CRS Updates Report on Dependent Care Tax Benefits

There are two current law tax provisions for dependent care: the dependent care tax credit (DCTC) and the exclusion from income for employer-provided dependent care assistance programs (DCAP). Both provisions use the same definitions of qualified employment related expenses and qualifying dependents. The Working Families Tax Relief Act of 2004 (P.L. 108-311) changed the definition of a qualifying dependent beginning in tax year 2005 to conform with changes made to the personal exemption for a more uniform definition of a child.

Qualified employment-related expenses are those expenses for household services and care of a qualifying dependent necessary for the taxpayer to be employed. For the purposes of qualified employment-related expenses, a qualifying dependent is a

• dependent less than 13 years of age for whom the taxpayer can claim a personal exemption (beginning in tax year 2005, the dependent under 13 must be a qualifying child of the taxpayer as defined for the personal exemption);¹

• dependent of the taxpayer who is physically or mentally incapable of providing self care (beginning in tax year 2005, the dependent who is physically or mentally incapable of providing self care must live with the taxpayer for at least half the tax year); or

• spouse of the taxpayer who is physically or mentally incapable of providing self care (beginning in tax year 2005, the spouse who is physically or mentally incapable of providing self care must live with the taxpayer for at least half the tax year).

Dependent Care Credit (DCTC). The DCTC is calculated as a percentage (as high as 35%) of qualified employment-related expenses for qualifying dependents. P.L. 108-311 eliminated, beginning in tax year 2005, the requirement that the taxpayer maintain the household.

The qualified employment-related expenses for the DCTC, beginning in tax year 2003, are actual expenses capped at $3,000 for one dependent and $6,000 for two or more dependents. If the taxpayer has two or more children, the $6,000 need not reflect $3,000 per child. The per child allocation does not matter as long as part of the $6,000 is spent on each child. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) raised the expense limits from $2,400 for one child and $4,800 for two or more children, and increased the credit percentage from 30% to 35%, beginning in tax year 2003. EGTRRA also increased the income level at which the credit rate begins to phase down resulting in a higher credit rate for incomes between $10,000 and $43,000. The EGTRRA increases will sunset at the end of 2010, and the DCTC will revert to tax year 2002 levels.

For married taxpayers, the qualified expenses are also limited to the lesser of the taxpayer's or spouse's earned income. If the spouse is a full-time student or incapable of providing self care, they are often not employed and earning income. A special rule exists for this situation. Each month that the spouse is a full-time student or incapable of providing self care, the spouse's income for purposes of calculating the credit is assumed to be $250 for one child, and $500 for two or more children. If the spouse is a full-time student all year, this results in an income for purposes of the credit equal to the tax year 2002 qualified expense levels of $3,000 for one child and $6,000 for two or more children.

Married taxpayers must generally file a joint return to take the DCTC, but special rules exists for couples who are legally separated or living apart. The 35% rate is reduced by 1% point for each $2,000 (or fraction thereof) by which income exceeds $15,000, but the rate is not reduced below 20%. As shown in Table 1, the credit is 20% at incomes above $43,000.

 Table 1. Maximum Dependent Care Tax Credit by Level of

 Table 2. Utilization of the DCTC by Income Level for a

These arrangements are often funded through salary reduction agreements. Under a salary reduction agreement, the employee agrees that a specified amount be set aside for the employer's DCAP.⁴ The employer DCAP must be a written plan meeting certain rules for nondiscrimination among employees, but need not be funded by the employer. By using a salary reduction, an employee receives the benefit of the income exclusion during the tax year rather than at year's end. The tax savings from using a DCAP include for federal taxes, the income set aside times the taxpayer's marginal tax rate;⁵ the payroll taxes on the income set aside (if the taxpayer's income exceeds the maximum amount subject to payroll taxes there is no payroll tax savings); and any applicable state taxes on the income set aside. Therefore, for any given amount set aside, the higher the taxpayer's tax brackets (at the federal and state level) the greater the potential savings from using a DCAP.

The Employee Benefits Research Institute (EBRI) reports⁶ that in 2005, the average employee contribution to a dependent care flexible spending plan was $2,630. The National Compensation Survey for 2006 by the Bureau of Labor Statistics shows that 30% of employees had access to a dependent care reimbursement account under a Section 125 "cafeteria" benefit plan.⁷

Interaction Between the DCTC and the DCAP. Although both provisions use the same definition of employment-related expenses, the same expenses cannot be used for both the DCTC and DCAP. Taxpayers must choose between the two tax provisions for the same qualified dependent care expenses. For taxpayers in tax brackets higher than the DCTC credit rate, the DCAP using a salary reduction arrangement is more advantageous. However, because the DCTC has a higher limit ($6,000) in the case of two or more children, a higher income taxpayer may use up to $5,000 in a DCAP with a salary reduction, and use $1,000 of taxpayer paid employment-related expenses for the DCTC.

Legislation in the 110th Congress

In the 110th Congress, several bills related to the dependent care tax provisions have been introduced. H.R. 1911, H.R. 2902, and S. 614 would increase the income level at which the credit rate begins to phase down (from $15,000 to $75,000) and expand the credit to include care of parents and grandparents of the taxpayer not living with the taxpayer. H.R. 1871 would establish a credit rate of 40% for taxpayers with incomes below $100,000 and a credit rate of 20% for taxpayers with higher incomes. H.R. 1871 would also adjust the $100,000 income level for inflation and make the EGTRRA changes to the credit permanent. H.R. 1421 and S. 816 would establish a minimum income of $250 a month for a stay-at-home parent and alter the income level at which the credit rate is reduced by a combination of income and number of eligible dependents. H.R. 2021 would increase the maximum qualifying expenses from $3,000 ($6,000 for two or more eligible dependents) to $5,000 ($10,000 for two or more eligible dependents), and increase the income level at which the credit rate begins to phase down (from $15,000 to $20,000).

² Other nonrefundable credits include those for education, retirement savings, adoption, and the child credit (which is refundable for certain taxpayers).

³ Internal Revenue Service, Individual Complete Report (Publication 1304), Table 3.3, available at [http://www.irs.gov/pub/irs-soi/04in33ar.xls].

⁴ The plan will then reimburse the employee from the set aside amount (employee contributions) for dependent care expenses. This type of arrangement is also known as a flexible spending arrangement or flexible spending account, and is often offered as part of a cafeteria benefit plan, in which employees may choose from one or more taxable or nontaxable benefits.

⁵ The marginal tax rate is the tax rate on an additional dollar of income.

⁶ Employee Benefit Research Institute (EBRI), Data Book on Employee Benefits, Chapter 48, updated March 2007. Data cited by EBRI are from a study by Mercer Human Resource Consulting.

⁷ U.S. Bureau of Labor Statistics, National Compensation Survey: Employee Benefits in Private Industry in the United States, March 2006, Table 24,August, 2006, pg. 29.