Keenan Briefings

Briefings

IRS Clarifies Taxability of Dependent Care Assistance Programs Unused Funds

May 11, 2021
  • Guidance issued on the taxability of dependent care assistance programs (DCAPs) for 2021 and 2022
  • Notice 2021-26 provides some helpful examples summarized in this Briefing

On May 11, 2021, the Internal Revenue Service (IRS) issued guidance on the taxability of dependent care assistance programs (DCAPs) for 2021 and 2022, clarifying that amounts attributable to carryovers or an extended period for incurring claims generally are not taxable. The guidance also illustrates the interaction of this standard with the one-year increase in the exclusion for employer-provided dependent care benefits from $5,000 to $10,500 for the 2021 taxable year under the American Rescue Plan Act (ARPA).

Because of the pandemic, many employees were unable to use the money they set aside in their DCAPs in 2020 and 2021. Generally, under these plans, an employer allows its employees to set aside a certain amount of pre-tax wages to pay for dependent care expenses. The employee's expenses are then reimbursed from the DCAP.

Carryovers of unused DCAP amounts generally are not permitted (although a 2½ month grace period is allowed). However, the Taxpayer Certainty and Disaster Tax Relief Act of 2020 allowed employers to amend their plans to permit the carryover of unused amounts to plan years ending in 2021 and 2022, or to extend the permissible period for incurring claims to plan years over the same period.

When employers adopt these amendments, unused funds carried over from prior years or available during an extended grace period are not taken into account for the following year. Absent these amendments, the maximum DCAP reimbursement per calendar year (tax year) is limited to $5,000.

Notice 2021-26 clarifies for taxpayers that if these dependent care benefits would have been excluded from income if used during taxable year 2020 (or 2021, if applicable), these benefits will remain excludible from gross income and are not considered wages of the employee for 2021 and 2022. In addition, the notice clarifies that these benefits will not be taken into account for purposes of the application of the limits under IRC 129 to other DCAP benefits available for taxable years ending in 2021 and 2022.

Notice 2021-15 PDF, issued in February 2021, states that if an employer adopted a carryover or extended period for incurring claims, the annual limits for dependent care assistance program amounts apply to amounts contributed, not to amounts reimbursed or available for reimbursement in a particular plan or calendar year. Therefore, participants in dependent care assistance programs may continue to contribute the maximum amount to their plans for 2021 and 2022.

Notice 2021-26 provides some helpful examples that are summarized below.

Example 1: Calendar Year DCAP – Employer Adopts the Extended Carryover and/or Grace Period Provision and Increased DCAP Maximum of $10,500 for 2021

January 1 – December 31, 2020

January 1 – December 31, 2021

January 1 – December 31, 2022

Employee elects $5,000

  • Employee does not use the funds because day care facilities are closed due to COVID-19
  • The unused $5,000 is available for the 2021 calendar year under the carryover or grace period

Employer adopts DCAP increase

Employee elects $10,500

  • $5,000 available from 2020
  • Employee has $15,500 available for the 2021
  • Employee has $15,500 in eligible expenses in 2021

Employee elects $5,000

  • Employee has $5,000 in eligible expenses in 2021

Tax Implications

The $5,000 balance is excluded from taxable income

The $15,500 is excluded from taxable income

The $5,000 funds from 2020 is excluded from taxable income for 2021

The $5,000 election is excluded from taxable income

 

Example 2: Calendar Year DCAP – Employer Adopts the Extended Carryover and/or Grace Period Provision and Increased DCAP Maximum of $10,500 for 2021

January 1 – December 31, 2020

January 1 – December 31, 2021

January 1 – December 31, 2022

Employee elects $5,000

  • Employee does not use the funds because day care facilities are closed due to COVID-19
  • The unused $5,000 is available for the 2021 calendar year under the carryover or grace period

Employee elects $10,500

  • $5,000 available from 2020
  • Employee has $15,500 available for the 2021 calendar year
  • Employee has $10,500 in eligible expenses in 2021*
  • The unused $5,000 is available for the 2021 calendar year under the carryover or grace period
  • Employer adopts a 2-1/2-month grace period for 2022

Employee elects $5,000

  • $5,000 from 2021
  • Employee has $10,000 available for the 2022 calendar year
  • Employee has $10,000 in eligible expenses in 2022
  • Any remaining funds not used in the 2023 grace period are forfeited

Tax Implications

The $5,000 balance is excluded from taxable income

The $10,500 is excluded from taxable income for 2021

 

