Question: Can employees use the dependent care FSA to pay for a nanny or relative to take care of a child at home?
Short Answer: Employees generally can use the dependent care FSA to pay for employment-related daycare services provided in-home by a nanny, relative, or other similar arrangement. However, there are several important limitations and potential employment tax consequences for employees to take into consideration.
- For more details on the increased $10,500 2021 contribution limit added by the American Rescue Plan Act (APRA), see: Dependent Care FSA Increase Passes Congress.
General Rule: Dependent Care Expenses Must be for “Care”
Employees’ dependent care expenses are eligible for reimbursement under the dependent care FSA only if the expenses are “employment-related,” which means they enable the employee and spouse to be gainfully employed by providing “care” to a qualifying individual.
“Care” in this context be provided in a variety of different arrangements and places, including inside and outside the home. The underlying requirement to qualify as “care” is simply that the main purpose is the person’s well-being and protection.
Household Services: Nanny, Au Pair, or Housekeeper Cares for Children Under Age 13
Employees can use the dependent care FSA to pay for a nanny, au pair, housekeeper, or other similar arrangement where the service provider cares for their children under age 13 to enable both the employee and the spouse to be gainfully employed.
Where a nanny’s services are split between caring for children under age 13 and other non-qualifying care functions (e.g., maintaining other aspects of the house), only those qualifying care-related expenses are reimbursable by the dependent care FSA. However, employees do not need to divide the expenses if the other non-qualifying care functions are only a small part of the nanny’s services.
- Employee pays a nanny $1,500/month to take care of her 9-year old child at home so the employee and spouse can work.
- The nanny also is responsible for overseeing the employee’s 15-year old child while the employee and spouse are at work.
- As part of the nanny’s duties, the nanny also regularly spends 30 minutes per day driving the employee to and from work.
- The employee can treat the full $1,500/month payment to the nanny as a work-related dependent care FSA expense even though the nanny provides other non-qualifying services for the employee.
- There is no need to divide the $1,500 expenses between the two children (even though the expenses are partly for the 15-year old child who isn’t a qualifying individual because the child is not under age 13) because the expense is also partly for the care of the employee’s 9-year-old child, who is a qualifying individual.
- There is also no need to carve out some portion of the $1,500/month for the time spent driving the employee to and from work because that is a minimal aspect of the nanny’s services.
Household Services: Family Member Cares for Children Under Age 13
In some cases, employees will pay a family member or relative to care for a child under age 13 so both the employee and the spouse can be gainfully employed. These employment-related expenses generally qualify for dependent care FSA reimbursement.
However, payments to the following family members are not dependent care FSA qualifying expenses:
- A person whom the employee or spouse can claim as a tax dependent;
- The employee’s child who was under age 19 at the end of the year (regardless of whether the child is a tax dependent);
- A person who was the employee’s spouse at any time during the year; or
- The parent of the child who is under age 13.
Potential Complications: Care Provider’s Social Security Number
The dependent care FSA TPA may require that the employee provide the nanny or other care provider’s SSN (or other TIN) in order to qualify as a reimbursable expense. Regardless, when employees subsequently file their individual tax return, they are required to list the care provider’s SSN on the Form 2441 to confirm the exclusion from income for the dependent care FSA reimbursements.
Where the care provider refuses to provide the SSN, the employee can receive the exclusion from income for the dependent care FSA reimbursements only if the employee can demonstrate due diligence in attempting to secure the SSN. This will generally require the employee to attach an additional written statement with the tax return explaining the employee’s efforts to obtain the care provider’s SSN, and the provider’s refusal to provide it. The statement can result in the nanny or other care provider being penalized for failure to provide the SSN.
Potential Complications: Care Provider’s Employment Taxes
Anyone paid to work in the home may be a household employee. If the nanny or other caregiver is a household employee, the individual hiring the nanny is responsible for—among other requirements—withholding and paying Social Security and Medicare taxes (FICA), federal unemployment taxes (FUTA), and any other applicable state or local payroll taxes and withholding. Failure to withhold and pay employment taxes for a nanny who is an employee can result in the hiring parent being liable for the employment taxes that should have been paid, plus interest and penalties. Penalties may also apply for failure to provide the nanny with a Form W-2. (Note that federal income tax withholding is not required for a household employee.)
