June 5, 2006
Dependent Care Reimbursement Expenses: New IRS Guidance
On May 24, 2006, the IRS issued proposed regulations under Code Section 21 addressing the requirements that apply to the availability of the dependent care tax credit. By and large, these requirements also apply to dependent care expense reimbursement programs (DCAPs) and, thus, the new regulations are relevant to the administration of DCAPs.
Content of Proposed Regulations. The proposed regulations replace regulations issued more than 20 years ago. They reflect the numerous changes made to the Internal Revenue Code in the interim, incorporate other guidance issued by the IRS, and address several new issues. Some of the key issues addressed by the proposed regulations include:
1)
Definition of Qualifying Individual. The proposed regulations adopt the definition of qualifying individual as updated for the Working Families Tax Relief Act (WFTRA), including the correction made to WFTRA late in 2005. A qualifying individual is: (i) a dependent (as defined in Section 152(a)(1) of the Code) who is under age 13; and (ii) a spouse or dependent (as defined in Section 152 determined without regard to subsections (b)(1), (b)(2), and (d)(1)(B) thereof) who is physically or mentally incapable of caring for him/herself and who has the same principal place of abode as the employee for more than one-half of the year.
In addition, the proposed regulations provide (for the first time) that in order to be a qualifying individual because of an inability to care for oneself, the individual must be incapable of caring for his/her hygiene or nutritional needs, or require full-time attention for his/her own safety or the safety of others.
2) Expenses for nursery school and kindergarten. The proposed regulations confirm prior guidance that expenses for kindergarten are not eligible because they are primarily for education. They also confirm that expenses for pre-school or similar programs below the kindergarten level may be eligible expenses, even if education is a significant part of the program. 3) Day camps. The proposed regulations confirm prior guidance that expenses for day camps, even camps that specialize in a particular activity, may be eligible expenses. 4) Alternative means to obtain care. The proposed regulations clarify that the care obtained for a dependent need not be the least expensive alternative available to the employee for obtaining the care, even if another caregiver is available at no cost. NEW! 5) Transportation expenses. The proposed regulations provide (for the first time) that the cost of transportation furnished by a dependent care provider may be an eligible expense. Transportation costs incurred by others (e.g., parents) are not eligible expenses. 6) Indirect expenses. The proposed regulations confirm prior guidance that expenses that are not directly related to care, but that must be incurred in order to receive the care (e.g., application fees, agency fees, and deposits), may be an eligible expense. However, these amounts are not eligible expenses if the care is not provided by the caregiver to whom the amounts were paid. Also, according to the proposed regulations, employment taxes paid with respect to the caregiver and the cost of providing room and board to the caregiver may be eligible expenses. NEW! 7) Absence from work. The proposed regulations provide (for the first time) that expenses incurred while an employee is absent from work are generally not eligible, but that they may be eligible if the absence is short and temporary (e.g., illness or vacation) and the employee must pay for dependent care on a weekly, monthly, or longer basis. NEW! 8) Part-time employment. The regulations provide (for the first time) that part-time employees who must pay for dependent care on a weekly, monthly, or longer basis are not required to allocate dependent care expenses between work days and non-work days. 9) Payments to related individuals. The proposed regulations confirm prior guidance that payments are not eligible expenses if made to (i) an employee’s spouse, (ii) a parent of the qualifying child (who is not the employee’s spouse), (iii) a child of the employee under age 19 as of the end of the year, and (iv) an individual for whom a federal income tax deduction is allowed to either the employee or the employee’s spouse.
Effective Date. The proposed regulations are not effective until the final regulations are published in the Federal Register, which may not occur for some time. However, plan sponsors may apply the proposed regulations now. We will monitor the progress of the proposed regulations and issue another alert when the final regulations are published.
Action Items. Employers that self-administer DCAPs and third party administrators should review the criteria used to adjudicate dependent care expenses to ensure it is consistent with the rules contained in the proposed regulations. In addition, plan documentation (e.g., plan documents and descriptive materials) should be similarly reviewed. If you would like our assistance with these tasks, please contact us.