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Thomas Wechter
The Child and Dependent Care Credit

The Child and Dependent Care credit allows a credit for amounts paid for child care and household services to enable the taxpayer to be gainfully employed.

December 9, 2010
by Thomas Wechter, JD, LLM

The child and dependent care credit should not be confused with the child credit. The child and dependent care credit allows a credit of at least 20 percent and up to 35 percent of the taxpayer's "employment related expenses" for household services and the care of qualifying individuals in an amount of not more than $3,000, if the household includes only one qualifying individual or $6,000 if two or more qualifying individuals. The child care credit is not refundable and cannot be carried to other years if more than the current tax liability. The child credit provides a credit for each qualifying child of $1,000 for 2010, and absent further changes, $500 for 2011 and subsequent years.

Background

In response to Smith v. C.I.R., 40 B.T.A. 1083 (1939) which held that the cost of nursemaids employed to take care of young children so that the parents could work were not deductible as business expenses, the Congress in 1954 provided an itemized deduction for child care expenses in the amount of $600 incurred for the care of children under the age of 12 and other dependents. The deduction was converted into a credit in 1976 by the enactment of the predecessor of Code Section 21. Since 1976, the child and dependent care tax credit has been modified no less than five times, to liberalize to whom creditable payments could be made, to raise and lower the age of a qualifying child from 11 or younger to 12 or younger, to 14 or younger and back to 12 or younger, and to lower and raise the maximum creditable expenses and the credit percentage.

The Mechanics of Computing the Credit

An individual taxpayer is entitled to a tax credit on a sliding scale from 35 percent (if the taxpayer's adjusted gross income is $15,000 or less) to 20 percent (if adjusted gross income is $43,001 or more) of expenses for household services or for the care of a qualifying individual incurred to enable the taxpayer to be gainfully employed. The household or care expenses taken into account in determining the credit are limited to $3,000 for one qualifying individual or $6,000 for two or more qualifying individuals and are also limited by the earned income of the individual taxpayer. Further the creditable expenses are reduced by income excluded under a dependent care assistance program provided by the individual taxpayer's employer.

For tax years beginning after December 31, 2010, the credit drops to 30 percent (if the taxpayer's adjusted gross income is $10,000 or less) and is decreased by one percentage point for each $2,000 of additional adjusted gross income, until it is reduced to 20 percent (if the taxpayer's adjusted gross income is greater than $28,000). The maximum amount of expenses for household services or care for a qualifying individual drops to $2,400 from $3,000 for one qualifying individual to $4,800 for two or more qualify individuals.

Qualifying Individuals

To qualify for the credit, the expenses must be incurred to enable the individual taxpayer to be gainfully employed for any period that the taxpayer has one or more qualifying individuals and the creditable expenses must be for household services or for the care of qualifying individuals. For these purposes, a qualifying individual is a dependent of the taxpayer 12 years old or younger, a dependent of the taxpayer or spouse who is physically or mentally incapable of caring for himself or herself and who has the same principal place of abode as the taxpayer for more than half of the tax year. A "dependent" is a qualifying child or qualifying relative. A qualifying child includes the taxpayer's children, descendants of a child, the taxpayer's brothers and sisters and their descendants, if they are younger than the taxpayer, have the same principal place of abode as the taxpayer for more than half the year and are under the age of 19, or 24 if a full time student. A qualifying relative includes any relative who receives more than half of his or her support from the taxpayer, whose gross income is not in excess of the dependency exemption and is not a qualifying child of any other person.

Creditable Expenses

Expenses for household services qualify for the credit, if performed in connection with the care of a qualifying individual and consist of services necessary to maintain the household. These services can include domestic cleaning services and the preparation of meals. Expenses are for the care of a qualifying individual if the primary function is to protect and assure the individual's well-being. Generally costs of food, lodging, clothing or education do not qualify, but if such costs are incidental to and inseparably a part of the care of a qualifying individual then the costs qualify. Nursery school, pre-school and similar programs for children are considered to be for a child's care, but costs of higher education programs such as kindergarten do not qualify. Expenses for services outside the taxpayer's household can qualify if incurred for the care of dependent 12 years old or younger or a dependent who spends at least 8 hours each day in the taxpayer's household but the taxpayer is not entitled to take the dependency exemption.

Qualifications and Limitations on Creditable Expenses

Expenses for household services and care of qualifying individuals will not qualify as qualifying expenses if paid to a dependent of the taxpayer, a child of the taxpayer under the age of 19 at the end of the tax year, a spouse of the taxpayer who is married to the taxpayer at any time during the tax year or a parent of a qualifying individual who is a child of the taxpayer under the age of 13.

The household expenses and care for qualifying individual expenses are limited to the taxpayer's earned income for the year. For married individuals, the limit is the lesser of the married individuals' earned income. If one spouse has no earned income, then the expenses are limited to that spouse's earned income. There is a special rule for married individuals where one of the spouses is a full time student at an education institution or is physically or mentally unable to care for himself or herself. The student spouse or incapacitated spouse is deemed to be gainfully employed for each month and to have earned income of at least $250 for any month that there is one qualifying individual or $500 per month for each month that there is more than one qualifying individual.

Claiming the Child and Dependent Care Credit

The credit is claimed on Form 2441, "Child and Dependent Care Expenses." The name, address and taxpayer identification number of any person to whom creditable payments are made must be included on the form. In addition, the taxpayer identification number of each qualifying individual must be included. The credit is disallowed if the proper identification information is not provided for the qualifying individual or the care giver.

The credit is limited to the taxpayer's tax liability for the year the credit is claimed and cannot be carried back or forward if the credit exceeds the taxpayer's tax liability. The expense limitation amounts and the adjusted gross income sliding scale amounts are not subject to a cost of living adjustment.

Conclusion

The child and dependent care credit is sometimes lost due to the income exclusion for employer provided child care and as a result has not received the attention it deserves. The child and dependent care credit provisions consist of over 1,800 words with multiple exceptions and limitations, which in many cases are at odds with the policy of promoting employment.

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Thomas R. Wechter, JD, LLM, is partner at Schiff Hardin LLP and concentrates his practice in the area of tax planning for individuals, corporations and partnerships and also handles matters involving tax controversies. Wechter has an LL.M. degree in Tax from New York University.