If the care provider is a household employee, it does not matter whether the work is full-time or part-time, or that the care provider was hired through an agency or from a list provided by an agency or association. It also does not matter whether the care provider is paid on an hourly, daily, or weekly basis, or by the job. These same onerous payroll requirements would apply. Many individuals will utilize a third-party service such as an agency to handle these employment tax obligations for a nanny or other care provider who is a household employee. (Note that both the agency fees and employment taxes for a nanny can qualify as a dependent care FSA expense.)
In some cases, the nanny or other caregiver will not be a household employee, and these employment tax obligations will not apply. That would be the case if the nanny is an independent contractor who is self-employed, which would be an uncommon result for a nanny working in the parent’s home. Another exception would be if the nanny is hired through a placement agency that exercises control over what work is done and how it will be done—and therefore the nanny is an employee of the agency.
- Parent hires nanny Betty to take care of her child under age 13 and do light housework four days per week in Parent’s home.
- Betty follows Parent’s specific instructions about childcare and household duties.
- Parent provides the household equipment and supplies that Betty needs to do her work.
- Betty is Parent’s household employee.
- Parent is responsible for employment tax collection and payment for Betty.
Employees utilizing a dependent care FSA to pay a nanny should consult with a personal tax advisor and/or an agency specializing in these issues to address all these potential “nanny tax” complications that could arise.
Fortunately, the IRS has multiple forms of guidance available that address the household employee issue:
- IRS Publication 503—Child and Dependent Care Expenses: https://www.irs.gov/pub/irs-pdf/p503.pdf
- IRS Dependent Care FSA FAQ: https://www.irs.gov/faqs/childcare-credit-other-credits/child-and-dependent-care-credit-flexible-benefit-plans
- IRS Tax Topics: Employment Taxes for Household Employees: https://www.irs.gov/taxtopics/tc756
- IRS Publication 926—Household Employer’s Tax Guide: https://www.irs.gov/pub/irs-pdf/p926.pdf
- IRS Form W-10 Instructions: https://www.irs.gov/pub/irs-pdf/fw10.pdf
- IRS Child Care Provider Audit Technique Guide: https://www.irs.gov/pub/irs-utl/child_care_provider.pdf
Determining Eligible Expenses
Ultimately, the determination as to whether the employee’s daycare expenses are eligible for reimbursement under the dependent care FSA is an individual income tax issue to be resolved by the employee. Where in question, employees should consult a personal tax advisor for assistance in determining whether their expenses are eligible for dependent care FSA reimbursement.
The dependent care FSA’s third-party administrator will require the employee to certify that the expenses are eligible for reimbursement upon submitting a claim. However, unless the administrator has reason to believe that an expense does not qualify for reimbursement, there will be no further inquiry made by the administrator. The employee is responsible for verifying the eligible expenses on the individual tax return (IRS Forms 1040 and 2441), and if ever raised on audit of the individual tax return by the IRS.
Other Dependent Care FSA Eligible Expense Issues
For more details on situations where the qualifying status of dependent care expenses is difficult to determine, see our prior posts:
- Dependent Care FSA Where Spouse Works from Home or is Self-Employed
- Dependent Care FSA During Maternity Leave
- Dependent Care FSA During Summer Break
- Dependent Care FSA for Part-Time Work
- Dependent Care FSA During Maternity Leave
- Health FSA and Dependent Care FSA for Parents
- Health FSA and Dependent Care FSA for Special Education
For more details on all issues related to Section 125 cafeteria plans, see our 2021 ABD Section 125 Cafeteria Plans Guide.
(e) Definitions and special rules.
For purposes of this section—
(1) Dependent care assistance.
The term “dependent care assistance” means the payment of, or provision of, those services which if paid for by the employee would be considered employment-related expenses under section 21(b)(2) (relating to expenses for household and dependent care services necessary for gainful employment).
