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Overview of Federal and State Child Care Related Tax Credits

The Child Care Law Center - June, 2002

  1. Salary Reduction Dependent Care Assistance Program

    1. General Description, Benefits, and Drawbacks
    2. Example of Employer Savings for 40 Person Company
  2. Information and Referral Services (Federal and State Credits)

    1. General Description, Benefits, and Drawbacks
  3. Employer Supported Child Care Center (In House or Existing) (Federal and State Credits)

    1. General Description, Benefits, and Drawbacks
    2. Examples of General Employer Savings from Child Care and from a 50 Child Center
  4. New Market Tax Credit for Equity Investments in Qualifying Community Development Entities

I. Salary Reduction Dependent Care Assistance Program

General Description

Dependent Care Assistance Programs (DCAPs) are a specialized type of Flexible Spending Account or IRC Section 125 Fringe Benefit Plan. Under a DCAP, employers can provide eligible employees up to $5000 per year in tax-free child care benefits. The program may be offered as an option in a cafeteria plan or independently. The money is set aside from the employee's pre-tax salary and accessed through reimbursement, child care vouchers or care provided in an outside facility or the employers own facility.

Employees do not have to pay federal income, Social Security or Medicare taxes on the money set aside under the DCAP. In California, employees may be eligible for the Dependent Care Credit based on the amount actually spent on child care.

Employers do not have to pay federal unemployment, Social Security, or Medicare taxes on the money set aside under the DCAP. In addition, funds set aside under DCAP are still deductible as paid wages.

Employers in California can also claim a 30% state tax credit on money set aside under the DCAP up to a maximum on $360 per child (not per employee).

Benefits

  • Low administrative/implementation costs
  • Reduction in employer costs through tax benefits

Drawbacks

  • Child care costs often exceed the $5,000 allowed under a DCAP
  • Generally will not provide tax savings to those employees earning less than $25,000 per year
  • Many families will not be able to take advantage of a program that reduces their paycheck and works on a reimbursement basis
  • Will not help in areas where there is a shortage of quality child care programs
  • Employee must use the money set aside by the end of the year or forfeit it (money left over at end of year goes back to employer).

Employer/Plan Requirements

  • The employer must create a separate written plan that meets the requirements of § 129(d) of the Internal Revenue Code
  • The employer must report the amount of dependent care expenses in box 10 of the employee's W-2 form
  • The plan must not discriminate in favor of highly compensated employees. Highly compensated employees are defined in 26 U.S.C. § 414(q) as any employee who:
  • Was a 5% owner during the year or in the preceding year, or
  • Had compensation from the employer in excess of $80,000, and
  • The funds must be used to pay for qualified child care service

Examples of Employer Savings

  • This example is based on the costs and savings of a hypothetical company with 40 employees participating in the program
    • Management Company Fees: annual fee, per employee fee, administrative fees
      • $1,675 in the first year
      • $1,000 for each subsequent year
    • Employer Payroll Tax Savings:
      • $15,300
    • Employer California State Tax Savings
      • $14,400
    • Total Actual Annual Savings
      • $28,025 in the first year
      • $28,700 in each subsequent year
  • It is not necessary for large numbers of employees to participate in the plan in order for companies to realize tax savings. The same employer from the example above would still have a first year savings of $560 and annual savings of $1235 if only 2 employees participated

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II. Information and Referral Services

General Description

Employers can contract with resource and referral services on a per use basis or to create an internal referral network that provides employees with information on child care options in the community. These services often include an education component that informs parents about the characteristics of quality child care. In some cases services provide training and support for providers.

Employers can claim a federal tax credit of 10% and a California state tax credit of 30% of any amount paid under a contract to provide child care resource and referral.

Benefits

  • Low cost to the employer
  • Assists employees with varying child care needs
  • Provides a fast, easy to establish interim solution.

Drawbacks

  • Depends on adequate child care services in the community
  • Does not assist employees in paying for child care.

Employer/Plan Requirements

  • In order to claim the tax credit, resource and referral plans must not discriminate in favor of highly compensated employees as defined by 26 U.S.C. § 414(q).

