Assumed Name/DBA Liability The sole proprietor is personally responsible for all debts and obligations of the business; to include, for example, the obligation to perform on contracts. Creditors of the business activity can proceed directly

against the sole proprietor and recover from his or her personal assets. Employees, customers, or other persons injured on the job or otherwise in contact with the business can seek recovery from the sole proprietor from his or her personal assets. Taxes Like all businesses, a sole proprietorship will pay income taxes, employment taxes, and – if it has employees – unemployment taxes. • A sole proprietorship, whether it has employees or not, is treated as a “pass through entity” for both federal and state income tax purposes. That is, the income passes through directly to the owner. The sole proprietorship itself does not file an income tax return. Instead, the sole proprietor files federal Form 1040 (U.S. Individual Income Tax return) with accompanying Schedule C on which business income and deductions are computed. The business income and personal income are taxed at the sole proprietor’s individual income tax rate. For Minnesota income taxes, the sole proprietorship files M1, Individual Income Tax Return with federal Form 1040 and Schedule C attached. • With Form 1040 the sole proprietorship must also file federal Schedule SE to calculate and pay the federal self employment tax. That tax has two parts: one (FICA) for contributions to Social Security and one for contributions to Medicare. • If a sole proprietorship has no employees, income tax filings and owner’s employment tax filings may be done using the sole proprietor’s Social Security Number as an identification number. The Social Security Number may also be used on the Minnesota M1 form when there are no employees. • If a sole proprietorship has employees, federal income tax filings for the business and federal employment tax filings for the sole proprietor and any employees must be made using a Federal Employer Identification Number (FEIN) which is available from the Internal Revenue Service at no cost by completing form SS4. In that

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