CRS Updates Report on Dependent Care Provisions

In the 2000 census, for more than 60% of the households with children under the age of six, all parents in the household worked. Some private surveys show that nearly 40% of those caring for aging parents and older individuals worked. For families, care for young children and older individuals who are physically or mentally unable to care for themselves is critical to maintaining participation in the workforce. To assist these families, current law provides two tax benefits related to dependent care: the dependent care credit and the exclusion from income for employer-provided dependent care assistance programs. Both provisions are for employment-related expenses for the care of dependents under the age of 13, or dependents (or a spouse) who are physically or mentally incapable of caring for themselves.

Some of the current tax provisions that were expanded in 2001 are set to expire December 31, 2012. These changes include increases for the

• maximum credit rate for the dependent care tax credit (DCTC) from 30% to 35%;

• income level at which the credit rate for the DCTC phases down from $10,000 to $15,000; and

• maximum amount of qualifying expenses from $2,400 to $3,000 for one child and from $4,800 to $6,000 for two or more children.

This report discusses current tax treatment of dependent care expenses under the DCTC and the dependent care assistance programs (DCAP), and issues for Congress in expanding tax benefits for working caregivers (including President Obama's Budget proposal).

This report will be updated as legislative activity warrants.

 Contents

The demographics of the workforce has changed considerably in the past few decades, as has the nature of caregiving responsibilities. Not only has the share of women working increased considerably over the past three decades, but the overall workforce has aged. While many workers today still care for children, they are also increasingly more likely to be caring for aging parents.

To address dependent care costs for working caregivers, 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). Some of the tax provisions for dependent care tax provisions are also expected to expire (not be in effect) after December 31, 2012. In addressing the expiration of these provisions, Congress may also consider whether to expand these tax incentives even more for working caregivers. The importance of this issue is underscored by the expansion of dependent care tax incentives in President Obama's Legislative Agenda¹ through the White House Middle Class Task Force chaired by Vice President Biden, which includes as one of its goals to improve work and family balance.

This report discusses

• current tax treatment of dependent care expenses under the DCTC and the DCAP, and

• issues for Congress in expanding tax benefits for working caregivers.

Under current law, there are two dependent care tax provisions targeted toward working caregivers: the DCTC is a tax credit and the DCAP is an exclusion from income for employer-provided dependent care assistance programs. These tax provisions are similar in that they both use the same definition of qualified employment-related expenses and qualifying dependent (discussed below). They differ, however, in how each affects tax liability by income category. The DCTC is a nonrefundable tax credit for qualified dependent care expenses and directly offsets tax liability dollar-for-dollar for working caregivers with a positive tax liability. The DCAP, on the other hand, is an income exclusion where the value of the tax benefit depends on a household's marginal tax rate. The DCAP is available to working caregivers whose employer offers it as a benefit. Working caregivers can only use one of these options. Both the DCTC and the DCAP rely on the same definitions of qualified employment-related expenses and qualifying dependents. This section discusses these issues in greater detail.

Qualified Employment-Related Expenses

Qualified employment-related expenses are defined by the Internal Revenue Service (IRS) as those expenses for household services and care of a qualifying dependent necessary for the taxpayer to work or to look for work. A taxpayer's work can be for others or in their own business or partnership and can be either full time or part time. Work also includes actively looking for work, but a taxpayer must have earned income to qualify in a given year.

The following are considered qualified employment-related expenses:

• Cost of care provided outside of one's home if the care is for a qualifying person who regularly spends at least 8 hours each day in his or her (i.e., taxpayer's) home.

• Care provided by a dependent care center is eligible only if the center complies with all state and local regulations.²

• Costs for transportation by a care provider to and from a dependent care center provided for a qualifying person (e.g., bus, subway, taxi, or private car) are also eligible. However, the transportation cost of the care provider coming to a working caregiver's home is not included.

• Fees and deposits paid to an agency to obtain the services of a care provider are included.

• Expenses paid for household services also meet the work-related expense test if they are at least partly for the well-being and protection of a qualifying person. Household services include ordinary and usual services done in and around your home that are necessary to run your home, and include services of a housekeeper, maid, or cook. However, they do not include the services of a chauffer, bartender, or gardener.

Definition of Qualified Dependent

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

• qualifying child of the taxpayer (as defined for the personal exemption) who is less than 13 years of age, and for whom the taxpayer can claim a personal exemption;

• dependent of the taxpayer who is physically or mentally incapable of providing self care, and who has lived 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 and who has lived with the taxpayer for at least half the tax year.