Tax Benefits Offsetting the Cost of a Referral Service

Under 26 U.S.C. § 45F(a)(2), employers can claim a tax credit of 10% of the amount spent on child care resource and referral services. The total credit allowed for child care expenditures and resource and referral expenditures is $150,000 per year.

Under § 23617 (b)(1)(C) of the California Revenue and Taxation Code, California businesses may also claim a 30% tax credit on contributions of California child care information and referral services for their employees. The total credit allowed under § 23617, which includes resource and referral expenditures and startup costs of creating a child care facility, is $50,000 per year.

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III. Creating an Employer Supported Child Care Center

General Description

There are several options for employers interested in providing on site or near site child care for their employees. The company may manage and operate the center itself or contract with a for-profit or nonprofit child care provider. A larger company may elect to create a child care center on its own, while smaller companies may create a center together in order to share the start up and operating costs. Employers may elect to make the program open to the public to help support the center financially. Some employers may also elect to create a separate nonprofit entity to provide child care services.

Once the child care center is open and running, many employers continue to subsidize the center. Some choose to charge the average rate for child care in the community and subsidize the rest, others offer a sliding scale based on employee salary and subsidize the difference.

The employer can claim a federal tax credit of 25% and a California state tax credit of 30% of the amount spent on qualified child care expenses.

Benefits

  • Creating new child care centers can directly address the community's need for quality child care
  • Decreases absenteeism caused by unreliable child care services
  • Effective recruitment/retention tool
  • Can be tailored to employee needs
    • Ex. Holiday programs when children are on vacation, after school programs, sick child care, etc...

Drawbacks

  • Start-up costs can be significant
  • Requires a long term financial commitment

Employer/Plan Requirements

  • The child care facility must meet all State and local licensing requirements
  • The federal tax benefit does not apply to family child care
  • The program must not benefit highly qualified employees as defined by 26 U.S.C. § 414(q)
  • The tax credit does not include expenses in excess of the fair market value of child care

Examples of Employer Savings

Federal Tax Benefits: Under 26 U.S.C. § 45F(a)(1), employers can claim a tax credit of 25% of the amount spent on providing child care services for its employees. The total credit allowed for child care expenditures and resource and referral expenditures is $150,000 per year.

California State Tax Benefits: California businesses can claim a 30% tax credit for the startup expenses of establishing a child care program or constructing a child care facility for its employees in California. The total credit allowed for a child care start up expenditures and resource and referral expenditures is $50,000 per year.

Employers can also claim a 30% tax credit on any amount spent to operate the center. The total credit allowed each year is $360 per dependent (not per employee). This total also includes any credits claimed on pre-tax money set aside through a DCAP.

In addition to the credits above, any amounts that exceed the $150,000 credit limit for federal taxes and the $50,000 credit limit for California may still be deductible. For example:

  • Any amount that the employer spends on the center that exceeds the deduction limit but is less than or equal to the fair market value for child care can be considered an ordinary business expense and is therefore deductible.
  • Start-up expenses may be amortized over 60 months or more under 26 U.S.C. § 195 or section 24414 of the California Revenue and Tax Code leading to further deductions.
  • Other capital expenses incurred in the creation of the center can be depreciated over a 39 year period under the Modified Accelerated Cost Recovery System (MACRS) as outlined in 26 U.S.C. 𨴀. Other costs of equipping the center can be depreciated over varying periods of time. IRS Publication 946 provides detailed information about depreciation and can be found at:http://www.irs.gov/pub/irs-pdf/p946.pdf *(PDF)
  • Both employees and employers can benefit further when employees pay their on-site child care fees through a pre-tax DCAP.

While start up and operating costs can be high (start up costs average about $2 million and operating costs begin at about $7,000 per child per year), many companies sponsoring child care report that their investment is paid back through the prevention of costs associated with absenteeism, lateness, and staff turnover. Other less tangible benefits include increases in sales and recruitment power from improved public relations.

