IRS Clarifies Rules For Dependent Care FSAs

Two recent proclamations by the Internal Revenue Service establish further clarity regarding the dependent care assistance programs, or DCAPs, within an employer’s flexible spending account plans.

The rulings were released a few months ago and seek to address lingering concerns about various aspects of the administration of these plans. Although the pronouncements came in the form of “proposed” regulations, employers and plan administrators may begin to use these new guidelines immediately for taxable years ending after the date of the specific ruling.

The July 12, 2006, regulations address overall issues related to the use of debit (or stored value) cards within an FSA program. While the bulk of the language in this regulatory clarification pertains to the health component of FSAs, one element of the guidance specifically focuses on the DCAP:

The IRS has declared definitively that debit cards may be used to pay for dependent care expenses. Before the ruling, there had been considerable debate regarding the appropriateness of this payment mechanism for DCAPs.

However, there is an important stipulation that must be considered before using the card for such expenses: The card may not be used to prepay for dependent care expenses.

So, when using a debit/stored-value system, the payment to a provider must be made after the service has been rendered, not in advance. For example, a participant may be required to pay the first month’s cost for dependent care services with cash and then pay successive payments with the card.

More extensive clarification of DCAP rules appeared in the proposed regulations issued May 12, 2006. This guidance, related to IRS Section Code Section 21, provides a broad set of definitions and rules for the proper administration of the dependent care FSA. The proper implementation of these rules within an employer’s plan maintains the tax-advantaged status of the DCAP and keeps the employee clear of any hidden liabilities when filing personal tax documents each April.

The long-standing debate about the use of DCAPs for expenses related to kindergarten costs has been definitively resolved under this ruling. It is now clear that “kindergarten” is to be considered educational in nature and, as such, is not eligible for payment with funds accumulated in a dependent care FSA. On the other hand, this does not preclude the use of DCAP funds for before-school or after-school programs which are seen to be employment-related as, therefore, eligible for reimbursement with these funds.

Day camps (even those related to an activity such as soccer, computers, music, etc.) are considered eligible expenses under a DCAP. Overnight camps are not afforded the same consideration.

Expenses related to transportation provided by camps, offsite after-school programs, etc. will be considered eligible expenses when reimbursed to the provider.

Wages paid to a dependent care provider are considered eligible for DCAP reimbursement, and so are some expenses whose status has been unclear. These expenses include room and board for the provider, employment taxes (such as FICA and Medicare) paid on behalf of the provider, and expenses incurred in procuring a provider, including application costs and agency fees.