The DCTC is calculated as a percentage (as high as 35%) of qualified employment-related expenses for qualifying dependents.

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 2012, and the DCTC will revert to tax year 2001 levels.³

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 qualified expense limitations 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 exist 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 CareTax Credit by Level of Income

       Table 2. Utilization of the DCTC by Adjusted Gross Income

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 and adult day 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 the age of 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.⁶ 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 benefit from a DCAP depends on the marginal tax rate of the working caregiver and the amount that the working caregiver allocates to the DCAP each year. The marginal tax rate is defined as the tax rate on the last dollar that the person earned that year and increases with income. Higher tax benefits from the DCAP accrue to individuals with higher marginal tax rates. Although the working caregiver also does not pay employment taxes (i.e., Social Security and Medicare payroll taxes) on the amount he or she contributes to the DCAP, these taxes generally do not vary by income.⁷ Thus, higher-income individuals receive a higher DCAP tax benefit than middle- and lower-income individuals.

According to a Mercer survey, 24% of small employers (10 to 499 employees) and 83% of large employers (500+ employees) offered a DCAP to their employees in 2009. The average contribution to a DCAP was about $3,050, which is lower than the $5,000 maximum allowed under current law.⁸ This difference may reflect the "use or lose" nature of the funds and changes in employment (for example, if an employee changes jobs from one employer who offers a DCAP to another who does not).⁹ Funds for dependent care expenses not used by the end of the year revert back to the employer.¹⁰ The Mercer survey found that an average of 1% of funds are forfeited under the use or lose rules.

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.

Issues for Congress

A key issue Congress may consider is expiring provisions relating to the maximum credit rate, the maximum amount of the qualifying expenses, as well as other provisions relating to the integration of the dependent care tax credit with other areas of the tax code (such as EITC and AMT). In doing this, Congress may also look at whether these provisions are adequately addressing the costs for working caregivers. This issue is also at the forefront of President Obama and Vice President Biden's Initiatives for Middle-Class Families. Included in their blueprint is a proposal to double the child and dependent care tax credit.

In addition to addressing the expiration of a number of provisions, some areas Congress may look at for expansion include the following:

• the definition of dependent to include care recipient populations that are not otherwise included under current law.

• the amount of work-related expenses that are used for calculating the DCTC or DCAP formula.

• the benefit to allow more lower-income caregivers to participate.

Expiring Provisions

A number of provisions for dependent care are set to expire (not be in effect) after December 31, 2012.¹¹ Initially provisions authorized by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16) were set to expire on December 31, 2010, but they were recently extended to December 31, 2012, through the Tax Relief Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312). Changes that are set to expire include the increases for the

• maximum credit rate for the DCTC from 30% to 35%;

• income level at which the credit rate for the DCTC phases down from $10,000 to $15,000; and

• maximum amount of qualifying expenses from $2,400 to $3,000 for one child and from $4,800 to $6,000 for two or more children.

One area for expansion relates to the definition of dependent who is the care recipient. Specifically, there has been interest to expand the definition to include aging parents or relatives or other care recipients who may not be living with the care provider.

As noted earlier, one key requirement for a dependent to be covered is that the care recipient must be physically or mentally incapable of caring for himself or herself, and he or she must live with the working caregiver for more than half the year. One of the key issues in expanding the definition of "dependent" is that the second criterion that requires the expenses to be work-related would still have to be met. It may be difficult to prove that expenses for someone currently not living with a working caregiver meet this IRS criteria discussed earlier.

Increase the Amount of Work-Related Expenses that Are Deductible or Credited

Neither the DCTC or DCAP maximum allowable amounts have been indexed for inflation, and survey data indicate that dependent care cost may far exceed existing thresholds. A recent survey from the National Association of Child Care Resource and Referral Agencies found that the average annual cost of care for an infant in a center in 2010 ranged from more than $4,650 in Mississippi to more than $18,200 in the District of Columbia. For a four-year-old, the average cost of care ranged from more than $3,900 in Mississippi to more than $14,050 in the District of Columbia in 2010. Parents of school-age children paid more than $2,450 in Louisiana and Tennessee to more than $10,400 in New York.¹² Among older care recipients, eldercare costs are also expensive. According to a recent survey, the median annual cost of adult day care is $15,600.¹³ Thus, the current amount of work-related expenses that are allowed as a deduction through a DCAP of $5,000 or taken as a tax credit through the DCTC (from $3,000 to $6,000 depending on number of children) may not be sufficient to adequately cover eligible expenses for working caregivers.

