The U.S. Internal Revenue Service (IRS) recently released proposed regulations that affect the benefits that employer-sponsored Dependent Care Assistance Programs (DCAPs) can provide and the types of expenses that Dependent Care Flexible Spending Arrangements (FSAs) can reimburse. These regulations clarify the types of expenses that qualify as “dependent care assistance,” as well as the individuals for whom expenses can be reimbursed. They also provide guidance and specific examples on what constitutes an employment-related expense. The proposed regulations will not become effective until the IRS publishes final regulations, but an employer or taxpayer may choose to apply the proposed regulations now.
New Expense Allocation Rules for Part-Time Employees
The proposed regulations include new special rules for part-time employees. Specifically, an employee who works part time must allocate dependent care expenses between days worked and days not worked. For example, assume an employee works three days per week, but the employee’s child attends a dependent care center five days per week. If the care center allows payment for any three days per week for $150 or five days per week for $250, the proposed regulations state that the employee’s expenses, based on days worked versus days not worked, are $150 rather $250. However, if the dependent care center did not offer the three-day option, the entire $250 weekly fee may be an employment-related expense.
Expenses Must Be for a Qualifying Individual
In order to be eligible for reimbursement under a DCAP or dependent care FSA, the expense must be for the care of a “qualifying individual” or for household services provided in connection with the care of that individual. Internal Revenue Code Section 21(b)(1) provides that a qualifying individual includes an employee’s dependent who is under age 13 or the employee’s spouse or dependent who is physically or mentally incapable of caring for himself and has the same principal address as the employee for more than half the taxable year. However, an individual cannot qualify as physically or mentally incapable merely because of an inability to engage in any substantial gainful activity or to perform the normal household functions of a homemaker. An individual is physically or mentally incapable of self-care only if, as a result of a physical or mental defect, the individual is “incapable of caring for the individual’s hygiene or nutritional needs, or requires full-time attention of another person for the individual’s own safety or the safety of others.”
Like gainful employment, the status of a spouse or dependent as a qualifying individual is determined on a daily basis. If an employee’s dependent turns 13 on June 15, the dependent no longer qualifies on that day.
Expenses Must Be Primarily for the Care of a Qualifying Individual
Expenses are for a qualifying individual’s care only if the primary function is to assure the individual’s well-being and protection. Proper expenses exclude amounts paid for food, lodging, clothing or education unless the care is provided in such a way that these other goods and services are “incidental to and inseparably a part of the care.” Otherwise, an employee should “reasonably allocate” the expenses that are not for the care of the qualifying individual.
Also, an employee does not have to choose the least expensive care option available in order for the expense to be employment-related. An expense falls into this category even if another caregiver is available to the employee at no charge.
Over the years the IRS has issued formal and informal guidance giving other specific examples that qualify as proper dependent care or employment-related expenses. The proposed regulations provide specific examples, some of which are new and others that restate prior guidance.
Expenses for Nursery School and Kindergarten
Expenses for pre-school or similar programs below the kindergarten level may be employment-related expenses even if education is a significant part of the program. However, expenses for programs at the level of kindergarten and above are primarily for educational purposes and, therefore, not employment-related.
Specialty Day Camps
The full amount paid for a day camp or similar program may be an employment-related expense even though the camp specializes in a particular activity, such as soccer or computers. Employment-related expenses do not include the cost of sending an individual to an overnight camp.
The cost of transportation furnished by a dependent care provider may be an employment-related expense. For example, the cost of transportation to a day camp or to an after school program may qualify.
Expenses that are related to dependent care but are not directly for the care of an individual, such as application and agency fees required to obtain dependent care, can be employment-related expenses. This is consistent with prior guidance stating that taxes that are employment-related as well as supplemental costs, such as a care giver’s room and board, can qualify as dependent care assistance.
Payments to Some Related Individuals Are Invalid Expenses
Under the Internal Revenue Code, payments to a dependent or child under age 19 cannot qualify as dependent care assistance. The proposed regulations clarify that payments to a spouse, or to a parent of the employee’s child who is not a spouse, cannot qualify as dependent care assistance. Behind this rule is the principle that a parent has an underlying legal obligation to a child; nonetheless, payments to other relatives may qualify as dependent care assistance.
In light of the new guidance, we suggest employers review their dependent care reimbursement programs and procedures. McDermott Will & Emery’s employee benefits lawyers are uniquely qualified to assist employers in evaluating the impact of the proposed regulations on Dependent Care Assistance Programs and Dependent Care Flexible Spending Arrangements.