Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 21.—Expenses for Household and Dependent Care Services Necessary for Gainful Employment

26 CFR 1.21–1: Expenses for household and depen- dent care services necessary for gainful employment.

T.D. 9354

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Expenses for Household and Dependent Care Services Necessary for Gainful Employment

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations regarding the credit for expenses for household and dependent care services necessary for gainful employment. The regulations reflect statutory amendments under the Deficit Reduction Act of 1984, the Tax Reform Act of 1986, the Omnibus Budget Reconciliation Act of 1987, the Family Support Act of 1988, the Small Business Job Protection Act of 1996, the Economic Growth and Tax Relief Reconciliation Act of 2001, the Job Creation and Worker Assistance Act of 2002, the Working Families Tax Relief Act of 2004, and the Gulf Opportunity Zone Act of 2005. The regulations affect taxpayers who claim the credit for expenses for household and dependent care services, and dependent care providers.

DATES: Effective Date: These regulations are effective August 14, 2007.

Applicability Date: For date of applicability, see §1.21–1(l).

FOR FURTHER INFORMATION CONTACT: Amy Pfalzgraf, (202) 622–4960 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains final amendments to the Income Tax Regulations, 26 CFR part 1, relating to the credit for expenses for household and dependent care services necessary for gainful employment (the credit) under section 21 of the Internal Revenue Code (Code).

On May 24, 2006, a notice of proposed rulemaking (REG–139059–02, 2006–1 C.B. 1052) regarding the credit was published in the Federal Register (71 FR 29847). Written and electronic comments responding to the notice of proposed rulemaking were received. No public hearing was requested or held. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision. The comments and revisions are discussed in the preamble.

Explanation of Provisions and Summary of Comments

1. Time of Payment and Performance of Services

Section 21(b)(2) provides, in part, that employment-related expenses are amounts paid to enable a taxpayer to be gainfully employed for a period for which there are one or more qualifying individuals with respect to a taxpayer. The proposed regulations provide that a taxpayer may take expenses into account under section 21 only in the later of the taxable year the services are performed or the taxable year the expenses are paid. The proposed regulations also provide that the status of an individual as a qualifying individual is determined on a daily basis, that a taxpayer may take into account only expenses that qualify before a disqualifying event, such as a child turning 13, and that the requirements of section 21 and the regulations are applied at the time the services are performed, regardless of when the expenses are paid.

A verbal comment inquired whether, to be creditable, expenses must be paid and services must be performed before a disqualifying event.

The determination of whether expenses qualify as employment-related expenses, including whether an individual is a qualifying individual, can be made only at the time services are performed. Only expenses for the care of a qualifying individual that are for the purpose of enabling the taxpayer to be gainfully employed qualify for the credit. Therefore, services must be performed prior to a disqualifying event and at a time when the purpose is to enable the taxpayer to be gainfully employed. For purposes of determining whether expenses are employment-related expenses, the time of payment is irrelevant, although payment must be made before the credit is claimed. The final regulations provide examples to illustrate these rules.

2. Care of Qualifying Individual and Household Services

Under section 21(b)(2)(A), expenses are employment-related only if the expenses are primarily for household services or for the care of a qualifying individual. The proposed regulations provide that the primary purpose of expenses for the care of a qualifying individual must be to assure that individual’s well-being and protection.

a. Costs for education

The proposed regulations provide that expenses for a child in nursery school, preschool, or similar programs for children below the kindergarten level are for the care of a qualifying individual and may be employment-related expenses. Expenses for a child in kindergarten or a higher grade are not for care and therefore, are not employment-related expenses. However, expenses for before- or after-school care of a child in kindergarten or a higher grade may be for care.

Commentators noted that some public school systems offer only half-day kindergarten, and that some parents send their children to private kindergarten because it offers a full-day program. Under the proposed regulations, a parent whose child attends a half-day kindergarten may claim the credit for the cost of an afternoon after-school program. However, a parent

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determining which expenses are for care and whether lodging and meals could be considered incidental and therefore, part of care. The commentator suggested that meals and lodging at a boarding school are incidental to and inseparably a part of the care provided.