To increase the amount of the work-related expenses that are subject to either a deduction or a credit, one direct approach is to increase the maximum thresholds for both the DCTC and the DCAP.

Another way to indirectly affect the amount of the available credit under the DCTC is to modify the applicable credit rate or the income thresholds. Under current law, the amount of the work-related expenses eligible for the credit depends on a taxpayer's adjusted gross income. Lower-income individuals are permitted to take a higher share of expenses than higher-income taxpayers. Changing the applicable credit rate can increase the availability of the credit to middle-income households.

This later approach was proposed by President Obama in his FY2012 Budget, which proposes to increase the credit for families earning between $15,000 and $103,000 annually. Specifically, the Budget proposes to permanently increase from $15,000 to $75,000 the adjusted gross income level at which the credit begins to phase down, maintaining the percentage point phase down for every $2,000 (or part thereof) in additional income, until the rate reaches 20% for taxpayers with incomes over $103,000.¹⁴ The Budget proposes to make this provision effective for taxable years beginning after December 31, 2011, meaning that the results of increasing the credit would likely not be seen until FY2013. Table 3 shows the impact of the President Obama's proposal on the amount of the dependent care expenses that would be eligible for the credit.

          Table 3. Maximum Dependent CareTax Credit Under Obama FY2012

A key concern of the DCTC is the inability of lower-income households to take advantage of the credit because the credit is nonrefundable. As noted earlier, a nonrefundable credit cannot be used in full if a working caregiver's tax liability is less than the amount of the credit. One legislative option is to make the credit refundable.

Lower-income households would benefit the most from making the tax credit refundable. As shown in earlier in Table 2, very few households with AGI up to $15,000 are eligible under current law for the DCTC because they have no tax liability. Those taxpayers with AGI of between $15,000 to $25,000 would only be eligible for part of the DCTC because they would not have sufficient tax liability to offset the full DCTC amount. Under current law, 60% of the tax benefits from the DCTC accrue to taxpayers with AGI over $50,000.

Estimates by the Tax Policy Center show that if the DCTC had been fully refundable in 2006, an additional 1.6 million households would have claimed the credit and the cost of the credit (in lost revenues) would have increased by $1.7 billion.¹⁵

Author Contact Information

² A dependent care center is a place that provides care for more than six person and receives a fee, payment, or grant for providing services of any of those persons, even if the center is not run for profit.

³ These provisions were initially scheduled to expire December 31, 2010, and were extended to December 31, 2012, by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312).

⁴ Other nonrefundable credits include those for education, retirement savings, adoption, and the child credit (which is refundable for certain taxpayers).

⁵ Internal Revenue Service, Individual Complete Report (Publication 1304), Table 3.3, available at http://www.irs.gov/pub/irs-soi/09in33ar.xls.

⁶ 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.

⁷ The one exception is for workers whose wages exceed the maximum amount subject to the Social Security payroll tax in which case there is no Social Security payroll tax savings.

⁸ Mercer Human Resource Consulting, National Survey of Employer Sponsored Health Plans, released July 2010.

⁹ Employers at their discretion may extend the deadline for using unspent balances up to 2 1/2 months after the end of the plan year.

¹⁰ See CRS Report RL32656, Health Care Flexible Spending Accounts, by Janemarie Mulvey.

¹¹The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16) provisions were set to expire on December 31, 2010, and the Tax Relief Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended these provisions in EGTRRA to December 31, 2012.

¹² National Association of Child Care Resource and Referral Agencies, Parents and the High Price of Child Care: 2011 Update.

¹³Genworth Financial, 2011 Cost of Care Survey: Home Care Providers, Adult Day Care, Health Care Facilities, Assisted Living Facilities and Nursing Homes, April 28, 2011.

¹⁴ U.S. Department of the Treasury, General Explanations of the Administration's FY2012 Revenue Proposals, p. 4, http://www.treasury.gov/resource-center/tax-policy/Documents/Final%20Greenbook%20Feb%202012.pdf.

¹⁵ Roberton Williams, President-Elect Obama's Tax and Stimulus Plans, Tax Policy Center, January 2009. See also, Jeffrey Rohaly, Reforming the Child and Dependent Care Tax Credit, Tax Policy Center, May 30, 2007, The Urban Institute and Brookings Institution.