There's little doubt that child care can be expensive, often rivaling the cost of college tuition and consuming a substantial share of the earnings it enables. Although costs vary widely by factors including the child's age, the care provider's geographical location, and the type of setting (e.g., center vs. home), 2014 data compiled by the not-for-profit organization Child Care Aware of America yield average annual costs nationwide for full-time, center-based care of $9,909 for an infant and $7,943 for a 4-year-old (Child Care Aware of America, Parents and the High Cost of Child Care, 2015 Report, Appendix VI, "Average Annual Cost of Full-Time Child Care in a Center and Public College Tuition and Fees by State"). Note, as an indication of geographical variance, that the average annual cost of care for an infant, for example, ranges from a low of $4,822 in Mississippi to a high of $22,631 in the District of Columbia. An interactive map (including comparisons with median income and public college tuition) is available at usa.childcareaware.org.
THE SEC. 21 FEDERAL CREDIT
The Sec. 21 nonrefundable credit for household and dependent care expenses is, of course, familiar to CPA tax preparers, and most working parents no doubt are at least aware of it. The credit is a percentage of amounts paid for expenses of household services and expenses for the care of a qualifying individual, where the expenses are incurred to enable the taxpayer to be gainfully employed. A qualifying individual is a dependent of the taxpayer under age 13 (or a spouse or dependent who is physically or mentally incapable of caring for himself or herself and has the same principal place of abode as the taxpayer for more than half the tax year) (Sec. 21(b)).
Allowable expenses, however, are capped at $3,000 per tax year for one qualifying individual and $6,000 for two or more. Allowable expenses also may not be greater than earned income, which for married couples (who must file jointly unless the married-individuals-living-apart rule applies) is that of the lower-earning spouse (Sec. 21(d)(1)).
The credit is between 35% and 20% of the allowable expenses, depending on the taxpayer's adjusted gross income (AGI). For the 35% credit, AGI must be $15,000 or less, and the credit percentage is reduced by one percentage point for each $2,000 (or fraction thereof) by which the taxpayer's AGI exceeds $15,000. Thus, the credit "bottoms out" at 20% of expenses for an AGI over $43,000. In other words, for taxpayers with the maximum allowable expenses, the credit amount with respect to one child is $1,050 at the lower end of the AGI scale, diminishing to $600 at the top. For two or more children, those credit amounts are doubled.
STATE CREDITS
Taxpayers and their CPAs may be less familiar with the variety of state personal income tax credits for child care across the country. Tax Credits for Working Families, a website of The Hatcher Group, maintains resources, including a chart of 21 states and the District of Columbia offering a credit, at taxcreditsforworkersandfamilies.org. Subscribers to commercial tax research services may also compare credits for each state.
Several states offer a credit equal to one-half of the federal credit and reduce the applicable percentage of allowable expenses at higher AGIs than the federal credit. For example, California allows a credit of 50% of the federal credit for taxpayers with an AGI of $40,000 or less; 43% for those with an AGI over $40,000 up to $70,000; and 34% for those with an AGI over $70,000 up to $100,000. No credit is allowed for an AGI over $100,000 (Cal. Rev. & Tax. Code §17052.6(b)(2)). So, for example, a California resident with an AGI of $70,000 who claims a federal credit of $1,200 for two children could claim a $516 credit against California tax ($1,200 × 43%).
A few states offer a credit equal to or even higher than the federal one. New York, for example, allows residents a credit of 110% of the federal credit if New York state AGI is $25,000 or less, phasing down to 100% as state AGI increases to $40,000 and to 20% for state AGI of $65,000 or more (N.Y. Tax Law §606(c)). (New York state AGI is based on federal AGI with modifications at N.Y. Tax Law §612(b).) New York City also allows a credit against its personal income tax for care of children under age 4 of taxpayers with an AGI up to $30,000. And, unlike the federal credit, the New York state and New York City credits are refundable.
The cap on allowable expenses was last increased for tax years beginning after 2002 by the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (along with the top applicable percentage). If it had been adjusted for inflation since 2002, the $3,000 expense limit for one child would be $4,013 in 2016, according to the U.S. Department of Labor's Bureau of Labor Statistics.
EMPLOYER-PROVIDED CHILD CARE CREDIT
A tax provision that can help employers provide child care for their employees is the Sec. 45F employer-provided child care credit. A general business credit, it is equal to 25% of qualified child care expenditures, plus 10% of "qualified child care resources and referral expenditures," with the resulting credit capped at $150,000 per tax year. Qualified child care expenditures are not only operating costs of a qualified child care facility of the taxpayer or under contract with the taxpayer but also amounts paid or incurred to acquire, construct, rehabilitate, or expand property used as part of a care facility of the taxpayer, not including land or any part of the principal residence of the taxpayer or an employee of the taxpayer (Sec. 45F(c)(1)(A)). Qualified expenditures may not exceed the fair market value of care provided.
Qualified child care resource and referral expenditures are amounts paid or incurred under a contract to provide child care resource and referral services to an employee of the taxpayer (Sec. 45F(c)(3)).
Enrollment in the facility must be open to employees of the taxpayer, and its use (as well as provision of resource and referral services) must not discriminate in favor of highly compensated employees (as defined under Sec. 414(q)). If the facility is the taxpayer's principal trade or business, at least 30% of its enrollment must be dependents of employees of the taxpayer (Sec. 45F(c)(2)(B)).
However, it appears most employers don't provide child care, or, if they do, they haven't taken advantage of this tax incentive. According to Table 21 of the 2013 IRS Corporation Income Tax Returns report, the most recent available, the aggregate corporate Sec. 45F credit amount for 2013 for active corporations (excluding S corporations, real estate investment trusts, and regulated investment companies) was an estimated $16.7 million, making it 0.02% of the aggregate tentative general business credit for the year.
One complication for both employers and employees is having to include the value of the care provided as taxable compensation to the employee. The care would not be considered a working condition fringe benefit since, if the employee paid for the care, it would generally not be allowable as a deduction under Sec. 162 or 167 (Sec. 132(d)). Conceivably, an employer in the trade or business of providing child care could provide care to children of its employees who perform substantial services in the same line of the employer's business, as a no-additional-cost service fringe under Sec. 132(a)(1). However, for determining whether the employer incurs additional costs to provide the service, Regs. Sec. 1.132-2(a)(5) prescribes special rules for "labor-intensive services"—surely an apt description of child care if there ever was one.
A few states also offer tax incentives for employer-provided child care. For example, Illinois allows a modified, lesser version of the federal credit (Ill. Comp. Stat. 5/210.5(a)). Ohio provides an enterprise zone credit to businesses that reimburse certain new employees for all or part of the cost of child day care services (Ohio Rev. Code §5709.65(A)(4)).
DIMINISHING RETURNS?
As things stand, high child care costs can make wage earning for many parents seem like an exercise in the law of diminishing returns. Tax credits, especially in states offering more generous credits, may make the economics more feasible for lower-income taxpayers and provide at least a slight offset for middle-income workers. Employer-provided child care could be a better remedy, but statistics for the federal business credit suggest it is not widely offered. Going forward, fresh proposals could gain traction, but in the meantime, working parents can at least seek out the best options for high-quality care and make sure they claim all available tax benefits.
Paul Bonner is a JofA senior editor. To comment on this article or to suggest an idea for another article, contact him at pbonner@aicpa.org or 919-402-4434.
