Advantages of Dependent Care Assistance Programs

Our topic is exclusion from taxable income for employer payments that would otherwise be included in the W-2 (Section 129). The savings can be in income tax as well as FICA.

The American Rescue Plan was signed into law on March 11. The credit, the direct reduction in tax liability, focuses not on school costs, but such costs as day care and nanny arrangements. After school programs may qualify.  

More specifically, the focus is on expenses a worker pays for the care of qualifying children under the age of 13 so the taxpayer can work. The family relationships for the one receiving care include a child, stepchild, foster child, brother, sister, step-sibling (or their descendants). 

Those receiving care must live in your home, and not provide more than half of their own support. Dependent care for a member of a household who is handicapped can also qualify. There are some rather complicated how-much-did-you-earn limitations plus limits aimed at a worker with high adjusted gross income. 

The employee’s credit may be as high as 50 percent of expenses in 2021, a temporary one-year increase from the high of 35 percent under prior law. The percentage for a particular employee may not be as high as 50 percent.

The limits on the worker’s credit, for 2021, are generally $4,000 and $8,000 – a maximum of 50 percent of $8,000 in expenses for one qualifying individual, or 50 percent of $16,000 for two or more receiving care.  See generally IRS Form 2441; the 2020 form presently available reflects the lesser 2020 limits of $3,000 for one dependent or $6,000 for two dependents (See section 21, “Child and Dependent Care Expenses,” Publication 503 for use in preparing 2020 returns, IRS.gov; and “Topic No. 602 Child and Dependent Care Credit,” irs.gov).

The Employer Pays the Employee’s Dependent Care

If an employer is to have such a tax-advantaged program that excludes compensation from the W-2, the plan needs to be in writing. The plan may be designed to allow participation by sole proprietors, partners, and more-than-2 percent shareholders in an S corporation.

The employer reports the total dependent care expenditures (not just the exclusion amount) in Box 10 of the W-2, including amounts covered under a cafeteria plan. To the extent such amounts exceed the exclusion, this excess is also included in wages. IRC Section 129 has nondiscrimination rules, which if violated, can result in highly-compensated individuals receiving taxable rather than tax-free reimbursements.

In general, the employer has to have a reasonable basis for believing reimbursements relate to dependent care enabling the employee and the employee’s spouse to be gainfully employed. The expenses need to be incurred with respect to caring for a qualifying individual.   

Reimbursable expenses don’t include items such as clothing, education, entertainment and food, although incidental amounts may qualify.  In-home care, however, can qualify.

Qualifying individuals include a dependent child who is twelve or younger, and a taxpayer’s spouse (or a dependent) if incapable of self-care and who has the same place of abode for at least half of the year. 

The dependent care exclusion for employer-provided reimbursements was sharply increased for 2021 only – to $10,500 ($5,250 if married filing separately).   

The exclusion, also known as employer-provided dependent care assistance program (DCAP) benefit, is ordinarily limited to $5,000 per year ($2,500 if married filing separately). Barring future change to the law, the provision reverts to the previous $5,000 per year limit.  

The limitation, the $5,000 amount that has been in place since 1986, is not adjusted annually for inflation. The annual limit is also a joint limit. The limit doesn’t turn on whether the married employee files jointly.  

There is also an amendment in the 2021 law permitting employers to amend cafeteria plans retroactively, which may help employees reach the new and increased 2021 maximum amount. There is also provision for the plan to adopt unlimited carryover from 2021 to 2022.

The exclusion generally looks to when the services were rendered (e.g., a reimbursement in January of 2022 for 2021 dependent-care expenses would result in a 2021 exclusion). In general, an employer amending a calendar year plan to reflect permitted changes would need to do so by December 31, 2021. Employers with dependent care accounts are to explain to the employee the rules governing their account and the employee credit concept.

Conclusion

Dependent care considerations can translate into an important fringe benefit for workers.  It can be a tax-advantaged benefit to workers and the employer if handled properly.  

The basics of such programs should be understood and considered by business owners and their tax advisers. The topic should be on the list for periodic review, whether such plans are to be considered or in place and the review focuses on such developments as we’ve discussed.