Bizarre Taxable Dependent Care

[Snaggletooth]

It is my understanding from the Tax Book (and other sources) that if an employer provides Dependent Care Benefits, this is Tax Free unless it exceeds $5000. Please stop and correct me immediately if I'm wrong and don't waste time reading the rest of this.

Have a hypothetical client, who received $4500 in dependent care benefits. This tells me NONE of this should be included in gross income. Hypothetical client paid out $4100 to babysitting firm. IRS has notified the client, and is maintaining $400 should be included in gross income. If you connect the dots on Form 2441, it confirms the IRS position.

Where have I taken the wrong fork in the road??

[appelman]

Have you completed the back side of the 2440?

You have to do this before completing the front. There can be a few hoops to jump through.

[Snaggletooth]

Connect the Dots

Yes Evan, I have actually filled out the 2441 and as stated in the original post, it confirms what the IRS is saying.

However, $5000 is supposed to be exempt, and jumping through the hoops on the form should not tamper with this.
I have sinned somewhere in my rationale...I think.

Thanks for your response.

[FEDUKE404]

Not automatically tax-free

A local business, with significant employee benefits, provides subsidized on-site day care. (They also once provided some fantastic comprehensive examples of the tax treatment of such.)

IIRC, the employee monthly paid a ridiculously low amount out-of-pocket, and then payroll cranked out the numbers for the actual value received per IRS rules. I think some taxable income was added to wages (for value received and even some tax consideration for "higher" income??), and adjusted numbers were also entered in box 10 of W2??

As for the OP, the general purpose of Form 2441 Part III is to "prove" you spent the funds, which is a different issue from simply being "tax free." Absent proof you spent the DCB amount (shown on W2) on qualifying dependent care, whatever is not used becomes taxable. That sounds as if that is what is occurring here, hence the $400 taxable income.

I'm still unclear whether the issue is with employer-provided day care, a DCB "pre-tax" plan, or perhaps both.

In any case, your tax software should guide you through the maze. If you look carefully (generally in W2 entry area) there likely is a box to check if the day care was at an employer-provided facility. Checking that box will generally activate the "additions" that appear on Form 2441. I think the W2 info gets transferred, and something like "See W-2" automatically appears in Part I of Form 2441 ??? There was also an off-the-wall IRS pub (separate from Form 2441 stuff) with some comprehensive examples.

I wish I could be of more help, but I've not had any dealings with that business for several years. (Also the IRS rules may have changed?) I do recall the magnificent work they did "explaining" everything to their employees. (Somewhere I may have even kept a copy!) FWIW: Their "facts" were more accurate than the tax software we were using at the time....so we had to do some overrides which were handled by "flagged" returns for management.

Good luck!

FE

[Gary2]

It is my understanding from the Tax Book (and other sources) that if an employer provides Dependent Care Benefits, this is Tax Free unless it exceeds $5000. Please stop and correct me immediately if I'm wrong and don't waste time reading the rest of this.

Have a hypothetical client, who received $4500 in dependent care benefits. This tells me NONE of this should be included in gross income. Hypothetical client paid out $4100 to babysitting firm. IRS has notified the client, and is maintaining $400 should be included in gross income. If you connect the dots on Form 2441, it confirms the IRS position.

It's only a Dependent Care Benefit if it's actually used to pay for qualified dependent care. Otherwise every employee, including those with no dependents, would be signing up to pocket their $5,000 tax free.

I haven't checked the employer rules for disbursing funds for a DCB. I know that for an FSA, they're not supposed to release funds without a qualifying receipt, which is why many (if not all) drug stores now print the qualifying amounts. But I suppose that if an employee is using a private babysitter, they may not get a formal receipt, so perhaps the employer is allowed to release the funds regardless, leaving the onus on the employee to prove they were spent for qualifying purposes.

[Snaggletooth]

New 2441

Thanks to all who have responded thus far. I concede even in my original post that the software fills out the 2441 in a manner that taxes the TP for the $400. And then proceeds to wipe out the dependent care credit.

There used to be a line on the 2441 which would stop this from being taxed. Bees Knees commented 3-4 years ago on this, as you took the lesser of two numbers and wiped out his taxability, at least to the extent of $5000. Since then, the form has added a line for benefits paid out of self-employment (which will be zero 99.99999% of the time). Now you take the lesser of three numbers (including the 0) to exempt your benefits. I don't recall a change in the code or regs which prompted this kind of change in format. The "new" line is line 24 on the 2011 version of the 2441.

