Boy, do I feel foolish. It turns out there's a fringe benefit I could have been giving my employees that would have saved both them and me money. It costs virtually nothing and is easy to implement. It's the Dependent Care Assistance Program or DCAP.

The DCAP allows employees with children under age 13 to pay up to $5,000 in child care expenses with "pre-tax" rather than "post-tax" dollars. And you, as their employer, get a benefit as well - you don't have to pay payroll taxes on that $5,000.

Paying with pre-tax dollars gives your employee an immediate financial gain. It lowers their adjusted gross income and their taxes. At the 20% tax bracket, this could save an employee around $1,000.

This is actually a very easy program to implement. But looking through the IRS regulations is mind-boggling. There are at least three ways to deal with child-care expenses, and the IRS often uses the same terms for each:

  • dependent care assistance program -- a simple plan, enabling employees to pay up to $5,000 in child care with pre-tax dollars
  • dependent care tax credit - - a tax credit, not deduction, available to lower-income employees
  • "cafeteria" or flexible spending plan - - a broad-based plan, allowing employees to pay many fringe expenses (including non-reimbursed health care) from pre-tax dollars

The least complicated of the three is the DCAP, which you can adopt with a simple written plan. You don't have to file the plan with the IRS or any place else.

"It's relatively straightforward, nothing that's exotic," explained Martin Nissenbaum, National Director of Personal Income Tax Planning at Ernst & Young, New York. "Any lawyer could find a sample plan." The requirements are simple too: "You have to provide notice of availability, it can't be discriminatory, and you may have to see whether the benefits apply in your situation."

Operating the plan is quite simple. "The plan could provide for payment directly to the child-care provider," said Nissenbaum. "Or more typically, the employee pays for child care, and the employer reimburses the employee." At the end of the year, you have to indicate the amount of child-care benefits provided on box 10 of the employee's W-2.

Nissenbaum is quick to remind employers to consult their own attorney or accountant to help them adopt a Dependent Care Assistance Program. I echo that advice because the rules are confusing, even though giving the benefit is simple.

The details are covered in IRS Publication 15-B. Here's some of the fine print:

  • You need a written plan. This doesn't have to be filed with the IRS or any place else, but it does have to be in writing. I've put up a link to a very detailed sample plan from on my website,
  • The plan has to be adopted before the benefits can be taken. Sorry, you can't use this for last year's taxes, but you can adopt a plan now for 2003.
  • The plan has to be available to everyone. You can't only give this to the employees you like, but the plan still is AVAILABLE to everyone even if only one employee has children and can take advantage of it.
  • The plan cannot favor "highly-qualified employees." That's defined as those with 5% or more ownership of the company or more than $90,000 in income.
  • The amount excluded from income can't be more than the earned income of either the employee or the employee's spouse. If your employee has a spouse who does not work, he or she will not be able to exclude ANY of their income. (There are special rules for spouses who are students or not able to care for himself or herself.)
  • The maximum amount allowed is $5,000 ($2,500 for married employees filing separate returns) and cannot be more than the actual expenses.

Remember, some low-income employees may actually fare better taking the "Dependent Care Tax Credit." But that's VERY complicated to figure out and should be left up to them.

As for me, I'm adopting a Dependent Care Assistance Plan this week!

Copyright Rhonda Abrams, 2003

Rhonda Abrams is the author of The Successful Business Plan: Secrets & Strategies and The Successful Business Organizer. Register to receive Rhonda's free business tips newsletter at