Dependent Care FSA Where Spouse Works from Home or is Self-Employed

Question:  Can employees utilize the dependent care FSA if their spouse works from home or is self-employed?

Short Answer: In most cases, employees with a spouse who works from home or is self-employed can still have eligible dependent care FSA expenses as long as the spouse has “earned income”.

General Rule: Dependent Care Expenses Must be “Employment-Related”

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.

If an employee is married, dependent care expenses will qualify as “employment-related” only if:

  1. The employee’s spouse is gainfully employed;
  2. The employee’s spouse is in active search of gainful employment;
  3. The employee’s spouse is a full-time student; or
  4. The employee’s spouse is mentally or physically incapable of self-care with the same principal place of abode as the employee for more than half the year.

Spouse Works from Home: Qualifies as Gainful Employment

Working from home qualifies as gainful employment for dependent care FSA purposes.

Therefore, even if the employee or spouse works from home, their dependent care expenses can still be eligible employment-related expenses for dependent care FSA reimbursement.

Spouse is Self-Employed: Qualifies as Gainful Employment

Self-employment qualifies as gainful employment for dependent care FSA purposes.

Therefore, even if the employee’s spouse is self-employed, their dependent care expenses can still be eligible employment-related expenses for dependent care FSA reimbursement.

Spouse is Self-Employed: Must Have Earned Income

A married employee’s dependent care FSA benefit limit is capped at the earned income amount of the lower earning spouse.  For example, if the spouse had only $1,000 in annual earned income, the employee’s maximum dependent care FSA benefit would be $1,000 (not the standard $5,000 for filing jointly, $2,500 for filing separately).

Spouses who are self-employed will therefore need to have earned income through their net earnings from self-employment for the employee to benefit from the dependent care FSA.  The general tax definition of “net earnings from self-employment” is copied below for reference.  The employee may need to consult with a personal tax advisor for guidance on calculating the applicable earned income amount in the dependent care FSA context.

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 through assistance with the employee’s personal tax advisor.  Where in question, employees should consult a personal tax advisor for assistance determining whether their daycare 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 a participant 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 (and if ever raised on audit of the individual tax return by the IRS).

Other Posts Addressing Tricky Dependent Care FSA Expenses

Regulations

IRS Publication 503:

https://www.irs.gov/pub/irs-pdf/p503.pdf

Exclusion or deduction.

The amount you can exclude or deduct is limited to the smallest of:

  1. The total amount of dependent care benefits you received during the year,
  2. The total amount of qualified expenses you incurred during the year,
  3. Your earned income,
  4. Your spouse’s earned income; or
  5. $5,000 ($2,500 if married filing separately).

The definition of earned income for the exclusion or deduction is the same as the definition used when figuring the credit except that earned income for the exclusion or deduction doesn’t include any dependent care benefits you receive.

You Must Have Earned Income

To claim the credit, you (and your spouse if filing jointly) must have earned income during the year.

Earned income. Earned income includes wages, salaries, tips, other taxable employee compensation, and net earnings from self-employment. A net loss from self-employment reduces earned income. Earned income also includes strike benefits and any disability pay you report as wages.

IRC §21(d)(1)(B):

(d) Earned income limitation.

(1) In general.

Except as otherwise provided in this subsection, the amount of the employment-related expenses incurred during any taxable year which may be taken into account under subsection (a) shall not exceed—

(A)  in the case of an individual who is not married at the close of such year, such individual’s earned income for such year, or

(B)  in the case of an individual who is married at the close of such year, the lesser of such individual’s earned income or the earned income of his spouse for such year. 

Treas. Reg. §1.21-1(c)(1):

(c) Gainful employment.

(1) In general. Expenses are employment-related expenses only if they are for the purpose of enabling the taxpayer to be gainfully employed. The expenses must be for the care of a qualifying individual or household services performed during periods in which the taxpayer is gainfully employed or is in active search of gainful employment. Employment may consist of service within or outside the taxpayer’s home and includes self-employment. An expense is not employment-related merely because it is paid or incurred while the taxpayer is gainfully employed. The purpose of the expense must be to enable the taxpayer to be gainfully employed. Whether the purpose of an expense is to enable the taxpayer to be gainfully employed depends on the facts and circumstances of the particular case. Work as a volunteer or for a nominal consideration is not gainful employment.

Treas. Reg. §1.21-2(b)(3):

(3) Definition of earned income. For purposes of this section, the term earned income has the same meaning as in section 32(c)(2) and the regulations thereunder.

IRC §32(c)(2)(A)(ii):

(2) Earned income.

(A)  The term “earned income” means—

(i)  wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income for the taxable year, plus

(ii)  the amount of the taxpayer’s net earnings from self-employment for the taxable year (within the meaning of section 1402(a)), but such net earnings shall be determined with regard to the deduction allowed to the taxpayer by section 164(f).

IRC §1402(a):

(a) Net earnings from self-employment.

The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss—…

 

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).

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