This exclusion applies to household and dependent care services you pay for (directly or indirectly) or provide to an employee under a dependent care assistance program that covers only your employees. The services must be for a qualifying person's care and must allow the employee to work. These requirements are basically the same as the tests the employee would have to meet to claim the dependent care credit if the employee paid for the services. For more information, see Qualifying Person Test and Work-Related Expense Test in Publication 503, Child and Dependent Care Expenses.

Employee. For this exclusion, treat the following individuals as employees.

1. A current employee.
2. A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction or control.
3. Yourself (if you are a sole proprietor).
4. A partner who performs services for a partnership.

Exclusion from wages. You can exclude the value of benefits you provide to an employee under a dependent care assistance program from the employee's wages if you reasonably believe that the employee can exclude the benefits from gross income.

An employee can generally exclude from gross income up to $5,000 of benefits received under a dependent care assistance program each year. This limit is reduced to $2,500 for married employees filing separate returns.

However, the exclusion cannot be more than the earned income of either:

1. The employee, or
2. The employee's spouse.

Special rules apply to determine the earned income of a spouse who is either a student or not able to care for himself or herself. For more information on the earned income limit, see Publication 503.

Exception for highly compensated employees. You cannot exclude dependent care assistance from the wages of a highly compensated employee unless the benefits provided under the program do not favor highly compensated employees and the program meets the requirements described in section 129(d) of the Internal Revenue Code.

For this exclusion, a highly compensated employee for 2001 is an employee who meets either of the following tests.

1. The employee was a 5% owner at any time during the year or the preceding year.
2. The employee received more than $85,000 in pay for the preceding year.

You can choose to ignore test (2) if the employee was not also in the top 20% of employees when ranked by pay for the preceding year.

Form W-2. Report the value of all dependent care assistance you provide to an employee under a dependent care assistance program in box 10 of the employee's Form W-2. Include any amounts you cannot exclude from the employee's wages in boxes 1, 3, and 5.

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