The IRS recently issued proposed regulations that update the rules regarding the Code Section 21 credit for employment-related dependent care expenses. These proposed regulations will also govern what expenses can be reimbursed tax-free under an employer###s Code Section 129 Dependent Care Assistance Program ("DCAP"). The proposed regulations reflect statutory changes enacted since the previous regulations were issued and also clarify a number of issues that have arisen administratively for the IRS over the years. The IRS will accept comments on the proposed regulations until August 22, 2006.
Employers may rely on the proposed rules now, pending publication of final regulations. As a result of the new rules, employers should review their DCAP plan document and summary plan description language. Specifically, employers will want to look at the definitions of "dependent" and "employment-related expenses" in their documents to see if they need to be updated.
Dependent
Dependent care expenses can only be reimbursed for the care of "dependents." The proposed regulations incorporate the definition of dependent introduced under the Working Families Tax Relief Act of 2004 ("WFTRA") and change that definition effective December 31, 2004. Under the new definition, a dependent can be: (1) the employee###s "qualifying child" who has not yet attained age 13; or (2) a person who is physically or mentally incapable of self-care, who lives with an employee for more than half a year, and who is the employee###s spouse, "qualifying child" age 13 or older, or "qualifying relative." The terms "qualifying child" and "qualifying relative" are defined in Code Section 152.
Action Items. Some employers have already modified the definition of dependent in their DCAP plan document and summary plan description to comply with WFTRA. Those who have not will want to do so now.
Employment-Related Expenses
The proposed regulations clarify that the following employment-related expenses are eligible for reimbursement under a DCAP:
- School Below Kindergarten Level. Expenses of pre-school or similar programs below the kindergarten level are for care and may be employment-related expenses, even if the school provides lunch and educational services. Expenses for school at or above the kindergarten level may not be reimbursed through a DCAP (although before- and after-school programs for these grade levels may be reimbursed).
- Day Camps. The full amount paid for day camps or similar programs may be an employment-related expense even if the camp specializes in a particular activity (such as soccer or computers). However, overnight camp expenses are not employment-related expenses.
- Transportation Expenses. The cost of transportation (such as transportation to a day camp or to an after-school program not on school premises) furnished by a dependent care provider may be an employment-related expense.
- Employment Taxes. Employment taxes are reimbursable through a DCAP if paid in connection with wages that are employment-related expenses.
- Room and Board. The additional costs for a care-provider###s room and board (over usual household expenditures) may be employment-related expenses.
- Indirect Expenses. Indirect expenses, such as application and agency fees, may be reimbursable employment-related expenses if the taxpayer is required to pay the expenses to obtain the care.
- Short and Temporary Absences from Work. Dependent care expenses for a period in which an employee is absent from work (whether paid or unpaid) are generally not employment-related expenses. But, short, temporary absences from work (such as minor illness or vacation) are disregarded for taxpayers who must pay for dependent care expenses on a weekly or longer basis, even if they do not take advantage of the care.
- Expenses for Part-time Employees. Generally, taxpayers who work part-time must allocate expenses between days worked and days not worked. The proposed regulations clarify, however, that taxpayers who work part-time but have to pay for dependent care on a weekly or longer basis are not required to allocate expenses between days worked and days not worked.
Action Items. Many summary plan descriptions and some plan documents contain detailed lists of eligible employment-related expenses. Employers should review these lists to make sure that they reflect the rules in the proposed regulations.
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