James G. Beierlein / James E. Van Horn
Professor of Agricultural Economics / Professor of Family Sociology
Agricultural Economics and Rural Sociology
Penn State University
Copyright/Access Information
A Salary Reduction Plan is one of the options available to employers
to assist employees in meeting the financial aspects of their
child care needs.
In salary reduction plans, popularly called Dependent Care Assistance
Plans (DCAPs), the employer and employee agree to reduce the employee's
income by a certain amount, which will be placed in a dependent
care assistance fund for the employee. In such an agreement, the
employee is not taxed on the amount set aside for dependent care
assistance, and the employer is subject to neither federal nor
state taxes. A tax consultant will be able to offer advice on
what is applicable.
The child care services allowed under a dependent care assistance
program include care at the parent's home, at another person's
home, or at a child care center. The child care program must be
either licensed or exempt from license. An employer can provide
services at an employer-operated child care center, a community
child care center, or a family day care home. The employer also
can provide funds to cover any eligible services that the parent
might choose. Employer programs that do not involve actual care
for the child, such as parent seminars or information and referral
services, would not qualify as dependent care assistance programs.
Both of these options originally had tax considerations that made
them less attractive to both employers and employees since the
Internal Revenue Service could have viewed money spent on a child
care program as either increased salary to participating employees
or a noncompensatory
business expense of the employer for the general benefit of employees.
However, the IRS Code, in Sections 125 and 129, now clarifies
and supports these options as forms of child care support.
The Economic Recovery Tax Act of 1981 (Section 129, IRS Code)
established child care services as a fringe benefit that is not
included in the employee's taxable income. However, the employer's
program must qualify as a Dependent Care Assistance Program as
described in Section 129 of the Internal Revenue Code.
A DCAP is a written plan of an employer for the exclusive benefit
of employees. The employees' rights under the plan must be legally
enforceable, and the employer must intend to maintain the plan
indefinitely when it is established. Although nondiscrimination
guidelines require that the plan cannot discriminate in favor
of highly paid employees, the plan can favor low income employees
and provide extra subsidies for those parents who have the hardest
time covering their child care costs. Employers can exclude employees
covered by a collective bargaining agreement as long as child
care benefits were negotiated in good faith by the employer with
the union. Length of service is not an issue in determining employee
eligibility for a DCAP plan. The Internal Revenue Service will
not issue regulations on IRC Section 129 but will provide clarification
through notices and Revenue rulings.
There are restrictions to the use of salary set aside in a DCAP.
At the beginning of a plan year, the employee must agree to have
a specific amount of compensation set aside for that year in a
DCAP that can be used for eligible child care expenses. The amount
can be deducted through regular payroll deductions, but the total
to be withheld cannot be increased or decreased during that year.
In addition, the employee cannot change or "revoke elections"
of the benefit unless there is a change in family status, such
as marriage, divorce, death of a spouse or child, etc. Neither
can an employee carry over an unused portion of the DCAP to be
used in the following year. If all of the monies are not used
during the specified year, the employee must forfeit the unused
portion. To avoid forfeiting money, the employee should use conservative
estimates for child care costs.
The employer should estimate how many employees with dependent
care expenses could save money through a salary reduction agreement.
If part of the work population are minimum wage or low income
employees who would not benefit from a salary reduction agreement,
the employer might provide a subsidy to assist these parents with
their child care expenses, as well as provide a DCAP, through
a salary reduction agreement, for higher income employees. For
the DCAP in a salary reduction agreement to comply with regulations
for cafeteria plans, key employees cannot choose more than 25
percent of the benefit, as described in IRC Section 416 (i).
- Allows employer to budget expenses.
- Ensures that funds are available to employees to meet their
child care expenses.
- Is a good public relations tool and improves employee relations.
- Provides a potential tax advantage for employer and employee.
- The "use it or lose it" policy could adversely affect employee.
A needs assessment should be conducted among employees to determine the interest in this type of assistance. A sample needs assessment with suggested questions can be found in this file under "Questionnaire." This questionnaire may be copied and distributed among employees as it is written, or changes may be made to reflect the needs and interests of a business.
A joint employee-management committee may be useful in developing the program/service. It can foster a sense of ownership of the program among employees and provide a forum for employees to give input into the design features of the program/service.
Before a Salary Reduction Plan/DCAP is established, certain legal requirements must be met in order for the plan to conform to IRS guidelines. Employers should confer with their legal counsel or tax consultant.
The following are examples of options that employers have for
financing the DCAP allowance:
- By underwriting the cost of the program as an add-on above and
beyond an employee's present salary and benefits.
- Through the salary deduction plan discussed above.
- Through a combination of both.
A corporation's legal, tax, and benefits personnel are invaluable
resources to utilize in deciding what alternative is best for
the company.
Under the DCAP the company has three options to choose from
in establishing a reimbursement system. They are:
- To provide the child care.
- To contract with a third party(s) for child care service for
its employees.
- To reimburse employees for child care expenses based on the
submission of receipts or canceled checks. The expertise of legal,
tax, and benefits consultants will prove useful in determining
the most appropriate option of reimbursement.
The law requires that an employer provide employees with reasonable
notice of the terms and eligibility of the program. The notice
must include a description of the child care tax credit available
to them and a statement of circumstances under which the tax credit
is more advantageous to the employee than exclusion from taxes
under the DCAP. (This becomes an issue when an employee chooses
to reduce salary and place that amount into a DCAP.)
The DCAP must also, by law, meet one of two nondiscrimination
tests. Employers should ensure that employees are aware of this
provision as well. The expertise and advise of the company's legal
counsel, tax consultant, and benefits personnel should be sought
to ensure that any DCAP meets the nondiscrimination requirements.
Employers should ensure that all employees are informed of this
program, using various public information sharing tactics including
seminars and meetings, flyers, notices on bulletin boards, articles
in the company's newsletters, etc. Human resources and/or personnel
staff should be
trained so that they will be fully capable of explaining the program
to employees and can answer any questions that may arise.
Employers are required by law to report to both the employee and the IRS on the financial aspects of a DCAP. Therefore, a reporting mechanism should be designed that allows an employer to do so quickly and accurately. Reporting requirements may be obtained through the IRS.
As stated before, legal, tax, and benefits consultants should
be involved in the establishment of your company's DCAP.
You may want to consult with your local Cooperative Extension
Service to help determine child care needs. The Cooperative Extension
Service could also present educational programs on child care,
parenting, and other work/family-related concerns.
Other people in your community may be consulted in planning a
child care assistance option. You should consider: nursery school
teachers, director or staff of day care centers, child care Resource
and Referral agencies, local Cooperative Extension 4-H agents,
retired persons with child development backgrounds, vocational
technical schools with child care curriculum, community colleges,
and local child care sponsoring agencies (such as a child care
council or community action agency).
Catalyst, a New York-based advisory organization that helps corporations
foster career development of women, has published a handbook for
smaller employers entitled *Flexible Benefits: How to Set Up a
Plan When Your Employees Are Complaining, Your Costs Are Rising,
and You're Too Busy to Think About It*. You can contact Catalyst
at 250 Park Avenue South, New York NY 10003 or call them at 212-777-8900.
You can obtain a booklet on DCAP plans, *Summary of Tax Provisions
for Employers*, by writing to the Child Care Law Center at 22
Second Street, Fifth Floor, San Francisco, CA 94105 or calling
415-495-5498. There is a charge for each of these publications.