Deep dive tax wonkery: why employer credits play nice with DCAPs

Today, let's wonk out about a common misunderstanding around employer care credits and how they relate to dependent care assistance programs and dependent care FSAs.

A lot of people in the care space - including the (excellent) Bipartisan Policy Center - have talked about employer care credits and dependent-care assistance programs (DCAPs) as if they're separate and mutually exclusive things. That's not quite right.

The credits my firm designs programs around are employer credits: they're received by businesses (or their owners, for passthrough entities like partnerships and S-corporations) for qualifying expenses on employee child care. Credits lower taxes owed dollar-for-dollar.

But, as we're all reminded every April, employees also owe taxes on their income.

The IRS considers anything your employer gives you for working there, whether money, goods, or services, to be taxable income unless there's a specific law saying that it isn't. This makes sense; we don't want CEOs dodging taxes by having their companies pay them in Lamborghinis instead of in dollars.

The rules about what sort of benefits you can exclude from your income are complicated, and most forms of benefits in this country are downstream of those rules. The two best-known examples of excludable benefits are health insurance and employer 401(k) contributions, but there are many other kinds.

For child care, there are two relevant provisions. First, there are Dependent Care Assistance Programs (DCAPs). This is money spent on childcare to allow employees to work. DCAPs allow up to $7,500 a year to be excluded from the employee's income, subject to various restrictions (most importantly, rules limiting how much of the benefits can go to executives and other senior employees compared to the rank and file).

Second, there's the broader concept of cafeteria plans (Sec. 125), which allow employees to redirect some of their own pay into various pre-tax channels, such as health FSAs and HSAs, group life insurance, adoption benefits, health and vision insurance, and others. Importantly, for all of these, it's the employee's money coming out of their regular wages. The employer doesn't spend money directly.

When a cafeteria plan and a DCAP love each other very much and are combined, you get a dependent care FSA, which I've written about before. The cafeteria plan part means "the employee redirects their own money," the DCAP part means "money spent on care is excluded from taxable income." It's the employee's own money, granted exemption from tax in exchange for being limited to spending on valid care expenses. Since it's not the employer's money, when employees use their DCFSAs, the employer isn't spending anything on care. So employer child care credits, which are received when an employer does spend money on care, don't apply. That's what the BPC and other commentators are thinking about.

But we don't have to combine a DCAP with a cafeteria plan! Sure, it's common to do it that way, because funding a DCAP from the employee's money means the employer spends nothing on care beyond some administrative overhead. But a DCAP can be funded by the employer separately, rather than as a wage deduction. And if the employer is paying, then that spending does meet the requirements of the employer child care credit (assuming the other requirements are met - that's a separate discussion).

The takeaways:

• A properly structured employer plan can yield big tax credits for the employer (maxing out at $500-600K federally for $1.2M of spending for 2026, and often much more when state credits are added in).
• Up to $7,500 of care spend per employee can be completely tax-free to the employee as an individual.
• Over $7,500 in spend, employees do owe tax on care benefits - but they still come out far ahead. Suppose a high-earning employee, in the 32% federal tax bracket, receives $30,000 of care support. $7,500 of this is tax-free. The remaining $22,500 is taxable income, on which they owe $7,200 in income tax and ~$550 in payroll tax. Net result: the employee pays $7,750 while getting $30,000 in care support, coming out tens of thousands of dollars ahead. That's roughly ten times the benefit they'd have gotten from maxing out a DCFSA.

Illustrative, not tax or legal advice.