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IRS Issues Final Regulations on Dependent Care Expenses

    Client Alerts
  • August 24, 2007

The IRS recently released final regulations regarding dependent care under Section 21 of the Internal Revenue Code (the “Code”).  Code Section 21 sets forth the requirements to claim the dependent care tax credit for dependent care expenses.  These rules also are of interest to employers since they are similar to the requirements for reimbursement under dependent care account plans.  The regulations are effective immediately.

The child care credit is a credit for a percentage of expenses for household and dependent care services necessary for gainful employment.  The credit is available to a taxpayer with one or more “qualifying individuals.”  A qualifying individual is the taxpayer's dependent who has not reached age 13 or a taxpayer's dependent or spouse who is physically or mentally incapable of self-care and has the same principal place of abode as the taxpayer for more than one-half of the tax year.  The applicable percentage depends on the taxpayer's adjusted gross income (subject to dollar amount limitations).

For the most part, the final regulations finalized the proposed regulations without change, but there are a few modifications of note to employers: 

  • Household and dependent care expenses must be for periods during which the taxpayer is gainfully employed or is actively searching for employment.  A spouse who is a full-time student is treated as gainfully employed and is considered to have a certain amount of “deemed income” for purposes of determining the maximum amount of reimbursable expenses. The final regulations clarify that individuals enrolled in educational institutions that only offer online classes do not qualify as eligible full-time students.
  • Expenses for a child in nursery school, pre-school or other similar programs below the kindergarten level may be appropriate employment-related expenses.  However, the IRS reiterated that kindergarten is considered an educational expense and is therefore excluded.
  • Expenses for a specialty day camp (one that specializes in a particular activity, like soccer or computers) may be appropriate qualifying expenses provided that these camps meet state law’s requirements for a dependent care center. Expenses for summer school and tutoring programs are considered educational expenses and do not qualify.
  • Expenses relating to sick care centers may qualify as a medical care or dependent care expense, but not both (as determined on a case-by-case basis).
  • Expenses for in-home day care above and beyond usual household expenses may be an employment-related expense – for example, the cost of providing room and board for a caregiver. 
  • The regulations require taxpayers to allocate the cost of dependent care on a daily basis if the expenses relate to a period during only part of which the taxpayer is employed or in active search of employment.  Allocation between work and non-work days is not required during “short, temporary absences” as long as the care-giving arrangement requires that care be paid for during the absence.  The final regulations include a new safe harbor providing that absences of up to two consecutive calendar weeks are treated as short, temporary absences.  Longer absences might also qualify depending on facts and circumstances; however, an example in the regulations indicates that a four month absence would not be considered a short-term absence.