  • In 1999, Chase Manhattan Bank conducted a return-on-investment analysis and found that its 110 child center in Brooklyn was saving it $1.5 million per year in avoided absenteeism alone. The cost of running the center was $700,000 in that year. (Susan Adams, Those Babysitter Blues, Forbes Magazine, p. 70 January 11, 1999).
  • When discussing the cost of the Los Angeles Department of Water and Power's two on-site child centers, human resources director, Beverly King said, "we found that it was costing us $1 million a year due to employee absences and tardiness related to child-care problems. Our estimates suggest that we gain $2.50 for every $1 we invest in child-care solutions." (Harry Anderson, Employers Waking up to the Child-Care Cries, The Los Angeles Times, part D; page 1; column 2 October 16, 1990).
  • A 1987 study for Union Bank at its 1,200 employee center in Monterey produced the following information (Lee McIntyre, Childcare on Board: The Growth of Work-Site Daycare, Federal Reserve Bank of Boston Regional Review, Vol. 10, No. 3 (2000)):
    • A 2.2% turnover for employees who used the center compared with a 9.5% turnover rate for parents who sought child care elsewhere.
      • The cost of hiring and training new workers is estimated at between three-quarters and one and one-half times an employee's annual salary.
    • Employees using the center missed 1.7 fewer days of work than other parents.
    • Mothers who used the center took maternity leaves that were 1.2 weeks shorter than mothers who did not.
    • 61% of those considering job offers from the bank said that the child care center would be a factor in their decision.
  • In 1990, 13 years after opening its on site daycare, Hoffman-LaRoche in New Jersey dedicated $1 million to expand the center, citing its impact on employee recruitment, retention and productivity. (Susan Seitel, Employer-Supported Childcare, available on the Work Family Connection's website at: http://64.37.108.10/open/FAQ_childcare.htm)
  • In Washington state, the Virginia Mason Hospital's on site child care center has had a dramatic impact on turnover. In the 15 years since the center was created, no employee using the center has left the hospital. (Seitel)
  • The chairman and CEO of Stride Rite Corporation, the company responsible for the first corporate-sponsored child care center in the nation in 1977, estimates that the company's two child care centers probably save him $22,000 per employee by helping him retain high quality employees and reducing turnover. The annual cost per child at the center is $7,000 per child which is shared by the company, the parent, and state subsidies.(Seitel)
  • Lost Arrow, a Ventura company, reported that its childcare center saved them money in 1992. (Seitel)
    • Savings from the Center:
      • Money saved from prevented lateness and turnover $160,000
      • 30% of company's subsidy is tax deductible $55,000
        • note-this would be 25% today
      • California Tax Credit $32,000
    • Total Savings $247,000
    • Total spent on operations $235,652
    • Net Savings: $11,348
  • The following savings are based on a hypothetical company, creating a center for 50 children at a cost of $8000 per year per child with the company charging $5200 per year per child and subsidizing the remaining $2800 per year per child:

    Start Up Year
    • Start-up costs through a management company $2,000,000
    • Operating Costs (including subsidies) $400,000
    • Total Start Up and Operating Costs $2,400,000
    • Employee fees $260,000
    • Net Costs $2,140,000
    • Federal Tax Credit $150,000
    • California Tax Credit for Start Up Costs
      (the remaining tax credit of $550,000 may be carried over to future years) $50,000
    • California Tax Credit for Subsidies $18,000
    • Total Tax Credits $218,000
    • Saved cost of having to replace and train 4 employees who stay because of the center
      (savings calculated at 3/4 of the annual salary of the employee):
      • One who makes $30,000 per year $22,500
      • One who makes $40,000 per year $30,000
      • One who makes $50,000 per year $37,500
      • One who makes $60,000 per year $45,000
    • Total Savings on Employment Costs $135,000
    • Total Savings (Employment and Tax Credits) $353,000
    • Total Costs in Start Up Year $1,787,000

    There will also be future tax deductions on start up and capital expenses as well as intangible benefits such as reduced absenteeism and lateness, increased productivity improved public image, stronger recruitment, and reduced maternity leave.