The final regulations do not adopt this comment. The example and the regulations clearly distinguish care from food, lodging, and education provided by a boarding school, which are not for the care of a qualifying individual, or incidental to or inseparably a part of the care provided.

e. Expenses for room and board of a caregiver

The proposed regulations provide that the additional cost of providing room and board for a caregiver over usual household expenses may be an employment-related expense. This rule is based on Rev. Rul. 76–288, 1976–2 C.B. 83, which holds that under the predecessor to section 21, a taxpayer furnishing meals and lodging to a housekeeper who provides care may deduct the allocable expenses attributable to the housekeeper that are in addition to normal household expenses. The ruling provides an example allowing a taxpayer to take into account the additional cost of rent for an apartment with an additional bedroom to accommodate the housekeeper and additional utilities attributable to the housekeeper.

The proposed regulations provide that the general substantiation rules of section 6001 and the implementing regulations apply to taxpayers claiming the credit. A commentator stated that the regulations should clarify whether an increase in utilities (such as electric, water, and gas) may be employment-related expenses and what constitutes acceptable proof of costs.

The final regulations adopt the first of these comments and include an example similar to the example in Rev. Rul. 76–288. However, the final regulations do not provide special substantiation rules for these costs. These rules encompass substantiation of allocations by taxpayers claiming the credit with respect to the additional cost of providing room and board for a caregiver.

whose child attends a full-day private kindergarten may not claim the credit for the cost of services performed in the afternoon, because the services are part of the kindergarten program and not after-school care. Commentators suggested that taxpayers who send their children to full-day private kindergarten should be allowed some apportionment of expenses for the afternoon portion of the kindergarten.

The final regulations do not adopt this comment. Kindergarten programs are primarily educational. See, for example, section 62(d)(1) (definitions of eligible educator and school) and section 530(b)(3)(B) (definition of school). Although nursery school and other programs below the level of kindergarten also may include significant educational elements, for administrative convenience the proposed regulations treat these programs as for care. The final regulations retain these rules for greater ease of administration.

A commentator suggested that amounts paid for sending a child to a private school by a taxpayer living overseas should be an employment-related expense if public education is not available. The final regulations do not adopt this comment. Employment-related expenses must be for the care of a qualifying individual and may not be for other services such as education.

b. Specialty day camps

The proposed regulations provide that the full amount paid for a day camp or similar program may be for the care of a qualifying individual although the camp specializes in a particular activity, such as soccer or computers. For administrative convenience, no allocation is required in this situation between the cost of care and amounts paid for learning a specialized skill.

A verbal comment requested that the regulations clarify that summer school is not day camp and that the cost of summer school is not creditable. Another commentator commended the proposed regulations for allowing the credit for the cost of “education day camps” that focus on reading, math, writing, and study skills.

The final regulations retain the rule that no allocation is required for the cost of a specialty day camp, but clarify that expenses for summer school and tutoring programs are not creditable. Summer

school and tutoring programs are indistinguishable from school and are education, not care. The final regulations provide examples to illustrate these rules.

Section 21(b)(2)(C) provides, in part, that the cost of services performed by a dependent care center are employment-related expenses only if the dependent care center complies with the applicable laws of the state and local government. A commentator requested that the regulations clarify whether a day camp is a dependent care center and must comply with this requirement. The final regulations clarify that the requirements of section 21(b)(2)(C) apply to day camps that meet the definition of dependent care center in section 21(b)(2)(D).

c. Sick child centers

A commentator asserted that sick child centers that provide care for children with illnesses who cannot be cared for by the primary care provider primarily provide dependent care and that any medical care provided is incidental. The commentator suggested that these costs may be employment-related expenses.

The final regulations do not adopt this comment. A taxpayer may take an amount into account as either an employment-related expense under section 21 or an expense for medical care under section 213 (but not both). See section 213(e). Whether the care provided at a sick child center assures a child’s well-being and protection or constitutes medical care is a factual matter that must be determined on a case-by-case basis.

d. Boarding school

The proposed regulations provide that an allocation must be made between expenses for the care of a qualifying individual and expenses for other goods or services, unless the other goods or services are incidental to and inseparably a part of the care. Specifically, amounts paid for food, lodging, clothing, or education are not for the care of a qualifying individual. The proposed regulations provide an example requiring a taxpayer to allocate the costs of a boarding school between care and education, meals, and housing.

A commentator stated that the example does not provide clear guidance for

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as these rules would be inconsistent with the statutory requirement that expenses are employment-related expenses only if paid to enable the taxpayer to be gainfully employed.

