Guest Article

(From the May 30, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Proposed Regulations on Child Care Tax Credit Affect Dependent Care FSAs

The Internal Revenue Service on May 24, 2006 issued proposed regulations on the child care tax credit that also govern benefits that employer-sponsored Dependent Care Assistance Programs (DCAPs) -- including Dependent Care Flexible Spending Arrangements (FSAs) -- can provide. The proposed regulations reflect a series of legislative changes to the relevant rules dating back to 1984. The proposed regulations will not become effective until published in final form, but still offer useful guidance on the IRS's position on certain issues for DCAP sponsors and administrators.

Link Between Child Care Tax Credit and DCAPs

IRC § 129 provides a gross income exclusion of up to $5,000 per year for benefits employers provide pursuant to DCAPs. However, the exclusion applies only to DCAPs -- including Dependent Care FSAs -- that satisfy certain requirements relating to eligibility, nondiscrimination, and notice. In addition, DCAPs may provide only "dependent care assistance," which means "the payment of, or provision of, those services which if paid for by the employee would be considered employment-related expenses under section 21(b)(2) (relating to expenses for household and dependent care services necessary for gainful employment)." IRC § 129(e)(1). Thus, IRC § 21 and the related regulations govern the types of benefits that can be provided under DCAPs, and the types of expenses that Dependent Care FSAs can reimburse.

Employment-Related Expenses

In general, employment-related expenses are expenses for "household services" and expenses for the care of a "qualifying individual," but only to the extent incurred to enable the taxpayer to be "gainfully employed." A "qualifying individual" is any of the following:

According to the proposed regulations, "An individual is physically or mentally incapable of self-care if, as a result of a physical or mental defect, the individual is incapable of caring for the individual's hygiene or nutritional needs, or requires full-time attention of another person for the individual's own safety or the safety of others." The fact the individual cannot engage in any "substantial gainful activity" or perform the "normal household functions of a homemaker or care for minor children" because of a mental or physical condition is not enough.

Significantly, qualifying individual status is determined on a daily basis. Thus, for example, if the taxpayer's dependent child turns 13 on July 1, 200X, then s/he is a qualifying individual only from January 1 through June 30, 200X.

Employment-related expenses specifically do not include the cost of sending a qualifying individual to an overnight camp. Additionally, otherwise eligible expenses incurred for services outside the taxpayer's household -- such as in a "Dependent Care Center" -- count only if incurred for the care of a qualifying individual who is under age 13, or any other qualifying individual who regularly spends at least 8 hours each day in the taxpayer's household. A "Dependent Care Center" is defined as a facility that provides care for more than six non-residents and receives a fee, payment, or grant for providing services to such individuals.

The "Gainfully Employed" Requirement

As noted, expenses are employment-related only if incurred to enable the taxpayer to be "gainfully employed." According to the proposed regulations, the employment might consist of service within or outside the taxpayer's home and includes self-employment. Actively seeking gainful employment also counts, but working as a volunteer or for nominal consideration does not.

Additionally, the fact an expense is incurred while the taxpayer is gainfully employed is not enough. The expense must be incurred to enable the taxpayer to be so employed. This determination is made on a facts and circumstances basis.

As with qualifying individual status, gainful employment is determined on a daily basis. Thus, if the taxpayer incurs expenses for a period during which s/he is gainfully employed (or seeking gainful employment) only part of the time, the expenses must be allocated on a daily basis. However, allocation is not required for short, temporary absences from work, such as for vacations or minor illnesses. Again, this is determined on a facts and circumstances basis.

A special rule applies to part-time employees. As a general matter, they must allocate dependent care expenses for days worked and days not worked. (A day worked is a day on which the taxpayer works at least one hour.) However, if the taxpayer has to pay dependent care expenses on a weekly or monthly basis, including days worked and not worked, the proposed regulations do not require the taxpayer to allocate expenses. The proposed regulations illustrate this special rule with the following examples.

Care of a Qualifying Individual and Household Services

In order to be employment-related, expenses must be for the care of a qualifying individual or for household services provided in connection with the care of a qualifying individual. According to the proposed regulations, expenses are for the care of a qualifying individual "if the primary function is to assure the individual's well-being and protection." This does not include amounts paid for food, lodging, clothing, or education. However, if these or other goods and services are "incidental to and inseparably a part of the care, the full amount is for care."

The proposed regulations clarify that taxpayers do not have to choose the least expensive alternative available for providing care in order for the expenses to be employment-related. This is true even if another caregiver is available to the taxpayer at no charge.

Household services are "the performance in and about the taxpayer's home of ordinary and usual services necessary to the maintenance of the household and attributable to the care of the qualifying individual." These do not include services provided by "chauffeurs, bartenders, or gardeners."

In the case of expenses partly for household services or partly for the care of a qualifying individual and partly for other goods or services, a "reasonable allocation" is required. The allocation is not required, however, if the expense for the other purpose is minimal or insignificant.

Specific Expenses

As noted, the IRC specifies that expenses for overnight camps are not employment-related expenses. The proposed regulations clarify that day camps may be employment-related expenses, even if they specialize in a particular activity -- like computers.

Also, the proposed regulations clarify that expenses for sending a child to nursery school or pre-school may be employment-related expenses, but expenses for sending a child to kindergarten or higher grade levels are not. However, before- or after-school care for a qualifying individual in kindergarten or a higher grade may be employment-related expenses.

Finally, the proposed regulations provide guidance on the following specific expenses.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have 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.