On Tuesday, Aug. 14, 2007, the Internal Revenue Service (“IRS”) issued final regulations titled the “Expenses for Household and Dependent Care Service Necessary for Gainful Employment.” The final regulations apply to the dependent care tax credit under Internal Revenue Code (“Code”) section 21, but also impact dependent care flexible spending account programs established under Code section 129. The final regulations, which are effective for tax years ending after Aug. 14, 2007, adopt with certain changes and clarifications the proposed regulations that were issued by the IRS May 24, 2006.

Employers who operate dependent care flexible spending account plans (“Dependent Care FSAs”) who did not take action as a result of the proposed regulations may now want to act. These employers may want to take advantage of the provisions of the regulations that allow for the reimbursement of more types of dependent care expenses. Specifically, employers may want to amend their Dependent Care FSAs and update plan communications to clarify that expenses for (i) specialty day camps, such as sport or computer camps, (ii) dependent care provider-supplied transportation, (iii) room and board for a dependent care provider and (iv) the cost of a dependent care provider when one parent works days and the other works nights, are reimbursable. Further, employers with Dependent Care FSAs that fail the Code section 129 non-discrimination tests should be most interested in these final regulations. If used properly, these final regulations might help these employers attract more participants into their Dependent Care FSA, which could increase the chance of passing the Code section 129 non-discrimination tests.

The final regulations also incorporate changes made in the law and reiterate the basic requirements that apply to Dependent Care FSAs. Specifically, the final regulations remind employers that only expenses necessary for gainful employment may be reimbursed. To this end, the final regulations incorporate a new safe harbor for short-term leaves of absence that will not affect an individual’s ability to participate in a Dependent Care FSA. Employers should now ensure that any employee on a leave of absence in excess of two weeks is not permitted to participate in the Dependent Care FSA during the leave. Employers should review and, if necessary, update their Dependent Care FSA plan documents to comply with the changes in the law and the final regulations. If you have any questions about the final regulations or Dependent Care FSAs, or would like to discuss the impact of the final regulations on your plans, please contact your Reed Smith attorney or one of the individuals listed below.