Tax Credit for Child and Dependent Care

Families have been subject to increasing economic pressure. Both spouses often feel the need to work to make ends meet. Both parents working outside the home may necessitate paying for child care. Congress has provided some relief from child care costs by implementing a federal income tax credit for child and dependent care expenses.

A tax "credit" can reduce the amount of income taxes due after they have been calculated, whereas a tax "deduction" reduces the amount of income that is subject to tax. A tax credit is therefore usually considered more desirable, as it results in a dollar-for-dollar reduction in the amount of tax owed. Some states also provide tax breaks for child care costs, but the amounts and requirements for such tax breaks vary. This article focuses on the federal credit for child and dependent care expenses.

Requirements for Tax Credit for Child and Dependent Care Expenses

In order to qualify for the tax credit, all of the following requirements must be met:

1. The care must be provided for one or more "qualified persons:" a dependent who was under age 13 during the tax year and for whom the taxpayer(s) could claim an exemption (although, under some circumstances, a custodial divorced parent may be able to claim the credit even where the exemption was allocated to the other parent in the divorce); spouses physically or mentally unable to care for themselves; or dependents who were physically or mentally unable to care for themselves and for whom the taxpayer could claim an exemption or could have, but the dependents had too much gross income. All dependents must be identified on the appropriate tax form.
2. The taxpayer (and spouse, if married) must "keep up a home" that is occupied by the taxpayer and the qualified persons. This means that the taxpayer (and spouse) must pay more than half the costs of running the home for the tax year, e.g., property taxes, mortgage interest, rent, food eaten at home, etc., but not clothing, transportation, or mortgage principal. Payments from public assistance are not counted. Although the care may take place in the home, it does not have to as long as the qualified person spends at least eight hours of the day at home. Expenses of day care at a nursery, senior citizen center or similar facility, and even day camps for kids, may qualify (although the costs of schooling from kindergarten on up are generally not qualified expenses).
3. The taxpayer (and spouse if married) must have "earned income" during the year, such as self-employment income, wages, salary, tips, etc. There is an exception for student-spouses and spouses who are unable to care for themselves.
4. The taxpayer (and spouse) must pay the care expenses to enable them to work, either for others or their own business, full or part time, or to enable them to look for work. Volunteer work is not considered "work" under this requirement. Merely having the expenses while working is not enough; the purpose of the expense must be to enable them to work.
5. The payments for care must be made to someone neither the taxpayer nor spouse may claim as a dependent. If the payments are made to a child of the taxpayer, that child cannot be a dependent and must be 19 or older by the end of the year, even if the child is not a dependent. The care payments may, however, be made to non-dependent relatives, even if they live in the home. The IRS warns that paying for care and related services in the home may make the taxpayer a "household employer" triggering FICA obligations.
6. When filing federal income tax returns, the taxpayer must choose a "status" as the filer (e.g., single, head of household, etc.); the tax rates may be different for different categories. The filing status of the taxpayer claiming a dependent-care credit must be single, head of household, qualifying widow(er) with dependent child, or married filing jointly. Married taxpayers filing separately are generally ineligible, subject to exceptions.
7. The care provider(s) must be identified on the tax return. The provider's name, address, and taxpayer identification are required (either the provider's Social Security number, if the provider is an individual, or the provider's employer identification number, if the provider is an organization or other entity). If the taxpayers is unable to obtain the provider's taxpayer identification number, the taxpayer may submit the other required information.

Claiming and Calculating the Credit; Limitations
The credit is a percentage of the care expenses, based on adjusted gross income. Such expenses must have been paid during tax year or, if prepaid, may be taken only in the year the care is actually given. Some employers allow employees to contribute a portion of their salaries or wages, up to a certain amount, to a "child care flexible spending account" (FSA). Payments for care can be made from such accounts and are not included in the employee's gross income but payments from an FSA reduce the available amount of the credit, as illustrated in the example below.

The credit is limited in amount ($3,000 for one qualified person and $6,000 for two or more qualified persons for the 2003 tax year). To determine the amount of the credit, the work-related care expenses are multiplied by a percentage. This percentage figure is based on adjusted gross income and may change from year to year.  For example, for the 2003 tax year, taxpayers with adjusted income of less than $15,000 were potentially entitled to deduct 35% of the expenses.  This percentage decreased from 35% to 20% as income rose, to 20% for income of $43,000 and above.

Thus, as an example, a couple who paid $8,000 in qualified, work-related child care expenses for their three year old in the 2003 tax year and had adjusted gross income of $34,000, were entitled to a credit of 25% of those expenses, or $2,000. Since this amount is below the $3,000 maximum, they could potentially claim all the expenses as a credit. However, if one spouse received $2,000 from an employer FSA and used it to pay part of the expenses, that amount is subtracted from the $3,000 maximum credit that can be claimed, resulting in a maximum of  $1,000 which is the most the couple may claim as a credit that year.

For the credit to be claimed, one of several tax return forms must be filed for that year and the amount of the credit is limited to the amount of the regular tax, after any allowable foreign tax credits have been deducted.  The deduction may also be affected by alternative minimum tax, for taxpayers with higher incomes.

© 2004 NextClient.com, Inc.  All rights reserved.