Child care expenses for work: summer camp to after-school programs to babysitting: what's deductible and what's not

With school out for the summer, working parents will not only need to arrange care for their children while at work, but how to do so in a cost effective way. For parents facing a summer season that requires juggling childcare and work (or finding work), the IRS provides a few tax breaks that can help make this balancing act a little less painful to the pocket. From the cost of day camp to summer school, how do you determine what kind of childcare is deductible and what is not? Let's take a look.

Child and dependent care credit: The child and dependent care credit is a popular credit that, in part, enables you and your spouse (if married) to reduce your taxes by the cost of certain qualifying expenses you incur to have someone care for your child or children who are under age 13 so that you can work or look for work. While the credit applies to a wide range of childcare services, there are a variety of popular childcare services that do not qualify. Not only are there limits on the types of care and services that qualify, but the credit is also subject to income and percentage limitations as well.

Eligibility and amounts: For 2008, you can claim up to $3,000 of expenses paid in the year for one qualifying individual, or $6,000 for two or more qualifying individuals, under the dependent and child care credit. However, as discussed below, the credit can only be taken for up to 35 percent of qualifying expenses. This means that you essentially will not be able to claim the full $3,000/$6,000 amount. Additionally, to be eligible for the credit, you and your spouse must meet certain conditions, including:

• You and your spouse (if married) must have earned income from wages, salaries, tips, other taxable compensation, or net earnings from self-employment for the year;
• The expenses must be made for children age 13 or younger;
• The expenses must have been incurred to enable you and your spouse to work or look for work (unless you or your spouse is a full-time student or incapacitated);
• The care payments must be made to someone you and your spouse cannot claim as a dependent; and
• Your child must have lived with you for more than half of the year.

Percentage and more restrictions: Another restriction limits the actual credit amount you can take to a percentage of your expenses. Depending on your income, the credit can reach up to 35 percent of your expenses. Thus, the potential maximum credit you can claim for 2008 is only $1,050 (35 percent of $3,000) for the care of one qualifying child, and $2,100 for the care of two children under the age of 13. The credit falls to 20 percent as your income level rises (at $43,000 adjusted gross income, the credit falls to 20 percent of expenses). Additionally, the child and dependent care credit is nonrefundable, meaning that any excess credit can not be carried over and used in later years to reduce your tax bill.

Comment. The $3,000 and $6,000 credit amounts must be further reduced by any child and dependent care benefits that your employer provides and that you exclude from your income.
Camp to day care, what expenses qualify?

To qualify for the credit, expenses must be incurred for the "care" of your child. With the dollar and percentage limitations, the child and dependent care credit will likely not pay for all of the expenses you incur to have someone care for your child (or children) when you're at work, or looking for work this summer. The IRS considers expenses are "for care" if their main purpose is the individual's well-being and protection.

Expenses that do not qualify for the child and dependent care credit:

• Kindergarten (the IRS considers both full-time and part-time kindergarten a non-qualifying educational expense);
• Overnight camp;
• Summer school;
• Tutoring programs; and
• Private school.

Expenses that qualify for the child and dependent care credit:

• Day camps or similar programs (even if the camp specializes in a particular activity, such as reading, writing, tennis, or computer skills);
• Nursery school, pre-school, or similar programs for children below the kindergarten level;
• Expenses for before- or after-school care of a child in kindergarten or higher may be expenses for care;
• Fees you paid to an agency to obtain services of a care provider; and
• Indirect expenses, such as application fees, agency or pre-school deposits, that you paid for purposes of obtaining child care.

Flexible Spending Accounts: Instead of taking the child care credit, consider taking advantage of a flexible spending account that covers dependent care expenses. Employers who allow medical flexible spending accounts usually have one for dependent care as well. Contributions are pre-tax and, unlike the child and dependent care credit, they are not limited by adjusted gross income. If you take the credit, however, you can't double dip and pay for the expenses through a flexible spending account.

Some employers go one step better for their employees than sponsoring a dependent care flexible spending account: they provide on-the-premises day care facilities. If set up properly, it can be a win-win for employers and employees.

IRS increases standard mileage rate; But does "actual expense method" yield better results?

In response to the record high gas prices, the IRS has raised the business standard mileage reimbursement rate from 50.5 cents-per-mile to 58.5 cents-per-mile. This new rate is effective for business travel beginning July 1, 2008 through December 31, 2008. While the increase is much needed, businesses should evaluate whether the IRS has done enough, or whether a switch to the actual expense method of calculating vehicle expense deductions may make more sense for 2008.

