IRS Proposes Regulations for Dependent Care Expense

On May 24, 2006, the Treasury Department and Internal Revenue Service published proposed regulations regarding the credit for expenses for household and dependent care services necessary for gainful employment and correspondingly for expenses payable under a Dependent Care Assistance Plan program (DECAP).

Effective Date

Although these regulations are proposed, the release points out that Dependent Care Assistance Plans may implement these changes now for tax years which end after May 24, 2006 or wait to implement them for tax years ending after the date the regulations are published in their final form (possibly by December 31, 2006).

Overview

The proposed regulations incorporate many of the rules in the previous regulations and reflect statutory changes that have occurred in recent years, most notably the definition of dependents contained in the Working Families Tax Relief Act. Additionally, these new rules provide for an increase in the maximum amount creditable expenses for purposes of the tax credit (no change in DECAP), and the monthly amount of deemed earned income of a spouse who is a full-time student or incapable of self-care.

The following discussion describes the major rules as promulgated in these proposed regulations.

Discussion

1. Taxable Year of Credit. The proposed regulations clarify that, regardless of the taxpayer's method of accounting, the credit is allowable only in the tax year the services are provided or the tax year the expenses are paid, whichever is later. This same rule would apply to an employer sponsored DECAP.

2. Special Rules for Children of Separated or Divorced Parents. Under the proposed regulations, in the case of a child of divorced or separated parents, only the custodial parent may claim the credit, even if the noncustodial parent may claim the dependency exemption for that child under Code Sec. 152(e). The proposed regulations define a custodial parent as the parent with whom a child shares the same principal place of abode for the greater portion of the calendar year.

3. Employment-Related Expenses. The basic rule has not changed: expenses are employment-related only if they are incurred to enable the taxpayer to be gainfully employed and the expenses are for household services or for the care of a qualifying individual. In some instances, the new regulations are more expansive:

a. Nursery School and Kindergarten. For nursery school and kindergarten expenses the following rule apples: The regulations provide that the expenses are primarily for the care of a qualifying individual if the primary nature of the services is to ensure the qualifying individual’s well-being and protection. Amounts paid for food, lodging, clothing, or education are not for the care of a qualifying individual. However, if these services are incidental to and inseparably a part of the care of a qualifying individual, the entire amount of the expense is deemed to be for care.

The presumption is that nursery schools provide care even though they provide educational services, even where they are a significant part of the program. On the other hand, programs at the level of kindergarten and above are primarily educational and therefore not expenses for day care.

b. Specialty Day Camps. The old rules were unclear as to what kinds of camps are primarily educational, especially involving sports and hobby-oriented camps (e.g., soccer camp, chess camp, computer camp, etc.). The new rule provides a blanket acceptance of specialty camps.

c. Transportation Expenses. The new rules provides that cost of transportation furnished by a day care provider may be an employment related expense and reimbursable through a DECAP.

d. Other Items. The cost of room and board for a daycare provider, the fees associated with applying for daycare or agency fees are all reimbursable through a DECAP.

4. Absence from Work. The proposed regulations also provide that, in general, dependent care expenses for a period in which the taxpayer is absent from work do not qualify as employment-related expenses. On the other hand, short temporary absences from work are disregarded for taxpayers who must pay for dependent care expenses on a weekly (or longer) basis. Additionally, taxpayers who work part-time must allocate expenses between days worked and days not worked. However, if a taxpayer who works part-time is required to pay for dependent care on a periodic basis that includes days worked and days not worked, the taxpayer is not required to allocate the expenses.

5. Cost of maintaining a household. For tax years beginning before January 1, 2005, the credit is available to a taxpayer who maintains a household that includes one or more qualifying individuals. For those years, a taxpayer is treated as maintaining a household for any period only if over half the cost of maintaining the household is furnished by the taxpayer or by the taxpayer and spouse. The proposed regulations provide that the term "cost of maintaining a household" has the same meaning as relating to the head of household filing status. The proposed regulations provide that the cost of maintaining a household does not include the value of services performed in the household by the taxpayer or a qualifying individual, or expenses paid or reimbursed by another person.

6. Principal Place of Abode. For tax years beginning after December 31, 2004, a qualifying individual must have the same principal place of abode as the taxpayer for more than half of the tax year. The proposed regulations provide that principal place of abode has the same meaning as in Code Sec. 152.

7. Definition of Marital Status. Under Code Sec. 21(e)(2), the credit is not allowed for taxpayers who are married unless they file a joint return. The proposed regulations adopt the rules of Code Sec. 7703 to determine whether taxpayers are married for this purpose. Further, the proposed regulations specify that taxpayers who are separated under a decree of divorce or separate maintenance are not married.

8. Payments to Related Individuals. Under the proposed regulations, a credit is not allowed under Code Sec. 21 for any amount paid to a taxpayer’s dependent or child under the age of 19. This rule would prohibit reimbursement for these expenses under a DECAP. Payments to a relative may qualify for the credit if the relative is not a dependent. Furthermore, the proposed regulations clarify that payments to either the taxpayer's spouse or the parent of the taxpayer's child do not qualify for the credit.

Action Plan

1. A DECAP Plan Sponsor should elect to adopt the new regulations effective now or defer their implementation until the regulations are final.

2. Discuss the options with the Plan’s third party administrator

3. Make sure these rules apply no later than the effective date of their adoption by the IRS.

4. Notify current DECAP Plan participants of changes to the Plan and the effective date of the changes.

We have limited our discussion to the impact of regulations on a DECAP Plan. Similar changes apply to taxpayers seeking to use the statutory tax credits.

I will continue to keep you informed of the developments on this topic as it becomes available, and look forward to your comments.

Special Note: AB 356

Our next legislative update will be on the COBRA Notice requirements established for California contracts and Plan Sponsors. We will publish this update on Monday, June 5, 2006.

This legislative update is published as an information source for our clients and colleagues. It is general in its nature and is no substitute for legal advice or an opinion in a particular case.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication, unless expressly stated otherwise, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.