Regulations Provide Guidance on Child and Dependent Care Credit

By Ellen Cook, MS, CPA


EXECUTIVE SUMMARY

  • The Working Families Tax Relief Act of 2004 made significant changes to Sec. 21, which provides for the child and dependent care credit.

  • The IRS issued final regulations under Sec. 21 that amended the existing regulations to reflect the changes made by the new law.

  • In addition to providing clarifying definitions, the final regulations introduce a new safe harbor for short and temporary absences from work.


According to the 2000 census, for more than 60% of households with children under age six, all parents in the household worked.1 Sec. 21 was enacted to provide such families with a tax benefit to help them stay in the workplace—a nonrefundable child and dependent care tax credit for employment-related expenses for the care of certain qualifying individuals. In tax year 2004, taxpayers claimed child and dependent care credits of $3.3 billion on 6.3 million returns.2

In August 2007 the IRS issued final regulations3 under Sec. 21. While generally in line with the proposed regulations issued on May 24, 2006,4 the final regulations, in addition to providing clarifying definitions, identify educational programs that do not qualify as employment-related expenses and introduce a safe harbor for short and temporary absences from work. Regs. Secs.1.21-1 through -4 apply to tax years ending after August 14, 2007.5 The proposed regulations apply in tax years for which the period of limitation on credit or refund had not expired as of May 23, 2006.

This article presents a summary of the Sec. 21 provisions, including the timing of the deduction as clarified in the regulations, and discusses the definitions of qualifying individuals, qualifying household services, and qualifying providers, with particular attention to programs that do and do not meet the requirements of employment-related expenses. Examples throughout the article are based on those included in the regulations.

Child and Dependent Care Credit

Sec. 21 allows for a nonrefundable credit for taxpayers who pay qualifying employment-related expenses for the care of eligible individuals so that the taxpayer may work or seek work. The credit is computed by multiplying the qualifying expenses by an applicable percentage ranging from 20% to 35% based on the taxpayer’s adjusted gross income.6 Qualifying expenses are capped at $3,000 for one qualifying individual and $6,000 for two or more qualifying individuals,7 although the taxpayer is not required to prorate the annual dollar limitation if the qualifying individual ceases to qualify during the tax year.8 The amount of qualifying expenses must be reduced by the amount excludible from gross income under Sec. 129 dependent care assistance plans.9

The credit is also subject to an earned income limitation. For an unmarried individual, the credit is limited to the individual’s earned income for the year; for a married individual, it is limited to the lesser of the individual’s earned income or his or her spouse’s earned income for the year.10 In the case of a spouse on a joint return who is either a student or physically or mentally incapable of self-care, the spouse will be deemed for each month that he or she is a full-time student or qualifying individual to have earned income of $250 in the case of one qualifying individual and $500 in the case of two or more qualifying individuals.11 How-ever, in the case of husband and wife, the deemed income will apply for only one spouse for any one month,12 as illustrated in the following examples.

Example 1: In 2007, A, who is married to B, pays employment-related expenses of $5,500 for the care of one qualifying individual. A’s earned income is $30,000. B is a full-time student for 10 months during the year. B is deemed to have earned income of $2,500 ($250 × 10 months) for the year. In computing the child and dependent care credit, the amount of employment-related expenses is the lesser of $2,500 (the lowest earned income of A or B) or $3,000 (the statutory limit of one qualifying individual), or $5,500 (the actual amount of expenses).

Example 2: Assume that in the case above, neither spouse has earned income. A is physically incapable of self-care; B is a full-time student for the entire year. The $5,500 payment is for A’s care. Only one spouse, A or B, is deemed to have $3,000 of earned income ($250 × 12 months). The other spouse has earned income of $0. In computing the child and dependent care credit, the amount of employment-related expenses is the lesser of $0 (the lowest earned income of A or B) or $3,000 (the statutory limit for the care of one qualifying individual) or $5,500. Therefore, the couple is not entitled to any child and dependent care credit.