4. Limitations on Amount Creditable

a. Dollar limit

Commentators suggested that the dollar limit on employment-related expenses should be increased from $3,000 for one qualifying child and $6,000 for two or more qualifying children, to $5,000 for each qualifying child. The final regulations do not adopt these comments as they are inconsistent with the statutory limitations.

b. Student at an educational organization

For purposes of the deemed earned income of a spouse who is a full-time student, section 21(e)(7) and (8) defines student as an individual who, during each of 5 calendar months during the taxable year, is a full-time student at an educational organization described in section 170(b)(1)(A)(ii). Section 170(b)(1)(A)(ii) provides that an educational organization normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.

A commentator suggested that a full-time student in an on-line degree program is a full-time student at an educational organization. The final regulations do not adopt this comment. A degree program offered by an organization that provides instruction exclusively over the internet (as opposed to an organization that provides courses on-line as well as traditional classroom instruction) does not have students in attendance at the place where its educational activities are regularly carried on and is not an educational organization within the meaning of section 170(b)(1)(A)(ii). Accordingly, an individual enrolled in a program provided by an organization that offers only on-line instruction is not a student for purposes of the deemed earned income rule. However, an individual who takes on-line courses at an organization that has traditional classroom instruction as well as on-line

f. Cost of overnight camp

A commentator suggested that the credit should be allowed for a portion of the cost of overnight camp allocable to time when parents work. The final regulations do not adopt this comment. Under section 21(b)(2), the cost of overnight camp is not an employment-related expense.

3. Expenses Enabling a Taxpayer to Be Gainfully Employed

Under section 21(b)(2)(A), expenses are employment-related only if the taxpayer’s purpose in obtaining the services is to enable the taxpayer to be gainfully employed. The expenses must be for periods during which the taxpayer is gainfully employed or is in active search of gainful employment.

a. Short, temporary absence exception

The proposed regulations provide that a taxpayer must allocate the cost of care on a daily basis if expenses are paid for a period during only part of which the taxpayer is employed or in active search of gainful employment. The proposed regulations provide an exception to the allocation requirement for a short, temporary absence from work for a taxpayer paying for dependent care on a weekly, monthly, or annual basis. Whether an absence is a short, temporary absence is determined based on all the facts and circumstances. The proposed regulations requested comments on an appropriate period to constitute a temporary absence safe harbor.

A commentator suggested that the exception for short, temporary absences should not be limited to taxpayers who pay employment-related expenses on a weekly, monthly, or annual basis. The commentator stated that regardless of payment schedule, taxpayers who take their children out of care due to a short illness or vacation typically must pay for that care when absent or risk losing it.

The final regulations adopt this comment and delete the provision that the temporary absence exception applies only to taxpayers who must pay for care on a weekly, monthly, or annual basis. The final regulations clarify, however, that only those costs that the taxpayer is required to pay during the absence qualify for the

exception. The final regulations provide examples to illustrate these rules.

A commentator suggested that a length of absence that is less than a taxpayer’s pay period should be deemed to be a short, temporary absence for that taxpayer, up to a maximum of 2 weeks. For example, the maximum short, temporary absence period of a taxpayer with a 1-week pay period would be 4 days. The final regulations do not adopt this comment, which would result in disparate treatment of taxpayers based on length of pay period.

A commentator suggested that the final regulations should adopt 12 weeks as a temporary absence safe harbor. The commentator based this suggestion on the Family Medical Leave Act (FMLA), which guarantees workers a maximum of 12 weeks of unpaid leave for the birth or adoption of a child and other purposes. The final regulations do not adopt this comment. Different policies underlie the FMLA and the dependent care credit. An absence of 12 weeks is not a short, temporary absence for purposes of claiming the credit.

The final regulations include a safe harbor that treats an absence of no more than 2 consecutive calendar weeks as a short, temporary absence, and modify the examples to illustrate this rule.

b. Other costs

A commentator suggested that the final regulations should clarify that expenses may be paid to enable a taxpayer to be gainfully employed and may be employment-related expenses if one parent works during the day and the other parent works at night, and the expenses are for care while one parent is working and the other is sleeping. Another commentator suggested that the cost of overnight care (not overnight camp) should be an employment-related expense for a taxpayer who works at night. The final regulations include examples illustrating that expenses may be employment-related expenses in these situations.

