Dependent Care Exclusion for Sole Proprietors on Schedule C


MWW15lecture

Lecture at MidWest Writers Workshop

Question:  Can a sole proprietor deduct child and dependent care expenses directly on Schedule C as part of a dependent care benefit plan, rather than claim the dependent care credit on line 49 of Form 1040?

Answer:

Under a qualified dependent care benefit plan, an employer can exclude or deduct the following dependent care benefits:

  1. Amounts the employer paid directly to either the employee or the care provider for the care of the taxpayer’s qualifying person while the employee is at work.
  2. The fair market value of care in a daycare facility provided or sponsored by the taxpayer’s employer, and
  3. Pre-tax contributions the taxpayer made under a dependent care flexible spending arrangement.

The amount that can be deducted or excluded is limited to the smallest of:

  1. The total amount of dependent care benefits the taxpayer received during the year,
  2. The total amount of qualified expenses the taxpayer incurred during the year,
  3. The taxpayer’s earned income,
  4. The spouse’s earned income, or
  5. $5,000 ($2,500 if married filing separately).

An employee’s salary may have been reduced to pay for these benefits.  However, IRS Pub. 503 makes the statement that if the taxpayer is self-employed and receives benefits from a qualified dependent care benefit plan, then the self-employed individual (sole proprietor or general partner in a partnership) is both the employer and the employee.  In this case, the self-employed individual would not get an exclusion from wages.  Instead, the taxpayer would get a deduction on Form 1040, Schedule C, line 14.  To claim the deduction, the self-employed individual uses Form 2441 to support the Schedule C deduction.

Why is this significant?   Deductions taken on Schedule C directly not only lower your taxable income (and federal income tax) and your self-employment tax.

Caution:  If your Schedule C shows a loss before your dependent care exclusion, and Schedule C is your only source of earned income (in other words, you do not have wages from another employer-employee activity), the  dependent care exclusion will not be allowed when you complete Form 2441   If you are married, your spouse’s earned income, if lower than your dependent care exclusion, would also lower the deduction available.  Also, if you have other employees (not subcontractors) that work for you in your sole proprietorship (other than your spouse or dependent), you may not exclude them from your plan.  Get advice on this from your tax preparer, preferably a CPA or enrolled agent.

Since IRS Pub. 503 and the instructions to Form 2441 implicitly give a self-employed individual permission to deduct his or her expenses directly on Schedule C rather than take the credit on line 49 on the Form 1040, with no mention of the anti-discrimination and the 25% rules, there are those who claim a sole proprietor with no employees can take the deduction.

Cross references:

  • IRS Pub. 503, Child and Dependent Care Expenses
  • Form 2441, Child and Dependent Care Expenses
  • IRC Sec. 129

 

 

 

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