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Case Study

American Rescue Plan Act: makes the Child and Dependent Care Credit much more lucrative

Date: April 27, 2021.

Type of Clients: Families.

Situation: The new American Rescue Plan Act of 2021 (ARPA) makes major, but temporary, changes to the rules for the child and dependent care credit.

Deadline: The changes only affect a client's 2021 tax year, so there's no immediate compliance impact. However, the favorable changes might affect how much a client is willing to spend on child and dependent care expenses between now and December 31.

Tax Action Required: Read this release for an analysis of the ARPA changes and be ready to advise clients accordingly. As stated, the changes will affect 2021 returns that are prepared next year.

Background

The new ARPA makes major, but temporary, changes to the federal income tax Child and Dependent Care Credit (CDCC). Except for high-income taxpayers, the changes are all favorable. To understand these changes, let's start by reviewing the basics.

CDCC basics

If you have one or more qualifying individuals (usually kids) under your wing, you're potentially eligible for the CDCC ( IRC Sec. 21 ). The credit covers eligible expenses that you pay to care for one or more qualifying individuals so you can work, or so both you and your spouse can work if you're married. If you're married, you generally must file a joint Form 1040 for the tax year in question to claim the CDCC. However, some married-but-separated taxpayers are exempted from the joint-filing requirement. [See IRC Sec. 21(e).]

Qualifying individuals are defined as your under-age-13 child, stepchild, foster child, brother or sister, step-sibling, or a descendant of any of these individuals. The individual must live in your home for over half the year and must not provide over half of his or her own support. A disabled spouse or dependent who lives with you for over half the year also can be a qualifying individual. [See IRC Sec. 21(b)(1) .]

Eligible expenses include payments to a daycare center, nanny, or nursery school. Costs for overnight camp don't qualify. K-12 costs also don't qualify because those are considered education expenses rather than care expenses. However, costs for before-school and after-school programs can qualify. In addition, costs of domestic help can qualify, as long as at least part of the cost goes towards care of a qualifying individual.

Expense Amount Limitation. Eligible expenses cannot exceed the income you earn (or your spouse earns if you're married) from work, self-employment, and certain disability and retirement benefits. If you're married, you generally must use the income earned by the lower-earning spouse for this limitation. So, under the general limitation rule, if one spouse has no earned income, you cannot claim the CDCC.

However, if your spouse has no earned income and is a full-time student or disabled, he or she is deemed to have imaginary monthly earnings of $250 if you have one qualifying individual, or $500 if you have two or more qualifying individuals. Under this exception, you can potentially claim the CDCC even though your spouse does not actually work and has no actual earnings.

Credit Amount Limitations. Except for tax year 2021, your eligible expenses cannot exceed $3,000 for the care of one qualifying individual or $6,000 for the care of two or more qualifying individuals. The maximum credit equals 35% of eligible expenses if your Adjusted Gross Income (AGI) is $15,000 or less. So, for folks with very modest incomes, the maximum credit is $1,050 ($3,000 x 35%) for one qualifying individual or $2,100 ($6,000 x 35%) for two or more.

Except for tax year 2021, your credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI in excess of $15,000 until the rate bottoms out at 20%. So, the credit rate is reduced to the minimum 20% if your AGI exceeds $43,000. The maximum credit for folks in this income category is $600 ($3,000 x 20%) for one qualifying individual or $1,200 ($6,000 x 20%) for two or more.

Note: Except for tax year 2021, the CDCC is nonrefundable. That means you can only use it to offset your federal income tax liability. If you have no liability, you get no credit.

Taxpayer-friendly changes for 2021

For your client's 2021 tax year only, the ARPA makes the temporary changes summarized below. These temporary changes are found in IRC Sec. 21(g), as amended by ARPA Sec. 9631(a).

Credit Is Potentially Refundable. For 2021, the allowable CDCC is refundable if your main residence is in the U.S. for more than half the year. For joint-filing married couples, either spouse can meet this requirement.

Credit Will Be Much Bigger for Many Families. For 2021, the dollar limits on the amount of eligible expenses for calculating the CDCC are increased to $8,000 if you have one qualifying individual (up from $3,000) or $16,000 if you have two or more (up from $6,000).