Commentators suggested that the cost of care should be treated as an employment-related expense for any period that a taxpayer is on short- or long-term disability, leave under the FMLA, paid medical leave, or paid maternity leave. The final regulations do not adopt these comments

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Section 1.21–4 also issued under 26 U.S.C. 21(f) * * *

§1.21–1 [Redesignated as §1.15–1]

Par. 2. Section 1.21–1 is redesignated §1.15–1.

Par. 3. New §§1.21–1, 1.21–2, 1.21–3, and 1.21–4 are added to read as follows:

§1.21–1 Expenses for household and dependent care services necessary for gainful employment .

(a) In general . (1) Section 21 allows a credit to a taxpayer against the tax imposed by chapter 1 for employment-related expenses for household services and care (as defined in paragraph (d) of this section) of a qualifying individual (as defined in paragraph (b) of this section). The purpose of the expenses must be to enable the taxpayer to be gainfully employed (as defined in paragraph (c) of this section). For taxable years beginning after December 31, 2004, a qualifying individual must have the same principal place of abode (as defined in paragraph (g) of this section) as the taxpayer for more than one-half of the taxable year. For taxable years beginning before January 1, 2005, the taxpayer must maintain a household (as defined in paragraph (h) of this section) that includes one or more qualifying individuals.

(2) The amount of the credit is equal to the applicable percentage of the employment-related expenses that may be taken into account by the taxpayer during the taxable year (but subject to the limits prescribed in §1.21–2). Applicable percent- age means 35 percent reduced by 1 percentage point for each $2,000 (or fraction thereof) by which the taxpayer’s adjusted gross income for the taxable year exceeds $15,000, but not less than 20 percent. For example, if a taxpayer’s adjusted gross income is $31,850, the applicable percentage is 26 percent.

(3) Expenses may be taken as a credit under section 21, regardless of the taxpayer’s method of accounting, only in the taxable year the services are performed or the taxable year the expenses are paid, whichever is later.

(4) The requirements of section 21 and §§1.21–1 through 1.21–4 are applied at the time the services are performed, regardless of when the expenses are paid.

courses, and that otherwise meets the definition of educational organization under section 170(b)(1)(A)(ii), may be a student for purposes of the deemed earned income rule.

The final regulations delete the crossreference in the proposed regulations to the definition of student in section 152(f)(2) (for taxable years beginning after December 31, 2004) or section 151(c)(4) (for taxable years beginning before January 1, 2005), and the regulations thereunder, as that term is defined in section 21(e)(7) and (8) and these regulations.

5. Substantiation

The proposed regulations provide that taxpayers claiming a credit for employment-related expenses must maintain adequate records or other sufficient evidence to substantiate the expenses in accordance with section 6001 and the regulations thereunder.

A commentator suggested that dependent care assistance program administrators should be able to rely on the representations of plan participants, without additional documentation, to establish that indirect expenses are required and are subject to forfeiture, the proper expense allocation for part-time employees, and whether expenses are paid on a weekly or monthly basis. The final regulations do not adopt this comment as these situations do not present unusual substantiation issues.

6. Conforming Changes

The final regulations incorporate several changes to conform to amendments to the statute. The final regulations reflect that the special dependency rule of section 21(e)(5) applies to children of parents who live apart at all times during the last 6 months of the calendar year as well as to the children of separated or divorced parents. The final regulations reflect the changes made to the definitions of qualify- ing individual and custodial parent by the Gulf Opportunity Zone Act of 2005 (Public Law No. 109–135, 119 Stat. 2577). Finally, the final regulations clarify that, for taxable years beginning after December 31, 2004, costs for care outside the taxpayer’s household of a qualifying individual who is a dependent or spouse incapable of self-care who regularly spends at least 8

hours each day in the taxpayer’s household may continue to qualify for the credit.

7. Effective Date

The final regulations apply to taxable years ending after August 14, 2007.

Effect on Other Documents

Rev. Rul. 76–278, 1976–2 C.B. 84, and Rev. Rul. 76–288, 1976–2 C.B. 83, are obsoleted as of August 14, 2007.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. Section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking that preceded these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Amy Pfalzgraf of the Office of Associate Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and Department of the Treasury participated in their development.

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Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows: