Editor: Albert B. Ellentuck, Esq.
A dependent care assistance program (DCAP) is a tax-favored arrangement by which the employer reimburses employees for dependent care expenses, makes payments to third parties for care of employees’ dependents, or provides a dependent care facility for employees. The employer can deduct amounts paid or incurred under a qualified DCAP. Employees can exclude employer payments from income (subject to certain limitations) if the expenses would be employment-related for child care credit purposes if they were paid by the employee (Secs. 129(a)(1) and (e)(1)). While this column assumes that the employer makes a payment or reimbursement to the employees, if the employer maintains a dependent care assistance facility, employees can exclude amounts based on their use of the facility and the value of the services provided. Regardless, employees cannot claim the Sec. 21 dependent care credit for amounts excluded from income (Sec. 129(e)(7)).
Dependent care assistance includes employer payments or reimbursements for dependent care services necessary for the employee’s gainful employment, including (1) expenses for household services incurred to provide care to qualifying persons and (2) expenses incurred to provide care to a qualifying person (Secs. 21(b)(2) and 129(e)(1)). The expenses must be primarily for the well-being and protection of the qualifying person.
To be a DCAP, a plan must meet the eligibility requirements of Sec. 129(d). If the plan does not meet the requirements to be a DCAP, it will still be treated as a DCAP in the case of employees who are not highly compensated employees. A highly compensated employee for dependent care purposes is an employee who (1) was a more-than-5% owner (directly or indirectly through family attribution (i.e., spouse, children, grandchildren, or parents) under Sec. 318) at any time during the current or preceding year or (2) for the preceding year, had compensation greater than $115,000 (for 2013 and 2014, as adjusted for inflation) and if the employer so elects, was in the top 20% of employees (based on compensation) for the preceding year.
Highly compensated employees who receive dependent care assistance under a plan that does not qualify as a DCAP under Sec. 129(d) cannot exclude the assistance from income (Sec. 129(d)(1)). Instead, the payments or reimbursements are subject to employment taxation and are reported as wages on the employee’s Form W-2, Wage and Tax Statement. However, non-highly compensated employees can exclude benefits (up to the maximum exclusion amounts) from a plan that does not qualify as a DCAP under Sec. 129(d) from income.
The amount that can be excluded from income is limited to the smallest of (1) the employee’s earned income or the earned income of the lower-earning spouse if the employee is married, (2) dependent care benefits received, or (3) $5,000 ($2,500 if married filing separately). Expenses paid to dependents of the employee or the employee’s spouse, or to children of the employee under age 19, are not excludable (Sec. 129(c)). Excess assistance is included in income in the year the dependent care services are provided, even if the reimbursement or payment is made in a later tax year (Sec. 129(a)(2)(B)).
Meeting the Rules to Be a Dependent Care Assistance Program
A qualified program must be documented in a separate written plan that can be part of a larger plan providing a choice of taxable or nontaxable benefits (a Sec. 125 cafeteria benefit plan). While the program need not be funded, it must meet the following requirements of Sec. 129(d):
- The program must provide dependent care assistance exclusively to employees.
- Dependent care assistance must be available and provided on a basis that does not discriminate in favor of highly compensated employees or their dependents. In testing this requirement, employees who have not attained the age of 21 and completed one year of service generally may be excluded. Similarly, union members generally are excluded if their benefits are provided under the terms of a collective bargaining agreement.
- No more than 25% of the program’s assistance benefits incurred during the year may be provided for shareholders or owners of the business. A shareholder or owner is anyone who, on any day of the year, owns more than 5% of the stock or the capital or profits interest in the business. Attribution rules apply to treat certain family members as owners for this purpose.
- The average benefits provided to nonhighly compensated employees must be at least 55% of average benefits provided to highly compensated employees.
- The plan must provide reasonable notification of the program’s availability and terms to eligible employees. Presumably, this requirement is satisfied by providing all eligible employees with a statement summarizing the plan’s requirements and benefits.
- Each employee must be furnished, on or before Jan. 31, a written statement showing the amounts paid or expenses incurred by the employer in providing dependent care assistance to the employee during the previous calendar year. This requirement is usually met by reporting the proper amounts on the employee’s Form W-2.
Certain employees can be excluded when applying these tests (Sec. 129(d)(9)). If a plan does not meet these requirements, highly compensated employees (as previously defined) must include the benefits in gross income (Sec. 129(d)(1)).
DCAPs can be (and often are) included as part of a Sec. 125 cafeteria benefit plan, which allows employees to choose between dependent care and other nontaxable benefits, or cash. (In fact, a cafeteria plan that satisfies the written plan requirements for plan benefits in Prop. Regs. Sec. 1.125-1(c)(1) also satisfies the Sec. 129 written plan requirements—see Prop. Regs. Sec. 1.125-1(c)(2).) However, for highly compensated employees to exclude dependent care assistance from income, the program must meet the Sec. 129(d) requirements previously listed, and the cafeteria plan must meet the applicable nondiscrimination rules of Sec. 125. Neither the status of the program as a DCAP nor the discriminatory status of the cafeteria plan affects other (non-highly compensated) employees.
Dependent Care Flexible Spending Accounts
A dependent care flexible spending account (FSA) is a benefit program under which dependent care reimbursement accounts are established for participating employees. The participants make elective (pretax) contributions to fund their individual reimbursement accounts. (These amounts are withheld periodically during the year.) The balances in the reimbursement accounts are then used to reimburse specific dependent care expenses incurred by the employee during the year—subject, however, to reimbursement maximums and other reasonable conditions.
A participant in the dependent care FSA is entitled to reimbursement solely for dependent care expenses (i.e., the participant cannot be entitled to receive reimbursements in the form of cash or any other taxable or nontaxable benefit). A dependent care FSA can be offered alone or as a part of a larger Sec. 125 cafeteria benefit plan. Dependent care FSA contributions are limited to $5,000 per year ($2,500 for married individuals filing separately).
The IRS views a dependent care FSA as a DCAP. Thus, the dependent care FSA must generally comply with the requirements normally applicable to an employer-provided DCAP. Unlike health care FSAs, dependent care FSAs do not have to provide uniform coverage throughout the coverage period (Prop. Regs. Sec. 1.125-5(d)(5)). This means the amount available currently to an employee for reimbursement of dependent care expenses under the program is limited to the amount of employee contributions made at that point, reduced for any prior reimbursements.
Example: L, a married employee who cares for her disabled mother, joins her employer’s dependent care FSA. Upon enrollment, she requests that the maximum of $5,000 be taken out of her $70,000 gross salary. The company deducts $416.67 from her monthly paycheck and deposits this amount into her dependent care FSA. At the end of the first quarter, L’s FSA contains $1,250. During the quarter, she incurred $5,000 in dependent care expenses, and she submits these expenses for reimbursement. The maximum amount of the reimbursement L will receive at the end of the first quarter is $1,250, the amount in her FSA at the time of her request.
Employees forfeit any amount remaining in their dependent care FSA at the end of the plan year unless the plan provides a qualifying grace period. A grace period of up to 2½ months immediately following the end of each plan year is allowed (Prop. Regs. Sec. 1.125-1(e); Notice 2005-42). Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions that remain at the end of the immediately preceding plan year. The employee forfeits any balance still remaining at the end of the grace period.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 26th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard Burris, Mary C. Danylak, James A. Keller, and Brian Martin, published by Practitioners Publishing Co., Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.