In computing the lowest earned income, a taxpayer is not required to take into account the earned income of a spouse who died or was divorced or separated from the taxpayer during the tax year.13 However, the taxpayer must take into account the entire year’s earned income of a spouse to whom the taxpayer is married at the close of the tax year even if the taxpayer and spouse were married for only part of the tax year.14

In general, married taxpayers must file a joint return in order to claim the credit.15 A married individual who (1) files a separate return and maintains a home that is the principal place of abode of a qualifying individual for more than half of the tax year, (2) provides over half of the cost of maintaining the household, and (3) lives apart from the spouse for the last six months of the year will be treated as not married for purposes of this credit.16 Such individuals, as well as those who are legally separated under a decree of divorce or separate maintenance, need not consider the spouse’s earned income when computing the limitation17 and may claim the credit if all other requirements are met.

Qualifying Individual

The Working Families Tax Relief Act of 200418 made three important changes to the child and dependent care credit effective for tax years beginning in 2005: (1) The definition of a qualifying dependent is conformed to that of the uniform definition of a child, thereby requiring the individual to have the same principal place of abode as the taxpayer for more than half of the tax year;19 (2) the taxpayer claiming the credit need not “maintain” the household; and (3) an individual who is physically or mentally incapable of caring for himself or herself must live with the taxpayer for more than half of the tax year in order to qualify.20 The regulations clarify and expand the definitions of qualifying individual, gainful employment, and qualifying individual and household services.

For tax years beginning after December 31, 2004, a qualifying individual is defined as one of the following:21

  • Taxpayer’s dependent (who is a qualifying child within the meaning of Sec. 152) who has not attained age 13;
  • Taxpayer’s dependent (as defined under Sec. 152 without regard to subsections (b)(1), (b)(2), and (d)(1)(B)) who is physically or mentally incapable of self-care; or
  • Taxpayer’s spouse who is physically or mentally incapable of self-care and who has the same principal place of abode as the taxpayer for more than half of the tax year.

An individual is physically or mentally incapable of self-care if, as a result of a physical or mental defect, that individual is incapable of caring for his or her hygiene or nutritional needs or requires the full-time attention of another person for his or her own safety or the safety of others.22

The exhibit compares the current definition and the requirements for tax years prior to January 1, 2005.

The regulations provide that an individual’s status as a qualifying individual is determined on a daily basis without counting the day the status terminates.23 Further, requirements of Sec. 21 as well as the regulations are applied at the time the services are performed, regardless of when the expenses are paid.24

Example 3: C pays $500 for 20 days of care (January 2–30, 2008) for her child, who is a qualifying individual. C’s child turns 13 on January 18, 2008. C’s child is a qualifying child for January 2–18 (12 days of care). C’s pro-rata amount that qualifies for the credit is $300 (12 ÷ 20 × $500). Because C’s child was a qualifying child for the 12 days for which services were performed, this amount qualifies for the credit whether it is paid before or after the child’s 13th birthday.

In the case of divorced parents, Sec. 21(e)(5) and the regulations25 give the credit to the custodial parent (the parent having custody for the greater part of the year), even if the noncustodial parent may claim the dependency exemption for that child for that tax year. The regulations26 clarify that in the case of divorce, a qualifying individual is one who:

  • Is under age 13 or is physically or mentally incapable of self-care;
  • Receives over half of his or her support during the calendar year from one or both parents who (1) are divorced or legally separated under a decree of divorce or separate maintenance, (2) are separated under a written separation agreement, or (3) live apart at all times during the last six months of the calendar year; and
  • Is in the custody of one or both parents for more than half of the calendar year.

Qualifying Services

The Code defines employment-related expenses as those for household services and for the care of a qualifying individual that are incurred to enable the taxpayer to be gainfully employed.27 The regulations add the phrase “or in active search of gainful employment”28 and make the following clarifications:29

  • Employment may consist of service within or outside the taxpayer’s home and includes self-employment.
  • It is not enough that the expense is incurred while the taxpayer is gainfully employed. The purpose of the expense must be to enable the taxpayer to be gainfully employed, which is determined by the facts and circumstances of each particular case.
  • Work as a volunteer or for nominal consideration does not qualify as gainful employment.

