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Guest Article

Deloitte logo

(From the September 25, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Guidance on Dependent Care Assistance Programs and the Definition of Dependent


Employers can provide up to $5,000 per year of nontaxable dependent care assistance to their employees pursuant to a dependent care assistance program (DCAP), such as a dependent care flexible spending arrangement (FSA). This tax-favored benefit generally is available to any employee who must pay someone to take care of his or her young children during the work day -- but only if those children are the employee's "dependents" for federal income tax purposes. This latter requirement can become an issue for employees who are divorced or separated because only one parent can claim a child as a dependent. The IRS has issued Notice 2006-86 to clarify the rules for deciding which parent can claim a child as a dependent in these circumstances.

The special tax treatment for DCAPs -- including dependent care FSAs -- is available only with respect to so-called "employment-related expenses." These are expenses the employee incurs to enable him or her to be gainfully employed, usually for the care of the employee's "qualifying individuals." A "qualifying individual" can be the employee's under age 13 "dependent," as defined by IRC § 152(a)(1). An individual is an employee's under age 13 dependent pursuant to this provision if:

  1. the individual is the employee's child, brother, sister, stepbrother, or stepsister (or a descendant thereof);
  2. the employee and the individual have the same principal place of abode for more than one-half of the taxable year; and
  3. the individual has not provided more than one-half of his or her own support for the year.

Even though only one taxpayer can claim an individual as his or her dependent in a given year, it is possible for a child to satisfy these criteria with respect to more than one taxpayer. This might be the case, for example, if a child lives with a parent and a grandparent, or if the child's parents separate and/or divorce during the year. If both taxpayers attempt to claim the child as a dependent, who prevails? According to IRC § 152(c)(4), the tie-breaker goes to --

  • the child's parent, if one of the competing taxpayers is not the child's parent;
  • the taxpayer with the highest adjusted gross income for the year, if neither of the competing taxpayers is the child's parent;
  • the taxpayer with whom the child lived the longest during the year, if both taxpayers are the child's parent; or
  • the taxpayer with the highest adjusted gross income for the year, if both competing taxpayers are the child's parent and the child lived with both for the same amount of time during the year.

This same definition of dependent is used for more than just the IRC § 129 exclusion for DCAPs. It also is used for the rules regarding head of household filing status under IRC § 2(b), the IRC § 21 child and dependent care credit, the IRC § 24 child tax credit, the IRC § 32 earned income credit, and the IRC § 151 deduction for dependents. Likewise, according to Notice 2006-86, this tie-breaker rule applies to all these provisions as a group rather than on a section-by-section basis.

However, in the case of divorced or legally separated parents the custodial parent may waive his or her right to claim the child as a dependent under IRC § 152(e). In that case, the noncustodial parent can claim the child as a dependent, but only for purposes of the IRC § 24 child tax credit and the IRC § 151 deduction for dependents. So even if the custodial parent waives his or her right to claim the child tax credit and dependency deduction with respect to his or her child, he or she still may be eligible to participate in his or her employer's DCAP.

Notice 2006-86 includes a series of examples to illustrate the operation of the tie-breaker rule, waivers under IRC § 152(e), and the interaction of these two provisions.

How Is This Relevant for Employers?

Employers are responsible for making sure their employees are aware of and understand the relevant eligibility requirements for DCAPs, which are linked to the IRC § 152 dependent definition. As the preceding discussion illustrates, these rules can be complicated and difficult to apply in certain circumstances. In these situations Notice 2006-86, and especially its examples, can serve as a useful guide for employers and their employees.


Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2006, Deloitte.


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