In Notice 2021-26, the IRS clarifies the taxable nature of benefits under dependent care assistance programs (“DCAPs”) that adopted the extended grace period or expanded carryover options for 2021 and/or 2022. See Notice 2021-26 (irs.gov).
Specifically, the IRS states that amounts which are available under the extended grace period or expanded carryover options will be excludable from the employees’ gross income if:
- The amounts would have been excluded from employees’ income had they been used during the original taxable year ending in 2020 or 2021; and
- If the available amounts due to the extended grace period or expanded carryover options are actually used during the following taxable year (i.e., 2021 as extended from 2020, or 2022 as extended from 2021).
Additionally, these DCAP benefits will not be counted toward the maximum exclusion from gross income that is applicable to other DCAP benefits for the 2021 and 2022 taxable years. Under previous guidance, the maximum DCAP exclusion from income has been increased from $5,000 to $10,500 (or for taxpayers who are married but filing separately, from $2,500 to $5,250) for calendar year 2021. Special rules apply for non-calendar year DCAPs.
Traditionally, qualifying DCAP benefits utilized during a calendar year are subject to an income exclusion of $5,000 (or $2,500 in the case of married individuals filing separate returns). These benefits are generally forfeited at the end of the plan year, unless the plan has adopted a 2 ½ grace period. Carryovers have not previously been allowed for DCAPs as they have for health FSAs.
However, due to the COVID-19 pandemic, numerous temporary relief was implemented, including for DCAP benefits. Under the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (also known as the Consolidated Appropriations Act, 2021 or CAA) and IRS Notice 2021-15, the following relief was provided with regard to DCAPs:
Expanded Carryover Rules
- Carryover to the 2021 Plan Year: This provision allows any unused benefits or from plan years ending in 2020 to be carried over to the plan year ending in 2021;
- Significantly, DCAPs were not previously allowed to have a carryover provision.
- Carryover to the 2022 Plan Year: This provision allows any unused benefits or contributions from plan years ending in 2021 to be carried over to the plan year ending in 2022.
Extended Grace Periods
- Grace Periods: DCAPs may adopt an extended grace period for plan years ending in 2020 or 2021, which is extended from the traditional two months and 15 days to a full 12 months after the end of such plan year in order for unused benefits or contributions to be utilized.
Thereafter, the American Rescue Plan Act (“ARPA”) temporarily amended Code section 129(a) to increase the amount of dependent care expenses that may be excluded from gross income.
DCAPs have historically been capped at reimbursing $5,000 per calendar year. However, under the ARPA, and only for taxable years beginning after December 31, 2020 and before January 1, 2022, DCAPs can reimburse over double! The maximum amount to be excluded for calendar year 2021 is now $10,500 (or $5,250 for married individuals filing single returns).
Note: To implement the carryovers or grace periods, or to increase the DCAP election amount to $10,500 for calendar year 2021, employers must amend their plans. Although generally Code section 125 cafeteria plans cannot be amended retroactively, the ARPA states that retroactive amendments are allowed for this purpose as long as: (1) the amendment is adopted no later than the last day of the plan year in which it is effective, and (2) the plan is operating consistent with the term of the amendment as of its effective date.
We thought this was the welcome news for employers who were struggling with allowing carryovers or grace periods for DCAPs that would exceed the $5,000 max. However, the IRS further expanded and clarified taxation relief in its newest guidance, Notice 2021-26 (irs.gov).
IRS Notice 2021-26
In Notice 2021-26, the IRS clarifies that DCAP amounts carried over (or available due to the extended grace period) from 2020 to 2021 or from 2021 to 2022 are excluded from income when used in that subsequent year if they would have been excluded from income if used during the original taxable year ending in 2020 or 2021.
Moreover, the amounts carried over (or available due to the extended grace period) are also disregarded for purposes of the income exclusion limits in that subsequent tax year. Take the following example: An employee elects $5,000 in 2020 but used none of it. The full $5,000 is carried over to 2021. Additionally, the employee elects $10,500 (as allowed by ARPA) for the 2021 tax year. If the employee incurs $15,500 in DCAP expenses in 2021, none of the $15,500 will result in taxable income. This is because the $5,000 carryover amount is disregarded, and under ARPA, up to $10,500 of DCAP expenses can be excluded for 2021.
The IRS includes some examples to explain how this works with both calendar year plans as well as non-calendar year plans.
Moreover, with regard to the ARPA increase to $10,500 of DCAP benefits for which employees may exclude, Notice 2021-26 clarifies that this is for the 2021 taxable year only (generally the calendar year). Therefore, a DCAP that runs on a non-calendar year basis, starting in 2021 and ending in 2022 will not have this full relief available. The Notice provides that the increased exclusion amount (i.e., in most cases the amount over $5,000) will not apply to the reimbursement of expenses incurred during the 2022 portion of the plan year.
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Elizabeth H. Latchana specializes in employee health and welfare benefits. Recognized for her outstanding legal work, in both 2019 and 2015, Beth was selected as “Lawyer of the Year” in Lansing for Employee Benefits (ERISA) Law by Best Lawyers, and in 2017 as one of the Top 30 “Women in the Law” by Michigan Lawyers Weekly. Contact her for more information on this reminder or other matters at 517.377.0826 or email@example.com.
Brian T. Gallagher is an attorney at Fraser Trebilcock specializing in ERISA, Employee Benefits, and Deferred and Executive Compensation. He can be reached at (517) 377-0886 or firstname.lastname@example.org.