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July 1999

It seems ironic that one of California's most worthwhile tax benefits is also apparently the least used.

In 1988, then-state Senator Gary K. Hart - now California's secretary for education - authored legislation that provides California businesses with a credit for making contributions to a qualified child care plan for their California employees' dependents. Mr. Hart's legislation also created a $50,000-per-year maximum credit for employers who pay or incur costs for the start-up expenses of establishing a child care program or constructing a child care facility in California, as well as costs for child care information and referral services. The facility is to be used primarily by the employees' children, or by the children of the tenant's employees.

This article's main focus is on the employer child care contribution credit, but the employer child care program credit is of equal importance and provides a valuable tax benefit. The two credits were scheduled to expire in 1997, but in 1998, the Legislature extended both credits through the year 2002. There are current legislative efforts to increase the credit amounts and to make them permanent (SB 549, Ortiz and Rainey, and AB 401, Strickland, for example), although they have not made much headway through the legislative process.

Statistics from the Franchise Tax Board show that 2,430 taxpayers claimed a total of $2.8 million in employer child care contribution credits in 1997. Of these taxpayers, 56 were corporations that claimed $1.4 million of the credit. In the same year, 736 taxpayers claimed the employer child care program credit that totaled $2.9 million. Of these taxpayers, 166 were corporations that claimed $2.44 million of the credit. These numbers seem ridiculously small in comparison to the hundreds of thousands of businesses that file returns every year and could probably qualify to claim one or both of these credits.

Benefits
The best way to fund a child care plan is to offset the cost with the tax benefits that are allowed under both federal and state tax laws. Benefits for which businesses may qualify by establishing a child care contribution plan include:

• A California tax credit of up to $360 per employee's dependent (including a self-employed individual's own dependents) who is under the age of 12, if certain requirements are met;
• A California deduction for the expenses in excess of the employer child care contribution credit (except for a self-employed individual's own child care expenses) if otherwise qualified; and
• A federal deduction for the full amount of expenses if otherwise qualified (except for a self-employed individual's own child care expenses).

Additional benefits may include:

• Lower self-employment taxes, payroll taxes, workers' compensation and pension costs;
• Improved employee morale and attendance;
• Greater productivity, fewer phone calls and lost time, and
• Attracting and retaining qualified employees.

And finally:

• Self-employed taxpayers with dependents under age 13, may be able to use the full amount of the expenses - up to $2,400 for each ($4,800 maximum) of their own children - for the federal child and dependent care expenses credit. This credit can range from $480 to $720 per dependent (up to two dependents).
• Employees' wages excluded through salary reduction under a cafeteria plan or a dependent care assistance program (DCAP) may qualify for the employer child care contribution credit and employees can exclude up to $5,000 per year in child care benefits from wages (more about this later). For cafeteria plans and DCAPs, employers may deduct child care expenses on their federal returns and expenses in excess of the California credits on California returns.

For California, it is not necessary to provide the names, addresses and federal identification numbers of the plan providers, although I suggest getting this information in case the employer is required to file Form(s) 1099.

In most cases, employers are not required to file federal Form 5500 for a child care plan.

Employees benefit from a child care contribution plan because they can acquire stable, reliable care for their children at a reduced cost; they will have fewer reasons to change jobs, and child care benefits are not subject to income and employment taxes.

Qualifying
The amount of the employer child care contribution credit equals 30 percent of the cost that an employer pays or incurs for contributions made directly to a qualified care plan on behalf of its California employees' dependents under the age of 12. The amount of the credit cannot exceed $360 per dependent in any taxable or income year. Qualified care plan includes California on-site and center-based services, in-home and home-provider care and dependent care specialized centers. Facilities must be licensed when required by state law.

