IRS Addresses Dependent Care Benefits Under Extended Claims or Carryover Period

(Parker Tax Publishing May 2021)

The IRS issued guidance which addresses the taxation of dependent care benefits, provided through a dependent care assistance program, available in tax years ending in 2021 and 2022 due to the application of either the carryover or the extension of a claims period under Section 214 of the Taxpayer Certainty and Disaster Tax Relief Act of 2020. The notice clarifies that (1) if these dependent care benefits would have been excluded from income if used during the preceding tax year (i.e., during the tax year ending in 2020 or 2021, as applicable), they will remain excludable from gross income and are not wages of the employee for the tax years ending in 2021 and 2022; and (2) these benefits will not be taken into account for purposes of the application of the limits under Code Sec. 129 to other dependent care benefits available for the tax years ending in 2021 and 2022. Notice 2021-26.

Background

Code Sec. 129 provides an exclusion from the gross income of an employee for amounts paid or incurred by the employer for dependent care assistance benefits provided to the employee if the assistance is furnished under a dependent care assistance program (DCAP) described in Code Sec. 129. Under Code Sec. 129(a)(2), the benefits that may be excluded with respect to dependent care assistance services provided during the tax year are limited. For 2020, the exclusion cannot exceed $5,000, or $2,500 in the case of a separate return filed by a married individual.

DCAPs may be provided by a flexible spending arrangement (FSA) under a Code Sec. 125 cafeteria plan. Thus, an employee may contribute to the DCAP through salary reduction, and the DCAP may reimburse the employee for dependent care expenses incurred during the year. The reimbursements of dependent care expenses are excluded from gross income under Code Sec. 129. Reimbursements that are not excludable are includable in the employee's gross income and wages.

The limitation under Code Sec. 129 applies to amounts paid or reimbursed for dependent care services provided during the tax year of the employee. Under Notice 2005-42, unused benefits in a DCAP may be used during a 2 1/2-month grace period following the end of the plan year. If the sum of DCAP benefits used in the tax year (including unused DCAP benefits used during a grace period, or a portion thereof, that falls in the tax year) exceeds the applicable limit under Code Sec. 129, however, the excess is taxable.

2020 and 2021 Legislation Relating to the Carryover of Unused DCAP Benefits

Under Section 214(a) and (b) of the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (the Act), which was enacted at the end of 2020 as part of the Consolidated Appropriations Act, 2021 (Pub. L. 116-260), DCAPs can carry over unused benefits from a plan year ending in 2020 to a plan year ending in 2021 and from a plan year ending in 2021 to a plan year ending in 2022. Alternatively, Section 214(c)(1) of the Act allows a DCAP to extend its claims period for a plan year ending in 2020 or 2021 to 12 months after the end of the plan year with respect to unused benefits remaining in the DCAP.

In Notice 2021-15, the IRS issued guidance regarding the implementation of the temporary ability under Section 214 to allow unused DCAP benefits remaining at the end of a plan year to reimburse dependent care expenses incurred in the next plan year, either due to a carryover or an extended period for incurring claims. Notice 2021-15 states that, if an employer adopts the Section 214 carryover or the extended period for incurring claims permitted by Section 214(c)(1), the annual limits under Code Sec. 125(i) and Code Sec. 129(a) for benefits under a health flexible spending arrangement and/or a DCAP apply to amounts contributed to a health FSA or dependent care assistance program for a particular year, and not to amounts reimbursed or otherwise available for reimbursement from a health FSA or dependent care assistance program in a particular plan or calendar year. Thus, unused amounts carried over from prior years or available during an extended period for incurring claims are not considered in determining the annual limit applicable for the following year.

Section 9632 of the American Rescue Plan Act of 2021 (ARP) (Pub. L. 117-2), increased the exclusion for employer-provided dependent care under Code Sec. 129 to $10,500 (half that amount in the case of a married individual filing separately) with respect to any tax year beginning after December 31, 2020, and before January 1, 2022. Under that provision, a DCAP generally may be amended retroactively to increase the contribution allowed under the plan if (1) the amendment is adopted no later than the last day of the plan year in which the amendment is effective, and (2) the plan is operated consistent with the terms of the amendment during the period beginning on the effective date of the amendment and ending on the date the amendment is adopted.

