II. INDIVIDUAL INCOME TAX A. Provide Uniform Treatment for Dependent Care Benefits (secs. 21 and 129) Present Law In general Present law contains two tax benefits for dependent care expenses: the dependent care credit and the exclusion for employer-provided dependent care expenses. While both provisions provide tax benefits for similar expenses, the tax benefit available differs under the two provisions. A taxpayer who maintains a household that includes one or more qualifying individuals may claim a nonrefundable credit against income tax liability for up to 35 percent of a limited amount of employment-related dependent care expenses. Eligible employment-related expenses are limited to $3,000 if there is one qualifying individual or $6,000 if there are two or more qualifying individuals. Thus, the maximum credit is $1,050 if there is one qualifying individual and $2,100 if there are two or more qualifying individuals. The applicable dollar limit is reduced by any amount excluded from income under an employer-provided dependent care assistance plan. The 35-percent credit rate is reduced, but not below 20 percent, by one percentage point for each $2,000 (or fraction thereof) of adjusted gross income above $15,000. Thus, for taxpayers with adjusted gross income of $45,000 or above, the credit rate is 20 percent. 86 87 Generally, a qualifying individual is (1) a qualifying child of the taxpayer under the age of 13 for whom the taxpayer may claim a dependency exemption, or (2) a dependent or spouse of the taxpayer if the dependent or spouse is physically or mentally incapacitated, and shares the 85 Sec. 21. 86 The expenses cannot exceed the earned income of the taxpayer (or, in the case of married taxpayers, the earned income of the spouse with the lowest earned income). 87 A qualifying child is determined by reference to the uniform definition of qualifying child enacted by Congress in 2004, effective for taxable years beginning after December 31, 2004. Secs. 21(b)(1)(A) and 152(a)(1) (as amended by The Working Families Tax Relief Act of 2004, Pub. L. No. 108-311, secs. 201 and 203). In general, a qualifying child means, with respect to a taxpayer for a taxable year, an individual who: (1) is a son, daughter, stepson, stepdaughter, adopted child, eligible foster child, brother, sister, stepbrother, or stepsister of the taxpayer, or a descendant of any such individual; (2) shares the same principal place of abode as the taxpayer for more than half the taxable year; (3) meets certain age requirements or is permanently and totally disabled; and (4) has not provided over one half of his or her own support during the year. Sec. 152(c) (as amended by the Act). same principal place of abode with the taxpayer for over one half the year. Married taxpayers must file a joint return in order to claim the credit. For purposes of the credit, taxpayers who are legally separated are not considered married. In addition, a taxpayer is not considered married if he or she files a separate return from his or her spouse, maintains a household which constitutes the principal place of abode of a qualifying individual for at least half the year, and the taxpayer's spouse is not a member of such household during the last six months of the year. For taxable years beginning in 2004 and 2005, the dependent care credit offsets the alternative minimum tax. For taxable years thereafter, the dependent care credit does not offset the alternative minimum tax. Amounts paid or incurred by an employer for dependent care assistance provided to an employee generally are excluded from the employee's gross income and wages for employment tax purposes if the assistance is furnished under a program meeting certain requirements. These requirements include that the program be described in writing, satisfy certain nondiscrimination rules, and provide for notification to all eligible employees. The definition of dependent care expenses eligible for the exclusion is the same as the expenses eligible for the dependent care credit. The dependent care exclusion is limited to $5,000 per year (regardless of the number of qualifying individuals) except that a married taxpayer filing a separate return may exclude only $2,500. Dependent care expenses excluded from income are not eligible for the dependent care tax credit. Reasons for Change The differing tax provisions for dependent care expenses create inequity in the operation of the tax laws. While the exclusion generally provides more favorable tax benefits than does the credit, it is not available to all taxpayers. Thus, individuals not covered by an employer's dependent care assistance plan may receive a lower tax benefit for the same expenses than an individual who is covered by such a plan. The differing benefits also add to complexity in the tax laws for taxpayers who may be eligible for both provisions. Description of Proposal The proposal repeals the exclusion for employer-provided dependent care. Thus, under the proposal, the dependent care credit is the exclusive means for receiving tax benefits for dependent care expenses." 89 88 Secs. 129 and 3121(a)(18). 89 The value of dependent care provided by an employer (e.g., day care provided on-site by an employer to employees without charge) is includible in gross income and wages under the proposal. The amount of employer-provided dependent care included in gross income is eligible for the credit. Effective Date The proposal is effective with respect to taxable years beginning after date of enactment. Discussion The proposal has two primary policy objectives: equity and simplification. The proposal provides greater equity among similarly situated taxpayers by providing the same tax benefit for persons with dependent care expenses. Under present law, taxpayers who are covered under an employer's dependent care plan generally receive greater tax benefits than other individuals with dependent care expenses. There are several significant differences between the dependent care credit and the exclusion for employer-provided dependent care, including the following: (1) the amount of the tax benefit provided by the exclusion, but not the credit, depends on the tax bracket (income plus payroll tax rate) of the taxpayer; (2) the amount of benefit provided by the credit, but not the exclusion, depends on whether the taxpayer has one or two qualifying individuals; (3) the credit is reduced for persons with incomes above certain