For 2021, the maximum credit rate is increased to 50% (up from 35%). However, the credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI in excess of $125,000. So, the rate is reduced to 20% if your AGI exceeds $183,000. Under the "regular" rules for tax years before and after 2021, the AGI threshold for the credit rate reduction rule is only $15,000, and the rate is reduced to 20% if your AGI exceeds $43,000.

So, for 2021 the maximum CDCC if you have AGI of $125,000 or less is $4,000 for one qualifying individual ($8,000 x 50%) or $8,000 for two or more qualifying individuals ($16,000 x 50%). Under the "regular" rules for tax years before and after 2021, the maximum credit amounts are only $1,050 and $2,100, respectively.

For 2021, the maximum CDCC if you have AGI of more than $183,000 is $1,600 for one qualifying individual ($8,000 x 20%) or $3,200 for two or more qualifying individuals ($16,000 x 20%). Under the "regular" rules for tax years before and after 2021, the maximum credit amounts when the credit rate is reduced to 20% are only $600 and $1,200, respectively.

Example 1: Your client, Sofia, is unmarried. In 2021, she pays $16,000 of eligible expenses for care of her two qualifying children so she can work. Sofia can count the entire $16,000 in calculating her allowable CDCC for 2021.

Say Sofia's 2021 AGI is $132,000. Her credit rate is reduced from 50% to 46% due to $7,000 of excess AGI ($7,000 / $2,000 = 3.5, which is rounded up to four percentage points). So, Sofia's allowable CDCC is $7,360 ($16,000 x 46%). That certainly helps!

Credit Rate Is Further Reduced or Eliminated for High-income Taxpayers. For 2021, the credit rate is 20% if your AGI is between $183,001 and $400,000. Once your AGI exceeds $400,000, a second credit rate reduction rule kicks in. Your rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI in excess of $400,000. [See IRC Sec. 21(g)(4), as amended by ARPA Sec. 9631(a) .] So, the rate is reduced to 0% if your AGI exceeds $438,000.

Example 2: Same facts as Example 1, except this time Sofia's 2021 AGI is $420,000. Her credit rate is reduced from 20% to 10% due to $20,000 of excess AGI ($20,000 / $2,000 = 10 percentage points). So, Sofia's allowable CDCC is only $1,600 ($16,000 x 10%). Better than nothing!

Example 3: Now let's say that Sofia's 2021 AGI is $439,000. Her credit rate is reduced from 20% to 0% due to $39,000 of excess AGI ($39,000 / $2,000 = 19.5, which is rounded up to 20 percentage points). So, the CDCC is completely phased out due to Sofia's high income. Rats! Liberalized CDCC versus Dependent Care Flexible Spending Account Deal for 2021

For tax year 2021, the ARPA also increases the maximum amount you can contribute to an employer-sponsored dependent care Flexible Spending Account (FSA) from $5,000 to $10,500 or from $2,500 to $5,250 if you use married-filing-separate status [ IRC Sec. 129(a)(2), as amended by ARPA Sec. 9632]. Your contribution to a dependent care FSA reduces your taxable salary for federal income and payroll tax purposes (and usually for state income tax purposes too). Then, you can take tax-free withdrawals to reimburse yourself for eligible dependent care expenses.

Depending on your specific circumstances, you can have dependent care expenses that are eligible for both the CDCC and for tax-free dependent care FSA withdrawals. If you fall into this category, you could contribute some amount to a dependent care FSA, collect the resulting income and payroll tax savings, and take tax-free withdrawals to reimburse yourself for eligible expenses. You could then claim the CDCC for "excess" eligible expenses under the CDCC rules, subject to the applicable CDCC limit on eligible expenses.

Is your client better off forgetting about the FSA option and just claiming the CDCC? It depends on the client's income and other factors. You have to run the numbers to find out.

Conclusion

At first glance, the ARPA changes to the CDCC rules for the 2021 tax year might seem pretty simple. On second glance, maybe not-simple is not in the cards these days. However, you may have clients who qualify for both the more-generous CDCC for 2021 and the more-generous child tax credit for 2021. If so, they could be in line for an unexpected windfall. Give them the good news.

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