You don't need to do anything, because of the grandparent exception. You will tell the IRS how much you paid her (and provide her SS#) when you fill out form 2441 (part III) to claim the Dependent Care FSA.
She will report the income on her form 1040. She does not need a W-2 (although you can provide her one if you want to).
Without a W-2, In TurboTax, she enters at:
Federal Taxes
Click on Wages and Income
Scroll down to Less Common Income
On Miscellaneous Income, 1099-A, 1099-C click the start button
On the next screen click the start button on Other Income not already reported on Form W-2 or Form 1099
Answer Yes on the next screen and enter the amount under Household Employee Wages
TurboTax will put the income on line 1 of form 1040 with the notation "HSH", on the dotted line. It is still considered earned income for the earned income credit and/or an IRA contribution.
She may not be able to use the free edition of TT, when entering this way.
