CRS Summarizes Current Dependent Care Benefits and Legislation

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);

• 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% beginning in tax year 2003) of qualified employment-related expenses for qualifying dependents. In addition to meeting the requirements for employment-related expenses and a qualifying dependent, a taxpayer must maintain the household. That is, the taxpayer must provide more than 50% of the household expenses. P.L. 108-311 eliminates, beginning in tax year 2005, this requirement to maintain a 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 CRS-3 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 $200 for one child, and $400 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 $2,400 for one child and $4,800 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 Income

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

A taxpayer can exclude from income up to $5,000 paid or incurred by an employer for qualified dependent care expenses under an employer-provided DCAP. The DCAP definitions for qualified dependent care expenses and qualified dependent are the same definitions as for the DCTC. An employer can provide direct payment to child care providers, provide on-site child care, or reimburse parents for child care they obtain. Similar to the DCTC, payments made to a dependent of the taxpayer or a child of the taxpayer under age 19 are not excluded from income.

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.² 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;³ 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) reports⁴ that in 2002, 21% of employers with 10 or more employees offered a flexible spending arrangement (under a Section 125 Cafeteria Plan), and 14% of eligible employees participated in a dependent care flexible spending arrangement. The average contribution to a flexible spending arrangement was $3,024.

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.

Current Legislation

In the 109th Congress, the current legislation related to the dependent care tax provisions focuses on

• EGTRRA. Legislation was introduced to eliminate the current sunset for the changes to the credit made by EGTRRA. At the end of 2010, the sunset would result in a lower qualified expense limitation, and a lower credit rate, particularly for taxpayers between $10,000 and $43,0000.

• Other changes. Legislation has been introduced to make the DCTC refundable or expand the exclusion for dependent care assistance programs.

² 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.

³ The marginal tax rate is the tax rate on an additional dollar of income.

⁴ Employee Benefit Research Institute (EBRI), Facts from EBRI, Flexible Spending Accounts, October 2003. Data cited in the EBRI report are from a study by Mercer Human Resource Consulting.