The primary function of the expenses must be to assure the qualifying individual’s well-being and protection.30 While food, lodging, clothing, and education are not generally considered qualifying care expenses, if such expenses are incidental to and inseparably part of the care, the full amount is considered for care.31 If not, a reasonable allocation must be made.32

Example 4: D places her four-year-old in preschool so that she may be gainfully employed. The preschool provides both lunch and snacks, which are included in the cost of the day care. The full amount paid to the preschool qualifies for the credit.

Example 5: E is a member of the armed forces who has been ordered to a combat zone. As a result, E places his 12-year-old in a boarding school that provides not only education but also meals and housing. Because the food and lodging are not incidental to care, only the part of the cost allocable to the care of the child is an employment-related expense.

Expenses for household services performed in and about the taxpayer’s home for ordinary maintenance may be employment related if the services are performed in connection with the care of a qualifying individual.33 The regulations make the following clarifications:

  • Services performed by chauffeurs, bartenders, or gardeners are not household services.34
  • The cost of transportation by a dependent care provider of a qualifying individual to or from a place where care of that individual is provided may be for the care of the qualifying individual.35
  • Payroll taxes associated with employment-related expenses are considered employment-related expenses.36
  • The additional cost of providing room and board for a caregiver over usual household expenditures may be an employment-related expense.37
  • Indirect expenses such as application fees, agency fees, and deposits required to obtain care for a qualifying individual may be employment-related expenses if the care is, in fact, provided.38

Example 6: F hires a full-time housekeeper to care for her children, ages 12 and 13, so that she may be gainfully employed. The housekeeper cleans house, cooks meals, drives F to and from her work (which is 15 minutes away), and otherwise cares for the children. Because the chauffeuring duties are minimal, no allocation of the cost is necessary. Further, although the housekeeper cares for the 13-year-old, who is not a qualifying individual, no allocation is required since the expenses are in part attributable to the 12-year-old. All of the housekeeper’s wages and related employment taxes are considered employment-related expenses.

Example 7: G hires a full-time housekeeper to care for his eight-year-old so that he can be gainfully employed. He moves from his two-bedroom apartment to a three-bedroom apartment so that the housekeeper will be available at all times. The additional cost of the three-bedroom apartment over the two-bedroom apartment, as well as the additional utilities expenses, all qualify as employment-related expenses.

Example 8: H places a deposit with a preschool to reserve a place for her child. If the child attends the school, the deposit is considered an employment-related expense. If H forfeits the deposit because her child attends another school, the forfeited deposit does not qualify as an employment-related expense.

Amounts paid by the taxpayer to the following individual caregivers do not qualify as employment-related expenses for purposes of the child and dependent care credit:

  • An individual for whom the taxpayer or his or her spouse can claim a dependency exemption for the tax year;39
  • A child of the taxpayer who has not attained age 19 at the close of the tax year;40
  • The spouse of the taxpayer at any time during the tax year;41 or
  • The parent of the taxpayer’s child who is a qualifying individual under age 13.42

For purposes of the above, the term “tax year” means the taxpayer’s tax year in which the service is performed.43

Example 9: J pays her mother to care for J’s four-year-old. The expenses otherwise qualify as employment related. As long as J’s mother is not her dependent, the amounts paid qualify for the child and dependent care credit. If J’s mother is her dependent, the amounts do not qualify.

Example 10: K, who is divorced and the custodial parent of a six-year-old, pays his ex-wife L to care for his child. The expenses otherwise qualify as employment related. If his ex-wife is the child’s mother, the amounts paid do not qualify for the child and dependent care credit. If L is not his child’s mother, the amounts do qualify.

The restrictions above normally do not apply to services performed by partnerships or other entities. However, if such an entity is formed primarily to avoid the “relationship” tests, the payments are deemed to have been made directly to each partner or owner in proportion to that partner’s or owner’s ownership interest. Thus, the expenses will not qualify for the credit.44

Qualifying Educational Programs

With regard to the cost of programs or activities that qualify as employment-related expenses, the Code excludes services provided outside the home, including dependent care centers, unless for a qualifying dependent or a qualifying individual who regularly spends at least eight hours each day in the taxpayer’s household.45 Dependent care centers must comply with all applicable laws and regulations of the state or local government,46 must provide care for more than six individuals, and must receive a fee, payment, or grant for providing services for any of the individuals.47