The $5,000 is excluded from taxable income for 2022

The $5,000 funds from 2021 is excluded from taxable income for 2022

 

 

Example 3: Non-Calendar Year DCAP (July 1 – June 30) – Employer Adopts the Extended Carryover and/or Grace Period Provision and Increased DCAP Maximum of $10,500 for 2021

July 1, 2020 – June 30, 2021

July 1, 2021 – June 30, 2022

July 1, 2022 – June 30, 2023

Employee elects $5,000

  • Employee does not use the funds because day care facilities are closed due to COVID-19
  • The unused $5,000 is available for the 2021 calendar year under the carryover or grace period

Employer adopts DCAP increase

July 1 employee elects $10,500

  • Employee has $15,500 available for the 2021 calendar year
  • Employee has $0 in eligible expenses in from July 1 – December 30, 2021
  • The unused $15,500 is available as of January 1, 2022
  • Employer adopts a 2-1/2-month grace period

January 1, 2022 employee has $15,500

  • Employee has $7,000 in eligible expenses January 1, 2022 – June 30, 2022
  • Employee has $8,500 in eligible expenses July 1, 2022 – September 15, 2022 under the grace period

July 1, 2022 employee elects $5,000

  • Employee has $2,500 in eligible expenses July 1, 2022 – December 31, 2022

Tax Implications

The $5,000 balance is excluded from taxable income for calendar year 2020

The $10,500 is excluded from taxable income for calendar year 2021

The $5,000 funds from 2020 is excluded from taxable income for calendar year 2021

$8,000 is included in taxable income*

*IRS Explanation for the Tax Implications for Calendar Year 2022

The maximum tax exclusion for reimbursements allowed for DCAPs is limited to $5,000 annually. The plan is allowed to extend up to an additional $5,000 during the extended carryover or grace period. These amounts are not eligible to carry over to the plan year beginning July 1, 2022 because the plan year ends in 2023.

As a result, only $10,000 of the $18,000 reimbursement is eligible to for the taxable year 2022.

The employee received total reimbursements of $18,000 during tax year 2022.

The remaining $8,000 is included in the employee’s gross income.

 

Example 4: Non-Calendar Year DCAP (July 1 – June 30) – Employer Adopts the Increased DCAP Maximum of $10,500 for 2021 without the Extended Carryover and/or Grace Period Provision

July 1, 2020 – June 30, 2021

July 1, 2021 – June 30, 2022

July 1, 2022 – June 30, 2023

Employee elects not to participate in the DCAP

Employer adopts DCAP increase

July 1 employee elects $10,500

  • Employee has $10,500 available for the 2021calendar year
  • Employee has $5,000 in eligible expenses in fromJuly 1 – December 30, 2021
  • Theunused $5,500 is available as of January 1, 2022
  • Employer adopts a2-1/2-month grace period

January1, 2022 employee has $5,500

  • Employee has $5,500 in eligible expenses January1, 2022 – June 30, 2022

July1, 2022 employee elects $5,000

  • Employee has $2,500 in eligible dependent careexpenses July 1, 2022 – December 31, 2022
  • Employee has $2,500in eligible dependent care expenses January 1, 2023 – June 30, 2023

Tax Implications

N/A

The $10,500 is excluded from taxable income for calendar year 2021

$3,000 is included in taxable income for 2022*

The $2,500 is excluded from taxable income for 2023

*IRS Explanation for the Tax Implications for Calendar Year 2022

The maximum tax exclusion for reimbursements allowed for DCAPs is limited to $5,000 annually. These amounts are not eligible to carry over to the plan year beginning July 1, 2022 because the plan year ends in 2023.

As a result, only $5,000 of the $8,000 reimbursement is eligible to for the taxable year 2022.

The employee received total reimbursements of $8,000 during tax year 2022.

The remaining $3,000 is included in the employee’s gross income.

The $2,500 reimbursement for the period of January 1, 2023 – June 30, 2023 is excluded from income provided reimbursements for the period of July 1, 2023 – December 31, 2023 does not exceed $2,500 for a total of $5,000.

 

Conclusion

Employers with non-calendar DCAP plans should still proceed with caution when considering adoption of the 2021 increase as this can adversely impact employees’ individual tax returns, but this guidance should be helpful in answering some of the lingering questions regarding the pandemic-related DCAP relief provisions.

The full guidance can be found at the link below.

https://www.irs.gov/newsroom/irs-issues-guidance-on-taxability-of-dependent-care-assistance-programs-for-2021-2022


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