levels, whereas the exclusion is not limited based on income; (4) the credit is not available to married taxpayers who file separate returns, whereas one-half the maximum exclusion is available to such taxpayers"; (5) the availability of the exclusion depends on the compensation arrangements of employers; and (6) for taxable years beginning after 2005, the exclusion will continue to apply in determining alternative minimum taxable income, but the credit will not offset alternative minimum tax liability of individuals. The proposal retains the present-law nonrefundable credit approach as the means of providing a tax benefit for dependent care expenses. A credit is broadly available, treats similarly situated taxpayers equally, and the value of the benefit is independent of the taxpayer's rate bracket. Other means of providing tax benefits for dependent care expenses are possible. For example, an above-the-line deduction would provide similar tax benefits to the exclusion; like the exclusion, an above-the-line deduction would provide a benefit that varies with the individual's tax rate and would not affect the taxpayer's eligibility for other tax benefits that vary based on adjusted gross income. From a theoretical perspective, a deduction may be more appropriate if dependent care expenses are viewed as affecting taxpayers' overall ability to pay taxes or as expenses for the production of income. A credit may be more appropriate if a goal of the tax benefit is to make dependent care expenses more affordable, or to target the benefit more toward certain taxpayers. If the primary objective of the credit is to lower the price of dependent care regardless of whether the individual has tax liability, that may suggest that the credit should be refundable. Refundable credits, however, are administratively complex and potentially more subject to fraudulent claims that are difficult to recoup. 90 Denying the credit to married individuals filing separate returns serves as a way to prevent avoidance of the income phaseout of the credit by splitting income between the spouses. The proposal also reduces complexity by applying a single set of existing rules for dependent care expenses. 91 Taxpayers who currently claim the exclusion for employer-provided dependent care benefits may face increased tax liability as a result of the proposal. Overall, the greatest tax impact of the proposal would be on taxpayers who are subject to the alternative minimum tax; most of the revenue increase from the proposal is attributable to the impact of the alternative minimum tax beginning in 2006, when the credit will no longer offset minimum tax liability. 91 As part of the 2001 simplification report, the Joint Committee staff previously noted that, in general, the exclusion is less complex than the credit. In that report, the Joint Committee staff generally recommended conforming the credit to the exclusion by having a single dollar amount of expenses that can be taken into account that does not depend on the number of children, eliminating the income phasedown of the credit, and allowing married taxpayers filing a separate return to claim one half the credit. Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01), April 2001, at 67-8. Other considerations in addition to simplification have resulted in a different proposal here. The current proposal also achieves simplification by eliminating the primary source of the complexity, the existence of two provisions with similar policy goals yet differing requirements. B. Combine Hope and Lifetime Learning Credits and the Above-the-Line (secs. 25A and 222) Present Law Hope credit The Hope credit is a nonrefundable credit of up to $1,500 per student per year for qualified tuition and related expenses paid for the first two years of the student's post-secondary education in a degree or certificate program. 92 The Hope credit rate is 100 percent on the first $1,000 of qualified tuition and related expenses, and 50 percent on the next $1,000 of qualified tuition and related expenses. The Hope credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified adjusted gross income between $43,000 and $53,000 ($87,000 and $107,000 for married taxpayers filing a joint return) for 2005. The first adjustment to these amounts as a result of inflation is expected in 2006. Thus, for example, an eligible student who incurs $1,000 of qualified tuition and related expenses is eligible (subject to the adjusted gross income phaseout) for a $1,000 Hope credit. If an eligible student incurs $2,000 or more of qualified tuition and related expenses, then he or she is eligible for a $1,500 Hope credit. 93 The qualified tuition and related expenses must be incurred on behalf of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer. The Hope credit is available with respect to an individual student for two taxable years, provided that the student has not completed the first two years of post-secondary education before the beginning of the second taxable year. The Hope credit is available in the taxable year the expenses are paid, subject to the requirement that the education is furnished to the student during that year or during the first three months of the next year. Qualified tuition and related expenses paid with the proceeds of a loan generally are eligible for the Hope credit. The repayment of a loan itself is not a qualified tuition or related expense. A taxpayer may claim the Hope credit with respect to an eligible student who is not the taxpayer or the taxpayer's spouse (e.g., in cases in which the student is the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year for which the credit is claimed. If a student is claimed as a dependent, the student is not entitled to claim a Hope credit for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any qualified tuition and related expenses paid by the student are treated 92 Sec. 25A. The Hope credit generally may not be claimed against a taxpayer's alternative minimum tax liability. However, the credit may be claimed against a taxpayer's alternative minimum tax liability for taxable years beginning prior to January 1, 2006. 93 The adjusted gross income phase-out ranges are indexed for inflation. Also, each of the $1,000 amounts of qualified tuition and related expenses to which the 100-percent credit rate and 50 percent credit rate apply are indexed for inflation, with the amount rounded down to the next lowest multiple of $100. |