Treas. Reg. §1.21-1(d):
(d) Care of qualifying individual and household services.
(1) In general. To qualify for the dependent care credit, expenses must be for the care of a qualifying individual. Expenses are for the care of a qualifying individual if the primary function is to assure the individual’s well-being and protection. Not all expenses relating to a qualifying individual are for the individual’s care. Amounts paid for food, lodging, clothing, or education are not for the care of a qualifying individual. If, however, the care is provided in such a manner that the expenses cover other goods or services that are incidental to and inseparably a part of the care, the full amount is for care.
(2) Allocation of expenses. If an expense is partly for household services or for the care of a qualifying individual and partly for other goods or services, a reasonable allocation must be made. Only so much of the expense that is allocable to the household services or care of a qualifying individual is an employment-related expense. An allocation must be made if a housekeeper or other domestic employee performs household duties and cares for the qualifying children of the taxpayer and also performs other services for the taxpayer. No allocation is required, however, if the expense for the other purpose is minimal or insignificant or if an expense is partly attributable to the care of a qualifying individual and partly to household services.
(3) Household services. Expenses for household services may be employment-related expenses if the services are performed in connection with the care of a qualifying individual. The household services must be the performance in and about the taxpayer’s home of ordinary and usual services necessary to the maintenance of the household and attributable to the care of the qualifying individual. Services of a housekeeper are household services within the meaning of this paragraph (d)(3) if the services are provided, at least in part, to the qualifying individual. Such services as are performed by chauffeurs, bartenders, or gardeners are not household services.
(9) Employment taxes. Taxes under sections 3111 (relating to the Federal Insurance Contributions Act) and 3301 (relating to the Federal Unemployment Tax Act) and similar state payroll taxes are employment-related expenses if paid in respect of wages that are employment-related expenses.
(11) Indirect expenses. Expenses that relate to, but are not directly for, the care of a qualifying individual, such as application fees, agency fees, and deposits, may be for the care of a qualifying individual and may be employment-related expenses if the taxpayer is required to pay the expenses to obtain the related care. However, forfeited deposits and other payments are not for the care of a qualifying individual if care is not provided.
(12) Examples. The provisions of this paragraph (d) are illustrated by the following examples:
Example (3). To be gainfully employed, M employs a full-time housekeeper to care for M’s two children, aged 9 and 13 years. The housekeeper regularly performs household services of cleaning and cooking and drives M to and from M’s place of employment, a trip of 15 minutes each way. Under paragraph (d)(3) of this section, the chauffeur services are not household services. M is not required to allocate a portion of the expense of the housekeeper to the chauffeur services under paragraph (d)(2) of this section, however, because the chauffeur services are minimal and insignificant. Further, no allocation under paragraph (d)(2) of this section is required to determine the portion of the expenses attributable to the care of the 13-year old child (not a qualifying individual) because the household expenses are in part attributable to the care of the 9-year-old child. Accordingly, the entire expense of employing the housekeeper is an employment-related expense. The amount that M may take into account as an employment-related expense under section 21, however, is limited to the amount allowable for one qualifying individual.
Example (7). Q pays a fee to an agency to obtain the services of an au pair to care for Q’s children, qualifying individuals, to enable Q to be gainfully employed. An au pair from the agency subsequently provides care for Q’s children. Under paragraph (d)(11) of this section, the fee may be an employment-related expense.
Treas. Reg. §1.21-4(a):
(a) In general. A credit is not allowed under section 21 for any amount paid by the taxpayer to an individual—
(1) For whom a deduction under section 151(c) (relating to deductions for personal exemptions for dependents) is allowable either to the taxpayer or the taxpayer’s spouse for the taxable year;
(2) Who is a child of the taxpayer (within the meaning of section 152(f)(1) for taxable years beginning after December 31, 2004, and section 151(c)(3) for taxable years beginning before January 1, 2005) and is under age 19 at the close of the taxable year;
(3) Who is the spouse of the taxpayer at any time during the taxable year; or
(4) Who is the parent of the taxpayer’s child who is a qualifying individual described in §1.21-1(b)(1)(i) or (b)(2)(i).
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).