Small Business Taxes & Accounting: Part II (Dependent Care Benefits)

I received a question from a client the other day and before I answered her I realized it would make a great blog post!  (Thanks, dear.)

"So now that Hunky is a real employee of his business, we're exploring the benefits he is going to offer himself (and his employees). I'm working on health insurance which I realize will change in January. What about offering childcare benefits? From the DOL website it looks like it's an arrangement between employer and employee. How would we go about arranging this? Would we pay a babysitter then provide documentation to Best.Dentist.Ever. which then reimburses us? Or could the business hire a part-time babysitter/nanny and pay her a paycheck? However, if she's an employee of the business, would our homeowners insurance cover her if she were injured on the job?"

I think your best option for childcare benefits would be to set up what's called a Dependent Care Assistance Program (DCAP) within a Flexible Spending Arrangement (FSA).  It will allow you to exclude from income up to $5,000 per year.  You would deduct an amount specified by the employee (up to $5,000) from their paychecks (usually in equal amounts throughout the year) and then reimburse them for their expenses as they paid them.  Basically this costs the employer nothing (actually saving it some in payroll taxes) and saves the employee the taxes on that amount.

This way, you could deduct from Hunky's paychecks up to $5,000 per year pre-tax.  That means no federal withholding, no medicare or social security for the employee or the employer.  That would save you about $2,500 in income and payroll taxes, considering your tax bracket.  Then, you would reimburse yourselves that $5,000, as it was paid to the child care provider.  You would, of course, have to submit documentation to Best.Dentist.Ever. and it would need to keep that on file.

The requirements for a DCAP in an FSA are:

1. The plan would need to be in writing and there are specific requirements for the plan document.  I can help you with that.
2. You can only offer it to employees.
3. You would have to offer the plan to all employees, not just Hunky.
4. You must notify the employees of the plan's availability.
5. You must report to each employee the amount of benefits (reimbursements) before January 31 of the following year.  This can be taken care of in the 'dependent care assistance' box on the W-2's.

The downside to this plan is that the max benefit is $5,000 for child care. If you wanted to hire a child care provider through the company, you could pay her whatever you wanted, but non-discrimination rules would require care to be provided to all employees' dependents.  (Assuming you want the benefits to be tax-free to Hunky, which is why you're thinking of doing this, I presume.)

Down the road, if you want to get more technical (and probably hire a service to manage it for you, depending on the complexity), other benefits that you can offer through a FSA in the same way include medical expenses and adoption expenses.

By the way, I'm not recommending a cafeteria plan (which offers more benefits) because Hunky would not be allowed to participate.  He's considered 'self-employed' for this purpose.

My firm is trying to exit FSA plan administration by the end of the year, but I am certainly willing to advise on the tax benefits of such a plan and recommend a new administrator.  Please contact me by email or in the comments below with questions!

Update: I just found out that anyone who is more than a 5% owner of a business will be limited to receiving 25% of the total benefits.  Therefore, if you don't have any employees that participate in the plan, you won't be able to take any benefits.  If you do have employees who participate, you will be limited to 33% of however much they take in benefits.