We have claimed the Dependent care Flexible Spending fund for my kid's daycare expenses for two years. But we just found out that parents must be working or actively looking for a job to be eligible for this TAX benefit. My wife have not been working for three years. Although she was trying to find a job, she didn't save any supporting documents such as interview appointments, etc. Now we are filing TAX form for 2009 and I need a help from you about the following questions:
1) Should we pay the tax on this fund that I have accumulated from my payroll?
2) Should we pay the tax only for the fund in 2009 or for the previous three years?
3) If we pay the tax for 2009, is it likely to trigger the auditing on my previous TAX forms?
4) If we also pay the tax for 2007 and 2008, should I include any penalty and how much?

Do appreciate your knowledge and help!

Looking for works isn't enough - if your wife didn't have income for the year then you can't take the deduction. The "looking for work" piece is that if she found work then the dependent care expenses that she incurred during that year while looking for work could be included.

My advice is to file your 2009 taxes properly - that is, showing $0 as qualified expenses on line 18 of form 2441. This will not by itself trigger an audit for prevoius years. I would expect that if you took the deduction in a year when your wife didn't have W-2 that the IRS would have figured it out by now. If they haven't coaiuhgt it yet they probably will, sooner or later. So you may want to file amended returns for both 2007 and 2008. That way you stop the clock on interest charges for underpayment of taxes for those years, whereas if you wait for the IRS to catch up with you you'll have a higher interest charge to contend with.

To calculate the interest owed - I suggest either using a tax return program like TacCut, or just pay the amount owed without any additional inerest included and let the IRS figure it out for you.

One last thing - obviously you should stop contributing to the dependent care account at work.