Businesses are allowed to deduct the expenses they incur for earning their business income on which they pay taxes. On the same lines, in 1976, the Child and Dependent Care Tax Credit (CDCTC) was established to allow working parents to offset the costs they incur for taking care of their child or dependent. A tax credit, you may be aware, is an amount you deduct from the taxes you have to pay, unlike deductions that are subtracted from your income. You can claim this credit based on the expenses you incur for your child or dependent, by filling up Form 2441.
A word of caution here: there is another tax credit called the Child Tax Credit (CTC) which provides tax relief for parents, whether working or not and who have qualifying children under the age of 17. The CDCTC, on the other hand, can be claimed only by those parents who have to pay for the care of their children or dependents so that they can work or look for work.
What is new for the tax year 2021?
The American Rescue Plan Act of 2021 has substantially increased the qualifying employment-related expenses incurred for child and dependent care from $3,000 to $8,000 for one qualifying person and from $6,000 to $16,000 for two or more than two qualifying persons. More importantly, the tax credit has been made refundable for 2021. What this means is that if your expenses exceed the tax you have paid, you will be entitled to claim the difference. A tax credit is non-refundable if the qualifying expense can only reduce your tax to zero. The maximum tax credit you can claim in 2021 has also been increased to 50% of your expenses i.e., $4,000 for one qualifying person and $8,000 for two or more qualifying persons. This credit percentage of 50% phases out from the adjusted gross income (AGI) level above $125,000 as income rises and gets reduced to zero from the adjusted gross income level above $438,000.Above $125,000, the credit percentage gets reduced by one percent for every $2000 increase in the AGI till $183,000 (Between $183,000 and $400,000 it remains at 21%) and then from $400,000 to $438,000 when it becomes zero. You can figure out the percentage from the 2021 Phase-out Schedule under Instructions for Form 2441.
If you are covered under a dependent care assistance program, the maximum amount that can be excluded from your income by your employer is increased to $10,500 from $5,000. For married employees filing returns separately, the maximum is half that. If the dependent care benefit is provided by your employer under a qualified plan, you can exclude the amount from your income without claiming the CDCTC. You and your spouse must have both earned income and file married jointly to exclude the benefits from your income or claim the credit. You can also claim the credit for the amount, if any, you may have incurred above $10,500 after excluding the deduction from your income. Let’s say you and your spouse have two qualifying children and your expenses for their care exceed $16,000. Your employer provides you with a qualifying dependent care assistance program and therefore you have excluded $10,500 from your income. For claiming the credit, you subtract $10,500 from $16,000 (being the maximum for two and more qualifying children), and on this $5,500 (16,500-10,500) you can claim the CDCTC at 50% if your AGI is below $125,000and the percentage of your AGI is above that amount.
You use Form 2441 (a) if you paid someone to care for your child or another dependent so that you can work or look for work to claim the CDCTC and (b) if you were a beneficiary of any dependent care program for 2021 to figure out the amount you can exclude from your income. You can claim the credit on expenses of 2020 also paid in 2021 provided you did not claim the credit on the maximum qualifying expense in 2020.
For whose expenses you can claim: A qualifying child or children for whom you can claim the credit should be under the age of 13 years. The child can be your own child or adopted or a stepchild or a foster child. There is no age limit if the child is incapacitated. They need to have either a social security number or an income tax identification number and must have lived with you for more than half the tax year. You can also take credit for the expenses incurred for your spouse if she was physically or mentally unable to take care of herself but has stayed with you for more than half the year. You can include any other person who was not capable of changing dresses or cleaning or feeding himself/herself and you have paid expenses for their care for more than half the year.
Who can claim the credit: To qualify for the credit, you and your spouse must work outside the home and therefore have to pay somebody else for taking care of your qualifying person/s. Both of you must have had earned income during the year. However, if one of you is a full-time student or was not able to take care of yourself, you are considered as having earnings. Married couples generally are required to file a joint income tax return unless your filing status is single, head of household, or qualifying widow(er) with a dependent. You should be paying the expenses for the care only to someone who is not your dependent. You will need to provide the name, address, and tax identification number (either social security number or individual taxpayer identification number) of your care provider. If your care provider is an organization, you need to provide their employer identification number in Form 2441. Remember, if you pay someone to come to your house to take care of the qualifying person(s), you may have to pay employment taxes as you may be considered a household employer.
How to calculate the credit
The credit is available only to those who earn an income by way of wages, tips, self-employment income, or any other taxable compensation. You will need to take cognizance of the following limits also.
Earned income limit: The amount of expense you can claim for the credit is restricted to either your income for the year if you are single at the end of the year and have a dependent or the smaller of yours or your spouse’s earnings if considered married at the end of the year. For example, if your income was $12,000 and your spouse’s income was $3,500, the expenses on which you can claim credit would be limited to $3,500 only. If one of you was a student for some months during the year or were unable to take care of yourself, you will still be considered to be earning $250 a month for each child or dependent but limited to $500 for two or more dependents. This is for those months you were a student or unable to take care of yourself and you are filing married jointly. Going by the rule on earned income limit, the lower of either your income or the spouse who is considered earning will be the limit for claiming expenses.
What if you do not have dependents but you are paying for your incapacitated spouse’s care while being a full-time student yourself without having any earned income? Deemed income would be $3,000 (12 x $250) for each of you. But this income can be attributed to only one of you. This means the lower income of one of you is zero and therefore you cannot claim the credit.
The Dollar limit: is the amount of expense announced by the IRS every year. For 2021, as stated earlier, it is $8,000 for one qualifying person and $16,000 for two or more than two qualifying persons.
Your claim for the CDCTC would be based on the lower of the two.
Calculating qualifying expenses
Expenses you incur should be for the purpose of allowing you to either work or look for work and for the care of a qualifying person. For an expense to be considered work-related, it should be exclusively for taking care of the qualifying person so that you can go to work. Paying for a nanny when you go to work would be a work-related expense but paying a babysitter when you go out shopping would not be. If your child is being taken care of in a dependent care center, the entire expenditure would be work-related. But if you work part-time, the expenses would qualify only for those days your child was in the dependent care center when you were actually working. Expenses related to your child attending a pre-school or a nursery school below the level of kindergarten qualify. However, expenses for food, clothing, entertainment, etc. cannot be included. Child support payments are not qualifying expenses.
Incidentally, if you have two qualifying children, and you pay for the care of only one of them, you can still claim expenses up to $16,000 (if filing married jointly).
Amount of credit: You sum up all the work-related expenses after factoring in the earned income or dollar limit and reduce this with any reimbursements you may have received through the qualified dependent care benefits or others. You then look up the percentage applicable to your AGI from the phase-out schedule [50% up to $125,000 and reduced percentages thereafter up to $438,000] and then multiply the amount with that percentage. This will be the amount of credit you are eligible for.
There are a lot of factors to be considered when filing taxes and claiming credit, like determining filing status. For these purposes, it is advised to take the assistance of a CFO consulting service to make the filing and reporting process easier.