A Dependent Care Assistance Program (DCAP) allows tax-free payment of day care expenses that employees incur so that they may work. The most common example of a DCAP arrangement is a dependent care flexible spending account (FSA), under which an employee sets aside pre-tax wages to reimburse qualifying day care expenses.
The general rule is that an employee may be reimbursed up to the annual contribution limit of $5,000 per calendar year from the DCAP without having to include the funds in taxable income. If the employee has money left over at the end of the plan year, the IRS rules generally require that the amount remaining in a DCAP must be forfeited, except that an employer may adopt a grace period that gives the employee an additional 2½ months to spend down the account. But if the employee takes advantage of the 2½ month grace period, any amount reimbursed above $5,000 during the calendar year must be included in the employee’s taxable income.
The COVID-19 pandemic caused substantial disruption in day care services during 2020 and 2021. Many day care centers closed entirely, and even those that didn’t found themselves restricting the number of children they could handle. As a result, employees who had elected to contribute to a DCAP during 2020 found that they could not spend the funds. The Taxpayer Certainty and Disaster Tax Relief Act of 2020, among other things, aimed to remedy this problem by allowing employers to amend their plans to permit the carryover of unused DCAP 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. While this allowed participating employees to avoid a forfeiture of the funds they contributed to their DCAP account, it left open the question of whether employees with unspent funds from 2020, who also elected to contribute during 2021, would find themselves taxed on any amounts spent in excess of the annual contribution limit (and possibly facing a similar problem with unspent funds at the end of 2021 spent during 2022).
The IRS has issued two pieces of guidance that resolves the issue favorably for employees who participate in calendar-year plans. In Notice 2021-15, the IRS states that if an employer adopted a carryover or extended period for incurring claims, the annual limit for the DCAP applies only to the amounts contributed, not to amounts reimbursed or available for reimbursement in a particular plan or calendar year. More recently, the IRS released Notice 2021-26, which further clarifies that: (1) if DCAP benefits would have been excludable if used in a prior tax year, they remain excludable in 2021 and 2022; and (2) carried over amounts and amounts subject to an extended claims period will not be considered when applying the annual DCAP maximum contribution limits for a subsequent plan year.
As a result of this guidance, for calendar year DCAP plans, unused amounts from the previous plan year that continue to be available due to a carryover or extended grace period will not count toward the annual maximum contribution and reimbursement limits during 2021 and 2022. For example, in 2021, individuals may contribute up to $10,500 toward the DCAP. If the employee also has available $3,000 of unspent funds from 2020, the employee could contribute $10,500 and be reimbursed for up to $13,500 in qualifying day care expenses during 2021 without having to include any of those amounts in taxable income. In 2022, individuals may contribute up to $5,000 and be reimbursed tax free up to $5,000 plus unspent amounts from 2021 that the employer makes available during 2022.
But for non-calendar year plans, the timing on when funds are spent may not align with the calendar year relief. For example, if the plan has a July 1 – June 30 plan year, unspent funds made available during the plan year that starts in 2021 may not be spent until 2022, and unspent funds made available during the plan year that starts in 2022 may not be spent until 2023. In both situations, some of those funds may be taxable to the employee. While this may still be better for the employee than forfeiting the funds, it creates tax-withholding and income-reporting administrative burdens for the employer.
Employers have the option to make unspent amounts from 2020 and 2021 available during the 2021 and 2022 plan years. Employers also have the option to increase the 2021 contribution limit to $10,500. Employers who had decided not to adopt these optional changes because they were unsure of the tax consequences for employees may want to reconsider in light of this recent guidance (taking into account whether the employer’s DCAP operates on a calendar year or non-calendar year). Employers considering a change should also keep in mind that DCAP nondiscrimination rules are the toughest to pass, so any changes (particularly to contribution limits) should be evaluated in light of recent nondiscrimination testing results.
If you have any questions about DCAPs or other employee benefits issues, we can help! Please contact Norbert Kugele, Stephanie Grant, Brianna Richardson or any attorney in Warner’s Employee Benefits/Executive Compensation Practice Group.
