By: HUB’s EB Compliance Team

At long last, the One Big Beautiful Bill Act (“OBBBA”) will increase the annual contribution limits for Dependent Care Assistance Programs (“DCAP”), which are sometimes referred to as Dependent Care Flexible Spending Accounts (“DCFSA”), though there are subtle differences. Except for a one-year increase in the contribution limits during the COVID-19 pandemic, the contribution limits had not changed since 1986.

With a renewed focus on these plans, this article is the first in a four-part series on different facets of DCAPs.

Dependent Care Assistance Programs

Authorized under §129 of the Internal Revenue Code (“IRC”), DCAPs allow for certain amounts related to dependent care to be excluded from the employee’s gross income. In its most common form, an eligible employee contributes to a dependent care account through their payroll on a pre-tax basis. The accrued funds are later used to reimburse their eligible qualified dependent care expenses incurred during the year. Pre-tax contributions allow the employee to reduce their taxable income, which also reduces the employer’s payroll tax obligations.

Allowable Expenses — Gainful Employment

Not all expenses related to the care of an eligible dependent are reimbursable under a DCAP. To initially determine which expenses are allowable, IRC §21(b)(2) defines allowable expenses as “expenses for household services and expenses for the care of a qualifying individual,” “but only if such expenses are incurred to enable the taxpayer to be gainfully employed.”

Gainful employment is determined on a daily basis, and the related expenses must allow an individual to actively work. Work can be full-time or part-time and includes working from one’s home (hybrid/remote). The fact that an expense is incurred while one is working is not dispositive that the expense was work related. Rather, the expense must be incurred to allow the individual to work and have earned income. Expenses may be incurred for an individual who is temporarily looking for work within the taxable year as long as they gained employment and have earned income for the year.

Married couples that may have one spouse employed, are also subject to certain requirements for eligible expenses to be considered work related. A spouse can be gainfully employed, looking for employment or a full-time student as defined by the IRS. An exception for spouses who are physically or mentally incapable of self-care, as defined by the IRS.

When approving expenses under DCAP, employers need to have a reasonable belief that the employee is entitled to the exclusion under §129, however, ultimately the burden of proving entitlement is on the individual.

Allowable Expenses — Care

The primary purpose of allowable expenses must be for the care of the qualifying individual. Treasury Regulation §1.21-1(d)(1) helps clarify what this means by stating these expenses “are for the care of a qualifying individual if the primary function is to assure the individual's well-being and protection.” This same regulation goes on to add that, “amounts paid for food, lodging, clothing or education are not for the care of a qualifying individual.” An exception is allowed for situations where, for example, a daycare facility provides meals but does not separate the cost of the care from the cost of the meals.

Qualifying Individuals

In addition to the requirements described above, the care must be for a qualified individual. Qualifying individuals can include:

  • A dependent child who has not reached age 13 (a “qualifying child”)
  • A dependent (either a qualifying child or qualifying relative), regardless of age, who:
    • Is physically or mentally incapable of caring for himself or herself and
    • Has the same principal place of abode as the taxpayer for more than half of the year
  • A spouse, if the spouse:
    • Is physically or mentally incapable of caring for himself or herself and
    • Has the same principal place of abode as the taxpayer for more than half of the year

DCAPs are most often used for childcare expenses of children who have not reached 13 for the parent to work. While the tax code allows for these definitions of qualifying individuals, plan documents may be more restrictive. Employers should understand which qualifying individuals are specifically allowed under their plans.

In part four of our series, we will be discussing the full scope of qualifying individuals under the plan and how understanding this may help certain plans pass nondiscrimination testing that may otherwise be a challenge.

Annual Contribution Limits

The annual DCAP contribution limit has been $5,000 (or $2,500 in the case of married individuals filing separately) since 1986. Under OBBBA, this limit will increase to $7,500 (or $3,750 in the case of married individuals filing separately) starting in 2026. Ultimately, these amounts are subject to potential limitations based on the earnings of both spouses.

For example, assume an employee is married, but their spouse only works occasionally and earns $3,000 in a specific year. If the employee elected the maximum $5,000 contribution, their tax benefit will be limited to their spouse’s earnings or $3,000. Thus, the earnings of the employee’s spouse act as another potential limit on DCAP contributions.

Employees with spouses who do not work because they either meet the requirements for being a full-time student or are incapable of self-care should consult with their tax professionals to understand their contribution limits.

Conclusion

This article is designed to provide an introductory overview of DCAPs, while also highlighting some less common nuances. Part two of our series on DCAPs will continue next month by highlighting when DCAP elections can be changed during the plan year.

If you have any questions, please contact your HUB Advisor. View more compliance articles in our Compliance Directory.

NOTICE OF DISCLAIMER

Neither HUB International Limited nor any of its affiliated companies is a law or accounting firm, and therefore, they cannot provide legal or tax advice. The information herein is provided for general information only and is not intended to constitute legal or tax advice as to an organization’s or individual's specific circumstances. It is based on HUB International's understanding of the law as it exists on the date of this publication. Subsequent developments may result in this information becoming outdated or incorrect and HUB International does not have an obligation to update this information. You should consult an attorney, accountant or other legal or tax professional regarding the application of the general information provided here to your organization’s specific situation in light of your or your organization’s particular needs.