Don’t Overlook the Child Care Tax Credit

For years, the tax code has offered an incentive for employers to provide child care to their employees in the form of the Section 45F child care tax credit. But the credit is rarely claimed, according to the Congressional Research Service.

Employers that qualify for the credit could significantly cut their tax bills, while simultaneously boosting employee recruitment and retention in today’s tight job market. Here’s what you need to know to take advantage of this break.

The Basics

The Sec. 45F credit is worth up to $150,000 per year to offset 25% of qualified child care facility expenditures and 10% of qualified child care resource and referral expenditures. You generally can deduct eligible expenses that exceed the limit.

Qualified child care facility expenditures are costs related to acquiring, constructing, rehabilitating or expanding depreciable property to be used as the employer’s qualified child care facility or part of it. They also include the following operating expenses paid by the employer:

• Amounts paid to support child care workers through training and scholarship programs, and
• Increased compensation to employees with additional training.

Your qualified child care facility expenses can’t exceed the fair market value of the care, however.

Qualifying for the Credit

A qualified child care facility must meet all the applicable state and local requirements and regulations, including the licensing requirements. In addition, the facility must satisfy the following four conditions:

1. The principal use of the facility is providing child care assistance, unless the facility is also the principal residence of the person operating it.
2. Enrollment is open to employees during the tax year.
3. If the facility is the principal business of the taxpayer, at least 30% of the enrollees must be dependents of employees.
4. The use of the facility (or the eligibility to use the facility) doesn’t discriminate in favor of highly compensated employees.

The Sec. 45F credit is subject to recapture if the qualified child care facility ceases to operate as such a facility or for certain ownership transfers within the first 10 years.

Qualified child care resource and referral expenditures include amounts you paid or incurred under a contract with a qualified child care facility to provide related resource and referral services to employees. The arrangement can’t discriminate in favor of highly compensated employees.

Combining the Credit with a Business Expense Deduction

While businesses may be able to deduct amounts incurred to provide their employees with child care as business expenses, the Sec. 45F credit generally is more advantageous. Plus, you may be able to claim both tax benefits.

For example, suppose you incur $700,000 in costs to contract with a qualified child care facility. You can apply up to $600,000 of those costs to the credit (25% of $600,000 equals $150,000, the annual limit). You’d need to reduce the business expense deduction by the amount of the credit, leaving you with a deduction of $550,000 ($700,000 minus $150,000).

If your business is subject to the corporate tax rate of 21%, you’d save $115,000 ($550,000 times 21%) in taxes from the business expense deduction, plus $150,000 savings from the credit — for a total of $265,000 in tax savings. If you simply claimed the business deduction for the full amount, you’d save only $147,000 (21% of $700,000). Pass-through entities could see even greater tax savings, because the owners’ individual tax rates are usually higher than the corporate rate.

Combining the Credit with Dependent Care Assistance

Employers can get more bang for their buck if they offer a qualified dependent care assistance program. These programs allow you to provide employees with up to $5,000 in tax-free assistance for qualified expenses.

Say you contract with a qualified child care facility to provide care for 10 employees and directly pay for $12,000 of each employee’s expenses at the facility. You can obtain a credit of $30,000 (25% of $120,000) and exclude up to $5,000 of the $12,000 from the employees’ wages. You’d reduce your employees’ income and payroll taxes, as well as your company’s payroll taxes.

Worth Considering

The Sec. 45F credit is part of the general business credit. The credit is nonrefundable, meaning you can’t claim the credit in an amount that exceeds your tax liability for the year. But, as part of the general business credit, any unused credit can be carried back one year or forward 20 years to offset past or future taxes.

The IRS recently launched a new resource page about the Sec. 45F credit to encourage more employers to take advantage of this potentially valuable tax-saving opportunity. Particularly when combined with the business expense deduction and dependent care assistance program tax breaks, the credit could make a substantial dent in the costs you’d incur to offer a desirable employee perk. Contact your tax advisor for more information and help filing the appropriate forms with the IRS to claim the credit.

Copyright 2024

This article appeared in Walz Group’s April 8, 2024 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.