I am williing to give up and trust the software as soon as someone can tell me WHY my taxpayer is not exempt up to $5000.

[JohnH]

Ron: I think the key point is that the $5,000 is not autpmatically tax exempt. It must actually be spent.

[FEDUKE404]

Explanation

...I am williing to give up and trust the software as soon as someone can tell me WHY my taxpayer is not exempt up to $5000.

**IF** we are talking about an employer dependent care plan (pre-tax concept) with $4500 in box 10 of the W2, and only $4100 was actually "spent" and shown on the Form 2441, then the $400 taxable makes perfectly good sense.

I had a client last year whose child had passed the magic age for dependent care in one tax year, and the parent forgot to advise payroll to halt the adjustments to his paycheck until a couple of months into the next year. So for the "new" year he had several hundred dollars showing in Box 10 of his W2, no (allowable) dependent care payments that could appear on Form 2441, and the income was rightfully ADDED to line 7 of his Form 1040 with the proper annotation ("DCB" I think). This falls into the "use it or lose it" scenario.

As for the point made by Gary2, the actual return of money (for qualifying expenses already paid by the client) depends upon the rules for filing claims. (There is often a third party involved for making such payments.) But it is important to note such "refunds" do not in any way change the underlying tax facts.

**IF** we are talking about employer provided (on-site) dependent care the rules are far more complex, as I mentioned earlier. Your tax software should automatically transfer the relevant numbers and supporting information to both Part I and Part III of the Form 2441. Hopefully the employer is up to speed re the proper preparation of all aspects of the W2 in that scenario.

FE

[Gary2]

Also, once you enter the W-2 Box 10 amount, most software will treat that as fully taxable until you enter the actual expenses (as well as income attributed to taxpayer or spouse being a student). Is it possible you're remembering that you had to do something to exclude the income, but don't remember the limits?

Also, if you look in the TTB, page 11-6, it says that the amount excluded from income is subject to four limits, not three: Earned income (or attributed for students), actual benefit, actual expense, and $5000.

[Davc]

And it must be spent on qualifying providers. There are limitations on paying your relatives.

[RitaB]

I spent five minutes trying to think of a title, and JohnH made a pithy comment

Thanks to all who have responded thus far. I concede even in my original post that the software fills out the 2441 in a manner that taxes the TP for the $400. And then proceeds to wipe out the dependent care credit...
I am williing to give up and trust the software as soon as someone can tell me WHY my taxpayer is not exempt up to $5000.

JohnH is on it, as usual. The employer has deducted $4500 from taxable income. The taxpayer only spent $4100 on child care, so $400 needs to be added back to income. $4100 is exempt from tax. No credit is figured cause, well, the $4100 was pre-tax. Now if the taxpayer had spent $4600, he would get to figure the credit on the $100 that was not pre-tax.

Edit: OK, three others commented while I was working on that answer. Yep, gonna be a productive day.

[FEDUKE404]

Minor clarification needed

JohnH is on it, as usual. The employer has deducted $4500 from taxable income. The taxpayer only spent $4100 on child care, so $400 needs to be added back to income. $4100 is exempt from tax. No credit is figured cause, well, the $4100 was pre-tax. Now if the taxpayer had spent $4600, he would get to figure the credit on the $100 that was not pre-tax.

Edit: OK, three others commented while I was working on that answer. Yep, gonna be a productive day.

Well, if the employee only had one qualifying dependent he could not go from $4600 to $4700....

(Which makes an even stronger case for using an employer dependent care plan for situations with only one qualifying child!)

Don't you just love those IRS rules????

FE

[RitaB]

Oh, the pressure

Well, if the employee only had one qualifying dependent he could not go from $4600 to $4700....

(Which makes an even stronger case for using an employer dependent care plan for situations with only one qualifying child!)

Don't you just love those IRS rules????

FE

Hey, I couldn't even come up with a title, how am I gonna think of important details like that?

[Gary2]

Hey, I couldn't even come up with a title, how am I gonna think of important details like that?

I'm betting you don't even want to hear how MA invokes its magical transformation powers on the dependent care rules, but somewhere along the line, they must have decided that the IRS rules were too simple.

[RitaB]

The state of affairs

I'm betting you don't even want to hear how MA invokes its magical transformation powers on the dependent care rules, but somewhere along the line, they must have decided that the IRS rules were too simple.

Haha, Gary, I believe you! I'd rather deal with IRS than TN Dept of Revenue anyday!