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Ashley Gillihan and John Hickman
Alston & Bird, LLP
September 2007
The IRS has issued final regulations regarding the dependent care tax
credit under Internal Revenue Code § 21. The final regulations mostly follow the
same approach as the agency took in regulations it originally proposed in May
2006. Although the new regulations interpret and expand on the dependent care
tax credit, they are also applicable and relevant to dependent care FSAs under
IRC § 129.
Some Background
Internal Revenue Code § 21 allows taxpayers to claim a tax credit for a
percentage of qualified dependent care expenses. The credit is allowed when the
taxpayer pays someone to care for his child or other qualified dependent so that
the taxpayer can work. The new final regulations are issued under this section
of the Code.
IRC § 129, by comparison, allows employers to establish a dependent care FSA to
which employees may elect to make pre-tax contributions. Contributions to the
FSA reduce the employee's taxable income and, consequently, his tax liability.
Employees then seek reimbursement of dependent care expenses from the FSA after
they have been incurred.
The final regulations regarding the dependent care tax credit (IRC § 21) are of
interest to employers because IRC § 129 specifically incorporates IRC § 21's
provisions. This article provides an overview of the new regulations, with a
focus on their impact on dependent care FSAs.
Employment-Related Expenses
IRC § 129 allows employees who contribute to a dependent care FSA to seek
reimbursement for "employment related" expenses as defined in IRC § 21. An
employment-related expense is defined generally as an expense for household
services and the "care" of the qualified dependent that enables the employee
(and spouse) to work or look for work. Expenses associated with a dependent's
education, clothing, and food do not generally qualify as "care" of the
qualified dependent.
The final regulations make a number of clarifications regarding whether certain
expenses are included in the definition of "care." Note that although the IRS
may indicate that a particular expense is deemed to be for the "care" of the
qualified dependent, the expense does not qualify for tax-free reimbursement
unless it is also necessary to enable the employee to work or look for work.
Preschool and Kindergarten. The final regulations clarify that expenses for
nursery school, preschool, or similar programs below the kindergarten level are
presumed to be for the care of the qualifying dependent. Expenses associated
with kindergarten or higher levels are not for care (although pre- and post-
school day care may be "care").
Day Camps That Specialize in a Particular Activity. The final regulations
also clarify that day camps may be considered to be for the care of a
qualifying dependent, even if the day camp specializes in a particular activity
such as soccer or computers. However, summer school or tutoring programs
(e.g., math programs) are indistinguishable from school and education;
therefore, they do not qualify as care despite the fact that they may enable the
taxpayer to be gainfully employed. In addition, a day camp that otherwise meets
the definition of a "dependent care center" (i.e., cares for more than six
individuals for a fee) must satisfy any applicable licensing, building, and fire
code requirements.
Overnight Camp and Overnight Care. The final regulations confirm that
overnight camp expenses are not employment-related expenses. However, the
regulations added a new example clarifying that overnight care (as
distinguished from an overnight camp) may be an employment-related expense.
One Spouse Works Days/One Spouse Works Nights. In a change in course from
past guidance, the final regulations clarify that day care provided while one
spouse works and the other sleeps (because he or she works at night) may be
employment-related.
Room and Board. The final regulations also clarify that the cost of
providing room and board for a caregiver above and beyond usual household
expenditures may be considered an employment-related expense. For example, the
additional costs to rent a three-bedroom apartment instead of a two-bedroom
apartment to accommodate a live-in housekeeper who cares for a qualified
dependent may be considered employment-related. The additional utilities
associated with the three-bedroom apartment may be employment-related as well.
Note: Substantiating the excess costs of a three-bedroom apartment or
utilities can pose administrative difficulties for employers that sponsor a
dependent care FSA and FSA plan administrators. Unfortunately, the final
regulations do not provide specific substantiation rules or guidelines.
Transportation. The final regulations clarify that the cost of
transportation by a day care provider to or from the place where care is
provided may be for the care of a qualifying dependent. The cost of
transportation provided by anyone other than the day care provider does not
constitute care of the qualifying dependent. Thus, amounts charged by a day care
provider for after school or other transportation service to the day care site
may now be reimbursable. This appears to be a relaxation of the prior rules.
Note that amounts paid to individuals employed as a chauffeur are still not
considered to be for the care of a qualifying dependent. However, the
regulations clarify that amounts paid to an individual whose primary purpose is
to provide care for the qualifying dependent (and household services
attributable to that care) may still be reimbursable even if the individual
drives the employee to and from work (the chauffeur services would be minimal
and insignificant).
Application and Agency Fees. Expenses that relate to but are not directly
for the care of a qualified dependent — such as application fees, agency
fees, and deposits — may be reimbursed if and only if the employee is
required to pay such fee or deposit to obtain the care and only if the care
is actually provided (forfeited fees are not included). In addition, the agency
fee or deposit is not considered to be for the care of the dependent until the
care to which the fee was associated is actually provided. This raises some
complicated administration issues when the fee is paid in one plan year and care
commences in the next. It is unclear which year the expense should relate to.
Exception for Allocation of Expenses for Days Not Worked. Generally,
expenses incurred for a period during which the employee did not work must be
allocated on a daily basis; however, the final regulations provide a couple of
practical exceptions:
- Temporary absences: No allocation is required for days that the
employee does not work due to a "temporary" absence such as vacation or illness
if the care provider requires the employee to pay for days that the child is
absent. Whether an absence is "temporary" is generally determined according to
the applicable facts and circumstances. However, an absence of no more than two
consecutive weeks is deemed to be a short "temporary" absence for the purpose of
the rules.
Note: This rule does not circumvent the general rule set forth in the
cafeteria plan regulations that reimbursement under a dependent care FSA may
only be provided after the expense has been incurred.
- Part-time employment. Generally, part-time employees must allocate
amounts for days worked and days not worked; however, if the employee is
required to pay on a periodic basis that includes days not worked, no allocation
is required.
Qualifying Individuals
The final regulations revise the definition of "qualifying individual" to
reflect the changes made by the Working Families Tax Relief Act of 2004
("WFTRA") and the Gulf Opportunity Zone Act of 2006 ("GoZone Act"). These two
acts revised the definition of dependent under IRC § 152 and then made
additional modifications to the definition in the various code sections
pertaining to employee benefits and tax credits, including but not limited to
IRC § 21.
In recognition of these changes, the regulations: 1) no longer require that an
individual "maintain a household" to qualify, and 2) define "dependent" for
purposes of identifying a "qualifying individual" by reference to IRC § 152 but
without regard to the following facts and circumstances that would otherwise
impact dependent status under § 152:
- Whether the individual is a dependent of a dependent;
- Whether the individual is married and filing a joint return with his/her
spouse; and
- Whether the individual has income in excess of the exemption amount
(specifically related to the definition of "qualifying relatives" under IRC §
152).
The final regulations also clarify that the special rule for children of
divorced or separated parents under § 21(e)(5) applies to children of parents
who lived apart at all times during the past six months.
Note: The IRS issued proposed regulations on May 2, 2007, regarding the
method of determining who is the "custodial parent" for purposes of IRC § 152(e)
and, by extension, IRC § 21.
A Final Note
The final regulations are effective for taxable years ending after August 14,
2007 (i.e., for calendar year 2007). The full text of the regulations can be
found online at:
http://a257.g.akamaitech.net/7/257/2422/01jan20071800/edocket.access.gpo.gov/2007/pdf/E7-15753.pdf
Advisory Board members John Hickman
(
jhickman@alston.com) and Ashley Gillihan
(
agillihan@alston.com) are partners
in the Atlanta office of Alston & Bird LLP.
Copyright © 2007 M. Lee Smith Publishers LLC. This article is an excerpt from Benefits and Compensation Law Alert (ISSN 1526-7967). Benefits and Compensation Law Alert is designed to provide accurate and authoritative information in regard to the subject matter covered. It is published with the understanding that neither the author(s) nor its publisher is engaged in rendering legal, accounting, or other professional services through its pages. If legal advice or other expert assistance is required, the services of a competent professional should be sought. (From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a committee of Publishers and Associations.)
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