Two or more employers who share in the costs eligible for the credit may claim the credit in proportion to their respective share of the costs paid or incurred. The credit is not available if the employee's dependent is in the care of a person who qualifies as a dependent or is a son, stepson, daughter, stepdaughter of that employee and is under the age of 19 at the close of the taxable or income year. If the duration of an employee's child care is less than 42 weeks, an employer with a child care contribution plan must reduce the amount of the credit by prorating the credit using the ratio of the number of weeks of care received divided by 42 weeks. Any unused credits that exceed net tax may be carried forward and used until exhausted.

No deduction may be claimed for that portion of expenses paid or incurred that is equal to the amount of credit allowed. If the credit is claimed for contributions for care at a facility that is owned by the employer, the basis of the facility must be reduced by the amount of the credit. There are also special limitations if an employer makes contributions to a qualified care plan and collects fees from parents to support child care facilities that the employer owns and operate. Finally, like most California credits, the employer child care contribution credit may not reduce regular tax below tentative minimum tax.

Let's Talk DCAPs
One common excuse that I hear from businesses is that they do not need to establish a child care contribution plan because they already offer their employees a cafeteria plan or a DCAP. But did you know that a business can use an employee's DCAP money to claim the employer child care contribution credit?

Over the past decade, the Legislature has tweaked and extended the employer child care contribution credit. In 1994, the Legislature made several changes to the credit that apply for years beginning on or after January 1, 1995. The 1994 legislation reduced the credit from 50 percent of qualified costs to 30 percent; reduced the maximum amount per dependent from $600 to $360; and changed the ages of qualified dependents from under 15 years to under 12 years. But the most significant change in that legislation was the repeal of the option of reimbursing employees for their child care expenses, and making it an exclusive requirement for employers to make contributions directly to qualified care plans.

This particular change of requiring direct payments was the result of an attempt by Franchise Tax Board staff to disqualify businesses that had DCAPs from claiming the credit. But remember the timing of the FTB's revenue-raising proposal of disqualifying businesses with DCAPs from claiming the credit: It was 1994, when California was still sunk in a recession, and the state needed cash. But the FTB's idea - an idea that became law - backfired.

 On April 23, 1993, FTB staff released Legal Ruling 93-1, and held that, for purposes of computing the credit, contributions included amounts designated by employees in a DCAP. After the 1994 legislation was enacted, the FTB took a closer look at the direct payment requirement. The FTB realized that businesses with DCAPs could still use the employee's money to claim the credit, so on December 29, 1994, the FTB superseded and replaced Legal Ruling 93-1 with FTB Notice 94-9. FTB Notice 94-9 states that for years beginning on or after January 1, 1995, amounts paid directly by employers to qualified care plans "continue to qualify for the credit, even when such payments are excluded under a salary reduction agreement ..." The notice also states that "amounts designated by employees as salary reduction agreements no longer qualify as 'contributions' for purposes of computing the credits where the employer requires the employee to seek reimbursement from the employer (or the plan) after the expenses are incurred ..."

The direct payment requirement created some reporting annoyances, including:

• Employers that contribute $600 or more to any one child care provider must file Forms 1099 with the government and child care providers; and
• According to the Internal Revenue Service, employees who have in-home child care providers, i.e., household employees or nannies, must pay employment taxes and file Forms W-2 for all wages, including amounts paid directly to the household employee by the parent's employer. This means that an in-home care provider will have some of the same earnings reported by both the parent and the parent's employer (IRS Information Letter to Spidell Publishing, Inc., dated April 16, 1996). In contrast, the Employment Development Department's position is that only the parent is the in-home care provider's employer (EDD Letter to Gina Rodriquez of Spidell Publishing, dated January 9, 1996). This results in some creative tax return preparation by affected child care providers.

Although the FTB has been disinclined to support legislation that would fix these reporting problems, most of the complications relate to in-home care providers. Fortunately, most employees use outside day-care services, so employers and employees with these problems are in the minority.

Examples
As shown in the examples below, an employer child care contribution plan virtually pays for itself. But the intrinsic benefits - happy, loyal employees - may be worth more than the monetary benefits.