On May 10, 2021, the IRS released Notice 2021-26, which clarifies taxability of dependent care assistance programs ("DCAPs") for 2021 and 2022, including the carry-over of unused balances from one plan year to the next and extended grace periods for incurring expenses.
Section 129 of the Code provides an exclusion from gross income for amounts paid for dependent care assistance benefits under a DCAP, and employees often contribute to the DCAP through payroll deduction under a cafeteria plan. For 2020, the exclusion could not exceed $5,000. Unused DCAP funds have not been available to be carried over to a subsequent plan year, but were allowed a 2 ½ month grace period after the applicable plan year. If the sum of DCAP benefits used in the taxable year exceeds the applicable limit for the year, the excess is taxable. While DCAP amounts may be carried over during the 2 ½ month grace period, the grace period does not increase the applicable limit for the year in which any such carryover is used.
The Taxpayer Certainty and Disaster Tax Relief Act of 2020 allows plans to be amended to permit unused DCAP amounts to be carried over 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, or to permit an extended period for incurring claims 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 addition, the limit for the 2021 taxable year was increased to $10,500. It is important to note this increase is only applicable for the individual's 2021 taxable year, not the plan year. Accordingly, in the case of a DCAP offered 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.
IRS Notice 2021-15, issued February 18, 2021, provides that unused DCAP benefit amounts carried over from prior years or available during an extended period for incurring claims are not taken into account in determining the annual limit applicable for the following year, thus clarifying that DCAP participants may continue to make contributions up to the maximum annual permissible plan limit even if they had carried over unused funds or are benefiting from an extended grace period. In addition, IRS Notice 2021-26 clarifies that DCAP benefits that would have been excluded from income if used during the taxable year ending in 2020 or 2021 remain eligible for exclusion from the participant's gross income, as applicable. IRS Notice 2021-26 also clarifies that benefits carried over from a plan year ending in 2020 or 2021 or permitted to be used pursuant to an extended claims period are disregarded for purposes of application of the DCAP limit for the subsequent taxable years of the employee.
Co-authored by Mckenna Gossrau, St. Louis summer associate.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.