Expenses of nursery school, preschool, or similar programs below kindergarten level, though they may include an education element, are considered for the care of a qualifying individual.48 On the other hand, other than before-school or after-school care, expenses for a child in kindergarten or higher grades are not considered employment-related expenses.49

Both the Code and the regulations exclude services outside the taxpayer’s household at an overnight camp.50 However, the cost of day camps, even those that specialize in a particular activity (for example, math, computer, or soccer camps), may qualify, without allocation, as employment-related expenses.51 The costs of summer school and tutoring programs do not qualify.52

Example 11: M sends her 10-year-old son to computer day camp while she works during the summer. N sends her 10-year-old daughter to math tutoring for three hours a day while she works. M’s expenses may be employment related but N’s are not.

Although the cost of overnight camp is excluded, the regulations explain that, for parents who work at night, the costs of overnight care and day care—when one parent sleeps during the day—may be qualifying expenses.53

Example 12: O and P are married with one qualifying individual, Q. O works during the day; P works at night and sleeps during the day. The amount paid by O and P for Q’s care may be considered as allowing O and P to be gainfully employed and so may be eligible for the credit.

Timing and Allocation Issues

Regardless of the taxpayer’s method of accounting, the expenses may be taken as a credit only in the tax year the services are performed or the tax year the expenses are paid, whichever is later.54

Example 13: R prepays her child’s January 2008 day care in December 2007. She should claim the credit in 2008, the later of the year the expenses are paid or the year the services are performed.

Generally, employment-related expenses must be allocated on a daily basis55 between days worked and days not worked, with only those expenses allocated to days worked available for the credit. The final regulations provide for a safe-harbor exception; that is, no allocation is required during “short, temporary absences” from work of two consecutive calendar weeks or less, such as for vacation or minor illness, if the taxpayer is required to pay for care during the absence.56 Unlike the proposed regulations, the safe harbor is not limited to taxpayers who pay for dependent care on a weekly, monthly, or annual basis. Longer absences may be considered for the exception depending on the facts and circumstances.57

The proposed regulations had included the facts-and-circumstances test only. One commentator on the proposed regulations suggested adopting a 12-week safe harbor to comply with the Family Medical Leave Act guarantee of unpaid leave for the birth or adoption of a child and other purposes. The suggestion was rejected, as was the recommendation that the cost of care during a period when the taxpayer is on short-term or long-term disability, paid medical leave, or paid maternity leave be treated as employment-related expenses.

Example 14: S is the custodial parent for two qualifying individuals. She hires a housekeeper at a monthly salary so that she may work. S becomes ill and is absent from work for three months; she continues to pay the housekeeper. During her absence, she performs no employment services but does receive payments under a wage continuation plan. Because the absence is not a short, temporary one, her payments to the housekeeper are not considered to be for the purpose of enabling her to be gainfully employed and are not eligible employment-related expenses for purposes of the credit.

Example 15: So that T may be gainfully employed, T’s child is enrolled in a qualified day-care center that requires payment even when a child is absent. T takes eight vacation days, during which he must pay for day care. Since the eight-day period is a short, temporary absence, T is not required to allocate expenses between days worked and days not worked. The entire amount, if otherwise qualified, may be considered in determining the credit.

A taxpayer who is employed part-time must allocate expenses unless he or she is required to pay on a periodic basis that includes both days worked and days not worked.58 A day on which the taxpayer works at least one hour is a day of work.

Example 16: U works part-time, generally three days per week. Her child attends a qualified dependent care center so that U may be gainfully employed. The center allows two options: a three-day-per-week plan for $150 and a five-day-per-week plan for $250. U enrolls her child in the five-day-per-week plan. U must allocate her expenses between days worked and days not worked since she was not required to pay for the full week. Thus, $150 (3/5 of $250) of the expenses is considered employment related. On the other hand, if the care center required all clients to pay the full $250 regardless of the number of days the child attended, all $250 of the weekly fee could be considered an employment-related expense.