    Subsequent Years of Operation
    • Operating Costs (Including subsidies) $400,000
    • Employee Fees $260,000
    • Net Costs $140,000
    • Federal Tax Credit $100,000
    • California Tax Credit for Subsidies $18,000
    • Total Tax Credits $118,000
    • Saved cost of having to replace and train 4 employees who stay because of the center
      (savings calculated at 3/4 of the annual salary of the employee):
      • One who makes $30,000 per year $22,500
      • One who makes $40,000 per year $30,000
      • One who makes $50,00 per year $37,500
      • One who makes $60,000 per year $45,000
    • Total Savings on Employment Costs $135,000
    • Total Savings (Employment Savings and Tax Credits) $253,000
    • Net Savings $135,000

    There will also be intangible benefits such as reduced absenteeism and lateness, increased productivity, improved public image, stronger recruitment, and reduced maternity leave.

Contracting with an Existing Day Care Center

If there is enough quality day care in the area, employers can contract with nearby providers to set aside slots for employee children on a yearly, school vacation, or emergency basis. Employers may also elect to subsidize these costs. The tax benefits of subsidizing these costs are identical to those of subsidizing in-house child care.

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IV. New Market Tax Credit (NMTC)

General Description

Congress created the New Market Tax Credit this year to stimulate investment in low-income communities. Taxpayers receive a 39% tax credit on equity investments in qualifying community development entities (CDEs).

CDEs must apply for certification to qualify for the NMTC and must apply to obtain allocations from the NMTC. Applications for certification and lists of certified CDEs are available on the Department of the Treasury's CDFI Fund Website at http://www.cdfifund.gov/

The government anticipates allowing for tax credits of $2.5 billion in 2002, the program's first year, representing the $1 billion allocated for 2001 and the $1.5 billion allocated for 2002. Once the allocations are available, CDEs will compete for a portion of the allowance.

Under the NMTC Companies can stimulate growth, including growth in child care resources, in low income communities where there clients or employees are based while gaining substantial tax credits.

Employer/Plan Requirements

  • All taxpayers are eligible to invest in CDEs under the NMTC.
  • In order to qualify for the NMTC, CDEs must apply for certification and then for allocation of funds.
    • As of May 6, 2002 there were eight certified CDEs in LINCC counties:
      • 1 in Glendale: California Community Reinvestment Corp.
      • 1 in Inglewood: Inglewood Neighborhood Housing Services, Inc.
      • 2 in Los Angeles: Community Commerce Bank; Los Angeles Community Reinvestment Committee
      • 3 in Oakland: Alliance for West Oakland Development; Community Bank of the Bay, and The Low Income Housing Fund
      • 1 in Salinas: California Coastal Rural Development Corporation
    • Under 26 U.S.C. § 45D(c)(1), all corporations and partnerships are eligible for CDE certification if:
      • The primary mission of the entity is serving, or providing investment capital for Low-Income Communities or Low-Income Persons; and
      • The entity maintains accountability to residents of Low-Income Communities through their representation on any governing board of the entity or on any advisory board to the entity
  • Only investors making qualified equity investments are entitled to the NMTC
    • Under 26 U.S.C. § 45D(B)(1), any investment in a certified CDE is qualified if:
      • The investment is acquired by the investor at its original issue solely in exchange for cash; and
      • Substantially all of the cash is used by the CDE to make Qualified Low-Income Community Investments as defined by 26 U.S.C. § 45D(d)(1).
  • CDEs who receive allocations must use them within 5 years.
  • Only for profit CDEs are eligible to offer NMTC to their investors.
  • Nonprofit organizations can create subsidiary for profit organizations.
  • Nonprofit CDEs may apply for NMTC allocations while in the process of creating a for profit branch.
  • A CDE can qualify for certification if its mission is narrowly focused on creating child care as long as it meets the other requirements of serving a low income community.
  • An investor can earmark its investment for the development of child care as long as that child care will be provided in low income communities.

Examples of Employer Savings

Taxpayers receive a 39% tax credit on the equity investments over a period of seven years. This translates to over 30% in present value terms. Investors will be able to claim a 5% credit on the investment amount for each of the first 3 years and a 6% credit for each of the next 4 years.

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