Comment. Not only did the IRS raise the standard business mileage reimbursement rate eight cents, to 58.5 cents-per-mile, it also increased the standard mileage rate for medical and moving expenses from 19 cents-per-mile to 27 cents-per-mile. These new rates are also effective July 1, 2008 through December 31, 2008. The charitable standard mileage rate remains at 14 cents, since it is fixed by the Tax Code.

Two reimbursement methods: There are two basic methods that business taxpayers may choose to compute their deduction for the business use of automobiles (including vans and light trucks): the IRS's standard mileage rate (SMR) and the actual expense method. The method a business chooses in the first year the vehicle is placed in service is important, as it affects whether a change in method can be made in later years.

Taxpayers may use the higher rate for business use of an automobile for the period starting July 1, 2008 through December 31, 2008. Travel before July 1 must be computed using the previous rate of 50.5 cents-per-mile. A business cannot split use of the actual method for one period and the standard mileage rate for the other - it is either one or the other for the entire 2008 tax year (The same rules apply to the medical and moving mileage rates of 19 cents for expenses before July 1 and 27 cents for the remainder of the year).

Standard mileage rate: Under the SMR method, the fixed and operating costs of the vehicle are generally calculated by multiplying the number of business miles traveled during the year by the business standard mileage rate (50.5 cents, for 2008). Although a business using the SMR method cannot deduct any of the actual expenses incurred for operating or maintaining the car, the IRS does allow additional deductions for business-related parking costs and tolls, as well as interest paid on vehicle loans and any state or local personal property tax paid on the vehicle.

Actual expense method: Under the actual expense method, taxpayers can deduct the operating and maintenance costs incurred for the car during the current year, which include:

Gas and oil;
License and registration fees;
Insurance;
Garage rent;
Tires;
Minor and major repairs;
Maintenance items such as oil
changes and tire rotations;
Interest paid on a car or truck loan; and
Car washes and detailing.

If the business use of the vehicle is less than 100 percent, expenses need to be allocated between business and personal use. For example, if based on the taxpayer's records, the total actual vehicle expenses for 2008 are $3,000, and the vehicle is only used 60 percent for business, the allowable deduction under the actual expense method is $1,800 ($3,000 x .60).

Switching methods: Once actual depreciation in excess of straight-line has been claimed on a vehicle, the SMR cannot be used. Absent this prohibition (which usually is triggered if depreciation is taken), a business can switch from the SMR method to the actual expense method from year to year. Businesses cannot, however, make mid-year method changes either to, or from, one method to the other. Additionally, if a taxpayer uses the actual expense method for the first year that a vehicle is placed in service, it cannot switch to the SMR method for that vehicle in later years. The actual expense method must always be used for that vehicle.

Comment. While a change cannot be made effective at mid-year, a business is free to decide at any time to switch from the SMR to the actual expense method for the entire year, as long as the decision is made before the time at which the federal income tax return is filed. That is, a taxpayer cannot use the SMR for part of the year and then use the actual expense method for the remainder of the year. If the actual expense method is used, only those expenses that are properly substantiated are allowed.

Example. Toy Store, Inc. has been using the SMR since its van was new back in 2006. With $90 fill-ups every other day, Toy Store is figuring that it might do better keeping tabs on how much it spends for gas, especially since it had a $2,500 transmission repair this year as well.
As long as Toy Store has records (e.g., credit card receipts and repair bills), it can decide on either the actual expense method or the SMR right up until it files its return for 2008.

For leased vehicles, the rule is even more stringent. A taxpayer who uses the SMR method for the first year the car is placed in service in the business must use the SMR for the entire lease period.

SMR and depreciation limits: The SMR method includes an amount for depreciation, measured by the cost of the vehicle and limited by the luxury depreciation limits. A taxpayer who changes from the SMR method to the actual cost method in a later year, and before the car has been fully depreciated, must use straight-line depreciation for the car's estimated remaining useful life. Therefore, taxpayers cannot claim an additional accelerated deduction for depreciation when using the SMR method. Based on statutory language, whether intended or not, bonus depreciation may not be claimed if the SMR is taken. Election of the standard mileage rate is considered an election out of MACRS.