Conclusion

Not all of the recommendations made by those who reviewed the proposed regulations were implemented, and some questions about specific provisions of the child and dependent care credit remain unanswered. However, the final regulations do clarify a number of definitions (qualifying individual, services, and providers), introduce a safe harbor for short, temporary absences, detail the timing and computation of employment-related expenses, and include examples illustrating major points, making it likely that more taxpayers will take advantage of the credit in the future.

For more information about this article, contact Prof. Cook at edcook@louisiana.edu.


Notes

1 Scott, “Dependent Care: Current Tax Benefits and Legislative Issues,” Congressional Research Service Report RS21466, July 16, 2007.

2 Id., citing IRS Publication 1304, Individual Income Tax Returns (Complete Report).

3 TD 9354 (8/14/07).

4 Prop. Regs. Secs. 1.21-1 through -4, REG-139059-02 (5/24/06).

5 Regs. Sec. 1.21-1(l).

6 Secs. 21(a)(1) and (2).

7 Sec. 21(c).

8 Regs. Sec. 1.21-2(a)(4).

9 Sec. 21(c).

10 Sec. 21(d).

11 Sec. 21(d)(2) and Regs. Sec.1.21-2(b)(4).

12 Regs. Sec. 1.21-2(b)(4)(iii).

13 Regs. Sec. 1.21-2(b)(2).

14 Id.

15 Sec. 21(e)(2).

16 Sec. 21(e)(4).

17 Regs. Sec. 1.21-3(b).

18 P.L. 108-311.

19 Sec. 21(b)(1)(A).

20 Secs. 21(b)(1)(B) and (C).

21 Secs. 21(b)(1)(A), (B), and (C) and Regs. Sec. 1.21-1(b)(1).

22 Regs. Sec. 1.21-1(b)(4).

23 Regs. Sec. 1.21-1(b)(3).

24 Regs. Sec. 1.21-1(a)(4).

25 Regs. Sec. 1.21-1(b)(5)(ii).

26 Regs. Sec. 1.21-1(b)(5).

27 Sec. 21(b)(2)(A).

28 Regs. Sec. 1.21-1(c)(1).

29 Id.

30 Regs. Sec. 1.21-1(d)(1).

31 Id.

32 Regs. Sec. 1.21-1(d)(2).

33 Regs. Sec. 1.21-1(d)(3).

34 Id.

35 Regs. Sec. 1.21-1(d)(8).

36 Regs. Sec. 1.21-1(d)(9).

37 Regs. Sec. 1.21-1(d)(10).

38 Regs. Sec. 1.21-1(d)(11).

39 Sec. 21(e)(6)(A) and Regs. Sec. 1.21-4(a)(1).

40 Sec. 21(e)(6)(B) and Regs. Sec. 1.21-4(a)(2).

41 Regs. Sec. 1.21-4(a)(3).

42 Regs. Sec. 1.21-4(a)(4).

43 Sec. 21(e)(6).

44 Regs. Sec 1.21-4(b).

45 Sec. 21(b)(2)(B).

46 Sec. 21(b)(2)(C) and Regs. Sec. 1.21-1(e)(2)(i)(A).

47 Sec. 21(b)(2)(D) and Regs. Sec. 1.21-1(e)(2)(ii).

48 Regs. Sec. 1.21-1(d)(5).

49 Id.

50 Sec. 21(b)(2)(A) and Regs. Sec. 1.21-1(d)(6).

51 Regs. Sec. 1.21-1(d)(7).

52 Id.

53 Regs. Sec. 1.21-1(c)(1).

54 Regs. Sec. 1.21-1(a)(3).

55 Regs. Sec. 1.21-1(c)(2)(i).

56 Regs. Sec. 1.21-1(c)(2)(ii).

57 Id.

58 Regs. Sec. 1.21-1(c)(2)(iii).

Newsletter Articles

TAX ACCOUNTING

Should Small Businesses File Form 3115?

Small business taxpayers should be aware of the implications of adopting the tangible property regulations through the small business exception and, especially, that any change to this treatment must be made very soon.

PRACTICE MANAGEMENT

2015 Tax Software Survey

See how nearly 5,000 paid CPA tax preparers rated the strengths and weakness of major tax preparation software products they used in 2015.