According to the IRS, in the case of a DCAP offered by a Code Sec. 125 cafeteria plan with a non-calendar plan year beginning in 2021 and ending in 2022, the increased exclusion amount will not apply to reimbursement of expenses incurred during the 2022 portion of the plan year. Thus, reimbursement of more than $5,000 from the DCAP may result in a portion of the employee's contribution to the DCAP for the 2021 plan year that is used to reimburse expenses incurred during the 2022 tax year becoming taxable upon reimbursement. Also, unused DCAP benefits from one tax year of the participant (typically the calendar year) used to reimburse expenses incurred in the immediately following tax year, where the expenses are incurred during the same non-calendar plan year spanning those two tax years, are not carryover benefits or benefits made available under an extended claims period. Accordingly, the guidance provided in Notice 2021-26, as discussed below, does not apply to these benefits.

Notice 2021-26

On May 10, 2021, the IRS issued Notice 2021-26, which provides guidance on the treatment of unused benefits made available in 2021 or 2022 due to a carryover or extended claims period allowed as a result of Section 214 of the Act. In Notice 2021-26, the IRS stated that, in applying the temporary ability to carry over amounts or extend claims periods under Section 214 of the Act, unused amounts carried over from prior years or available during an extended period for incurring claims are not considered in determining the annual limit applicable for the following year. The IRS concluded that inherent in the legislation temporarily permitting unused amounts to be carried over to 2021 or 2022, or made available under an extended claims period, is that amounts that continue to be available are excluded from income if used by the participant for dependent care benefits. Consequently, in Notice 2021-26, the IRS clarifies that DCAP benefits that would have been excluded from income if used during the tax year ending in 2020 or 2021, as applicable, remain eligible for exclusion from the participant's gross income and are disregarded for purposes of application of the limits for the subsequent tax years of the employee when they are carried over from a plan year ending in 2020 or 2021 or permitted to be used pursuant to an extended claims period. The following example illustrates the possible tax consequences of electing $10,500 in DCAP benefits for a plan year beginning in 2021 but ending in 2022.

Example: An employee is covered by a non-calendar year Code Sec. 125 cafeteria plan that offers a DCAP benefit. The cafeteria plan has a July 1 to June 30 plan year. The employee elects no DCAP benefits for the plan year beginning July 1, 2020, and there are no unused amounts from prior plan years available. Pursuant to Section 9632 of the ARP, the employee elects to contribute $10,500 for DCAP benefits for the plan year beginning July 1, 2021. The employee incurs $5,000 in dependent care expenses during the period from July 1, 2021, to December 31, 2021, and receives $5,000 in reimbursements during 2021. The $5,000 is excluded from the employee's gross income and wages pursuant to Code Sec. 129. The employee has $5,500 of DCAP benefits available as of January 1, 2022. For tax year 2022, the exclusion for DCAP benefits under Code Sec. 129 is $5,000. The employee incurs $5,500 in dependent care expenses during the period from January 1, 2022, through June 30, 2022, and is reimbursed $5,500 by the DCAP. The employee elects to contribute $5,000 for DCAP benefits for the plan year beginning July 1, 2022. The employee incurs $2,500 in dependent care expenses during the period from July 1, 2022, to December 31, 2022, and is reimbursed $2,500 by the DCAP. The employee receives a total of $8,000 in reimbursements for DCAP benefits during 2022. Of the $8,000 received in the 2022 tax year, $5,000 is excluded from the employee's gross income and wages under the exclusion for DCAP benefits under Code Sec. 129. The remaining $3,000 received by the employee is included in the employee's gross income and wages.

For a discussion of the exclusion for amounts received under a dependent care assistance program, see Parker Tax ¶120,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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