IRS Explains Tax Treatment of Dependent Care Benefits Under New Rules

The IRS has issued Notice 2021-26 to explain the tax treatment of dependent care flexible spending account plan (“DCAP”) benefits under the Consolidated Appropriations Act (“CAA”) and the American Rescue Plan Act (“ARP”).

Law. The CAA allows DCAPs to 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, with respect to unused benefits remaining in the DCAP, a DCAP may extend its claims period for a plan year ending in 2020 or 2021 to 12 months after the end of the plan year.

The ARP increases the exclusion for employer-provided dependent care to $10,500 (half that amount in the case of a married individual filing separately) with respect to any taxable year beginning in 2021. In the case of a DCAP 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. After December 31, 2021 the exclusion reverts to $5,000

Notice 2021-15 (see the Alert of 3/2/21) provides guidance regarding the implementation of the temporary ability 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 to an extended period for incurring expenses.

Notice 2021-26. In Notice 2021-26, the IRS explains the application of these new rules by giving three examples. 

Example 1 involves a calendar year plan (which matches most employees’ tax years) that offers DCAP benefits. A covered employee elected to contribute $5,000 for 2020 but incurred no dependent care expenses during the plan year. The plan allows the employee to carry over the unused $5,000 in DCAP benefits to the 2021 plan year. The employee: (i) elects to contribute $10,500 for the 2021 plan year; (ii) incurs $15,500 in dependent care expenses in 2021; and (iii) is reimbursed $15,500 by the plan. The $15,500 is excluded from the employee’s gross income because $10,500 is excluded as 2021 benefits and the remaining $5,000 is attributable to the permitted carryover.

Example 2 involves a plan year that begins July 1. For the plan year beginning July 1, 2020, the employee contributes $5,000, but incurs no dependent care expenses. The plan allows a $5,000 carryover. The employee elects to contribute $10,500 for DCAP benefits for the plan year beginning July 1, 2021. The employee has $15,500 available for dependent care expenses for the plan year beginning July 1, 2021. The employee incurs no dependent care expenses during the period from July 1, 2021, to December 31, 2021, and has $15,500 of DCAP benefits available as of January 1, 2022. 

For the taxable year 2021, the employee did not receive any DCAP benefits because no dependent care expenses were incurred in 2021. For the taxable year 2022, the exclusion for DCAP benefits will again be $5,000. The employee incurs $7,000 in dependent care expenses during the period of January 1, 2022, through June 30, 2022, and is reimbursed $7,000 by the DCAP. The plan adopts a 2½ month grace period that is added to the end of the plan year beginning July 1, 2021 The employee elects to contribute $5,000 for DCAP benefits for the plan year beginning July 1, 2022. The employee incurs $8,500 in dependent care expenses during the period from July 1, 2022, through September 15, 2022, and incurs $2,500 in dependent care expenses during the period from September 15, 2022, through December 31, 2022. For the employee’s 2022 tax year, only $10,000 in benefits will be excludable from the employee’s income (i.e., $5,000 as an allowable carryover to the plan year beginning July 1, 2021, and $5,000 as a permitted contribution during the 2022 tax year). Any remaining benefits are included in the employee’s gross income.

In Example 3, an employee is covered by a plan with a July 1 to June 30 plan year. The employee elects no DCAP benefits for the plan year beginning July 1, 2020. 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. 

Under current law, for the taxable year 2022, the exclusion for DCAP benefits 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 taxable year, $5,000 is excluded from the employee’s gross income. The remaining $3,000 received by the employee is included in the employee’s gross income.

Notice 2021-26 is available at: https://www.irs.gov/pub/irs-drop/n-21-26.pdf