Bonus depreciation: The 2008 Economic Stimulus Act also reprised bonus depreciation that was used to accelerate economic recovery after 9-11 and Hurricane Katrina. Under the new law, qualifying businesses can take 50-percent first-year bonus depreciation of the adjusted basis of qualifying property. The original use of the property must begin with the taxpayer and occur during the 2008 year. The taxpayer must place transportation property in service before December 31, 2009.

To reflect bonus depreciation as it applied specifically to passenger vehicles, the new law raised the Code Sec. 280F cap on "luxury" automobile depreciation to $8,000 if bonus depreciation is claimed for a qualifying taxpayer (for a maximum first-year depreciation of no more than $10,960 and $11,160 for vans and light trucks).

For passenger automobiles first placed in service in 2008 and to which the 50-percent additional first-year depreciation deduction does not apply, the depreciation deduction limitations for the first three tax years are $2,960, $4,800, and $2,850, respectively, and $1,775 for each succeeding year. For trucks and vans first placed in service in 2008 and to which the 50-percent additional first-year depreciation deduction does not apply, the depreciation deduction limitations for the first three years are $3,160, $5,100, and $3,050, respectively, and $1,875 for each succeeding year.

Documentation and substantiation: The types of records required to substantiate expenses associated with the business use of an automobile depend on whether the SMR or actual expense method is used. In general, adequate substantiation for deduction purposes (for both SMR and actual expense method taxpayers) require that the following be recorded:

• The amount of use (i.e. the number of miles driven for business, and even personal, use);
• The date of the expenditure or use; and
• The business purpose of the expenditure or use.

Taxpayers using the SMR should maintain a daily log book or "diary" that substantiates miles driven, the dates of the vehicle's use, the destination, and the business purposes of the trip. For taxpayers who deduct the actual expenses associated with the business use of an automobile, substantiating costs will be more complicated and time-consuming. A mileage log is a necessity, as it should thoroughly account for miles driven (bifurcating both business and personal use).

Taxpayers should also keep receipts, copies of cancelled checks, bills paid, and any other documentation showing costs incurred and expenditures made. For depreciation purposes, taxpayers also need to document the original cost of the vehicle and any improvements made to the automobile, as well as the date the vehicle was placed in service.

With the price of fuel biting into your budget, getting as much of your spending back through smart tax planning makes more sense than ever these days. In addition to the fuel efficiency of your vehicle, don't forget to add its tax efficiency in computing bottom line ownership and operating costs.

IRS Increases Mileage Rates through Dec. 31, 2008

Issue Number: IR-2008-082

WASHINGTON — The Internal Revenue Service today announced an increase in the optional standard mileage rates for the final six months of 2008. Taxpayers may use the optional standard rates to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes.

The rate will increase to 58.5 cents a mile for all business miles driven from July 1, 2008, through Dec. 31, 2008. This is an increase of eight (8) cents from the 50.5 cent rate in effect for the first six months of 2008, as set forth in Rev. Proc. 2007-70.

In recognition of recent gasoline price increases, the IRS made this special adjustment for the final months of 2008. The IRS normally updates the mileage rates once a year in the fall for the next calendar year.

"Rising gas prices are having a major impact on individual Americans. Given the increase in prices, the IRS is adjusting the standard mileage rates to better reflect the real cost of operating an automobile," said IRS Commissioner Doug Shulman. "We want the reimbursement rate to be fair to taxpayers."

While gasoline is a significant factor in the mileage figure, other items enter into the calculation of mileage rates, such as depreciation and insurance and other fixed and variable costs.

The optional business standard mileage rate is used to compute the deductible costs of operating an automobile for business use in lieu of tracking actual costs. This rate is also used as a benchmark by the federal government and many businesses to reimburse their employees for mileage.

The new six-month rate for computing deductible medical or moving expenses will also increase by eight (8) cents to 27 cents a mile, up from 19 cents for the first six months of 2008. The rate for providing services for charitable organizations is set by statute, not the IRS, and remains at 14 cents a mile.

The new rates are contained in Announcement 2008-63 on the optional standard mileage rates.

Taxpayers always have the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates.

Rates remain the same from 1/1 through 6/30/08

• Business, 50.5 cents
• Medical, 19 cents
• Charity, 14 cents

Mileage Rate Changes from 7/1 through 12/31/08

• Business, 58.5 cents
• Medical, 27 cents
• Charity, 14 cents

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