Regulations provide guidance on child and dependent care credit.

• Author: Cook, Ellen D.

EXECUTIVE SUMMARY

* The Working Families Tax Relief Act of 2004 made significant changes to Sec. 21, which provides for the child and dependent care credit.

* The IRS issued final regulations under Sec. 21 that amended the existing regulations to reflect the changes made by the new law.

* In addition to providing clarifying definitions, the final regulations introduce a new safe harbor for short and temporary absences from work.

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This article discusses changes to and clarifications of the child and dependent care credit rules made by final regulations issued in August 2007.

According to the 2000 census, for more than 60% of households with children under age six, all parents in the household worked. (1) Sec. 21 was enacted to provide such families with a tax benefit to help them stay in the workplace--a nonrefundable child and dependent care tax credit for employment-related expenses for the care of certain qualifying individuals. In tax year 2004, taxpayers claimed child and dependent care credits of $3.3 billion on 6.3 million returns. (2)

In August 2007 the IRS issued final regulations (3) under Sec. 21. While generally in line with the proposed regulations issued on May 24, 2006, (4) the final regulations, in addition to providing clarifying definitions, identify educational programs that do not qualify as employment-related expenses and introduce a safe harbor for short and temporary absences from work. Kegs. Secs.1.21-1 through -4 apply to tax years ending after August 14, 2007. (5) The proposed regulations apply in tax years for which the period of limitation on credit or refund had not expired as of May 23, 2006.

This article presents a summary of the Sec. 21 provisions, including the timing of the deduction as clarified in the regulations, and discusses the definitions of qualifying individuals, qualifying household services, and qualifying providers, with particular attention to programs that do and do not meet the requirements of employment-related expenses. Examples throughout the article are based on those included in the regulations.

Child and Dependent Care Credit

Sec. 21 allows for a nonrefundable credit for taxpayers who pay qualifying employment-related expenses for the care of eligible individuals so that the taxpayer may work or seek work. The credit is computed by multiplying the qualifying expenses by an applicable percentage ranging from 20% to 35% based on the taxpayer's adjusted gross income. (6) Qualifying expenses are capped at $3,000 for one qualifying individual and $6,000 for two or more qualifying individuals, (7) although the taxpayer is not required to prorate the annual dollar limitation if the qualifying individual ceases to qualify during the tax year. (8) The amount of qualifying expenses must be reduced by the amount excludible from gross income under Sec. 129 dependent care assistance plans. (9)

The credit is also subject to an earned income limitation. For an unmarried individual, the credit is limited to the individual's earned income for the year; for a married individual, it is limited to the lesser of the individual's earned income or his or her spouse's earned income for the year. (10) In the case of a spouse on a joint return who is either a student or physically or mentally incapable of self-care, the spouse will be deemed for each month that he or she is a fulltime student or qualifying individual to have earned income of $250 in the case of one qualifying individual and $500 in the case of two or more qualifying individuals. (11) However, in the case of husband and wife, the deemed income will apply for only one spouse for any one month, (12) as illustrated in the following examples.

Example 1: In 2007, A, who is married to B, pays employment-related expenses of $5,500 for the care of one qualifying individual. A's earned income is $30,000. B is a full-time student for 10 months during the year. B is deemed to have earned income of $2,500 ($250 x 10 months) for the year. In computing the child and dependent care credit, the amount of employment-related expenses is the lesser of $2,500 (the lowest earned income of A or B) or $3,000 (the statutory limit of one qualifying individual), or $5,500 (the actual amount of expenses).

Example 2: Assume that in the case above, neither spouse has earned income. A is physically incapable of self-care; B is a full-time student for the entire year. The $5,500 payment is for A's care. Only one spouse, A or B, is deemed to have $3,000 of earned income ($250 x 12 months). The other spouse has earned income of $0. In computing the child and dependent care credit, the amount of employment-related expenses is the lesser of $0 (the lowest earned income of A or B) or $3,000 (the statutory limit for the care of one qualifying individual) or $5,500. Therefore, the couple is not entitled to any child and dependent care credit.

In computing the lowest earned income, a taxpayer is not required to take into account the earned income of a spouse who died or was divorced or separated from the taxpayer during the tax year. (13) However, the taxpayer must take into account the entire year's earned income of a spouse to whom the taxpayer is married at the close of the tax year even if the taxpayer and spouse were married for only part of the tax year. (14)

In general, married taxpayers must file a joint return in order to claim the credit. (15) A married individual who (1) files a separate return and maintains...