On May 24, 2006, the Internal Revenue Service (IRS) issued proposed rules that would clarify and replace existing rules concerning reimbursement of dependent care expenses under Code 21. The IRS has requested comments on these proposed regulations by August 22, 2006.
Code 21 explains the requirements that taxpayers must meet in order to claim the dependent care tax credit (DCTC) for dependent care expenses, and also addresses expenses reimbursed under a Dependent Care Assistance Program (DCAP).
The proposed regulations include 27 years’ worth of statutory changes and add new rules to address administrative concerns.
The following is an overview of the proposed regulations and the impact these regulations will have on Dependent Care Assistance Programs / Dependent Care FSAs. Although the regulations are only proposed at this point and may change in response to comments, these are proposed regulations that employers may rely on immediately.
Changes from existing guidance:
Transportation. Transportation costs furnished by a dependent care provider to or from the place of care are eligible for reimbursement.
Temporary Absences. While dependent care expenses for a period in which the employee is absent from work are generally not employment-related expenses, the proposed rules provide that for administrative convenience, short, temporary absences from work (such as for minor illness or vacation) are disregarded for taxpayers who must pay for dependent care expenses on a weekly or longer basis. Examples state that an absence of four months is not temporary, while an absence of two days would be, particularly if the child care expenses are payable on a weekly basis.
Example: If a day care provider requires weekly payments but the employee takes a two week vacation, expenses incurred during the second week would not be eligible for reimbursement. If the employee is required to make monthly payments to the day care provider, both weeks of vacation would be reimbursable.
Part-Time Work. Employees who work part-time must allocate expenses between days worked and not worked. However, if they are required to pay for dependent care on a weekly or longer basis, they are not required to allocate expenses.
Example: If an individual works two days a week, and can pay for child care on a daily basis, then they cannot be reimbursed for child care expenses in excess of those two days. If an individual works part-time, but is required to pay for child care on a weekly basis, they may be reimbursed for the entire weekly expense.
Clarifications of existing guidance:
Preschool and Kindergarten. The proposed regulations clarify that Kindergarten expenses are explicitly ineligible, while expenses for nursery school, pre-school, or similar programs below the kindergarten level are eligible for reimbursement.
Specialty Day Camps. The full cost of a day camp that specializes in a particular activity may be eligible for reimbursement. Day camps may be considered employment-related expenses, even though education may be a significant part of these programs. Day camps may be considered to be for the care of a qualifying individual, even if the camp specializes in a particular activity, such as tennis or computers.
Application and agency fees. Expenses that relate to, but are not directly for, the care of a qualifying individual (such as application fees, agency fees, registration fees, and deposits) may be considered employment-related expenses if they must be paid in order to obtain the care and ONLY if the care is actually provided. The agency fee or deposit is not considered to be for the care of the individual until the care to which the fee was associated is actually provided. Also the expense must be incurred during the plan year in which the service was provided.
Example 1: If a deposit reserving a place at a preschool is required, but the child ends up attending a different preschool, then the deposit is forfeited.
Example 2: If an application fee is required in May for a camp that does not begin until June, then the application fee is not considered to be for care or reimbursable until June when the service is actually provided.
Payments to Related Individuals. Payments to the taxpayer’s spouse or to a dependent child under age 19 are not reimbursable.
Special Rule for Divorced or Separated Parents. When a child’s parents are divorced or separated, the child is treated as a qualifying individual of the custodial parent only. The custodial parent is the parent with whom the child lives for the greater portion of the year. As a result, the custodial parent is the only parent who can seek reimbursement from a DCAP.
This is just a brief summarization of the Proposed Regulations. We recommend that employers review the proposed rules and incorporate them into DCAP administration and employee communications. Even though an expense is permissible for reimbursement under the IRS rules, employers still need to make sure that the expense is reimbursable under their own DCAP Plan Document and SPD.
