IRS Issues Proposed Dependent Care Expense Regulations
by Andy R. Anderson, Morgan, Lewis & Bockius LLP, Chicago, IL
In late May 2006, the Internal Revenue Service (IRS) issued updated, expanded, and relocated proposed regulations governing dependent care expenses. While superficially focused on the individual income tax credit for dependent care expenses , these proposed regulations will significantly influence the operation of tax-free dependent care assistance programs and will in particular lead to modifications in the administration of and communications related to dependent care spending accounts.
The proposed regulations update regulations dating from 1979 to reflect seven significant new laws, interim IRS pronouncements about the operation of the dependent care expense credit, and even a change in the Code Section applicable to the credit. The proposed regulations are generally more expansive and definitive than prior guidance and may lead to greater use of dependent care spending accounts--and also greater complications associated with verifying dependent care expenses. The regulations, and particularly the examples contained in the regulations, also attempt to reflect the modern realities of dependent care provider payment requirements, workforce trends, and the role of women in the workplace.
The proposed regulations govern the operation of the dependent care credit found in Code Section 21. The nonrefundable credit allows taxpayers who incur dependent care expenses to deduct a percentage of the household and dependent care expenses that are necessary for gainful employment. The credit is available for one or more qualifying individuals (generally defined as a Code Section 152 dependent under the age of 13 or a dependent who is mentally or physically incapable of self-care and has the same principal place of abode as the taxpayer) and phases down from 35% to 20% of the expenses depending on the taxpayer’s adjusted gross income. The maximum amount of eligible expenses is $3,000 for one dependent and $6,000 for two or more dependents. The amount of eligible expenses is also limited to the lesser of the earned income of the taxpayer or the taxpayer’s spouse, and the proposed rules provide income “deeming” rules for full-time students or individuals incapable of self-care ( these limits are $250 per month for one dependent and $500 per month for two or more dependents).
Now, as a result of the proposed regulations, there will be a single readily available source for the current rules governing the dependent care credit—and many of these rules are also used by employers to administer the terms of their dependent care spending account plans. The proposed rules will apply to taxable years ending after they are issued as final regulations, but they may be applied to 2006 administrative issues associated with the dependent care spending account operations.
Further, given that many employers struggle with the 55% utilization test for their dependent care spending account , these new rules provide an opportunity to recommunicate the benefits of dependent care spending account programs to their employees and take advantage of the new rules to increase the participation rate in the programs. The IRS has invited comments on the proposed regulations (which are due August 22, 2006) and will, if requested, schedule a public hearing on the proposed regulations.
What’s New or Clarified in the Proposed Regulations for Dependent Care Spending Accounts?
The proposed regulations have been moved to Code Section 21 and contain a number of new or clarified concepts. Beyond changes that are unique to the dependent care credit, the proposed regulations:
- Clarify that expenses are only eligible in the later of the year in which the services are provided or the year the expenses are paid;
- State that kindergarten expenses are primarily for education and are not eligible expenses;
- Permit expenses for specialty day camps, such as soccer camp or computer camp;
- Allow employees to treat limited transportation expenses incurred by a dependent care provider as employment related expenses;
- Recognize that indirect expenses such as application or agency fees may be eligible for reimbursement;
- Require allocating expenses on a daily basis to determine whether the expenses are employment related (but also create administrative convenience rules for minor illness, vacations, and part time workers who are required to pay for dependent care on a weekly or longer basis);
- Remove the prior prohibition on night school qualifying as a full-time course of study; and
- Clarify that payments made to the taxpayer’s spouse or the child’s parent do not qualify as eligible expenses.
What New Opportunities are Contained in the Proposed Regulations?
Several of the new or clarifying components of the proposed regulations will allow more employees to take advantage of (or greater advantage of) a dependent care spending account. Chief among these are the clarification of the ability to submit specialty day camp expenses to a dependent care spending account. Because specialty day camp expenses can range up to $500 per week and run for the majority of the summer, many parents planning for these expenses in 2007 can easily incur at least $4,000 in these expenses during the course of a summer for a single eligible dependent.
Another significant opportunity in the proposed regulations is that the full-time student income deeming rules will now apply to night class students. This opportunity means that a married couple can submit dependent care expenses to a dependent care spending account even if one parent is a full-time night student (up to, at most, $3,000 in deemed income for one dependent and $5,000 for two or more dependents).
What New Obstacles are Contained in the Proposed Regulations?
The proposed regulations remind employers that eligibility for dependent care expenses are determined on a day-by-day basis. This leads to particular problems for full-time employees who are on a lengthy leave after paying for (and sometimes already submitting) dependent care expenses. These problems are more acute for part-time workers who are not employed every day during the week (but may pay for dependent care expenses on a full week or full month basis). While the proposed regulations provide some rules of convenience that ease these problems , few employers are currently actively involved in monitoring these details of dependent care expenses. It remains to be seen whether the reemphasized “daily basis” rules lead to greater scrutiny of dependent care expense claims, particularly when the dependent care administrator also has access to payroll, vacation, and leave data for the same employee.
The proposed regulations incorporate many interim legislative changes and serve as a handy reminder of the significant changes to Code Section 21 over recent years. Some of these changes may not have made their way into companies’ dependent care spending account communications and operations, including:
- Updating the definition of a dependent;
- Reducing the maximum age to 13;
- Increasing the deemed earned income for spouses who are full-time students or incapable of self-care;
- Revising special rules for divorced or custodial parents; and
- Replacing household maintenance with “same principal place of abode” requirements.
Employers who offer dependent care spending accounts or provide other dependent care assistance programs, such as tax-free or subsidized onsite day care, should carefully review the proposed regulations. This review will uncover rules and clarifications that can be applied to the 2006 operation of dependent care spending accounts and may uncover housekeeping items that have not yet made their way into dependent care spending account administration or communication. Finally, the proposed regulations will lead to revisions to the 2007 open enrollment communication material. Practitioners who advise clients on dependent care spending account issues should also watch for any changes to the proposed regulations when they are finalized by the IRS.