IRS Releases Dependent Care Expenses Guidance

The IRS today issued Notice 2021-26 on the taxability of dependent care assistance programs (DCAP) for 2021 and 2022, clarifying that amounts attributable to carryovers or an extended period for incurring claims generally are not taxable. The guidance also illustrates the interaction of this standard with the one-year increase in the exclusion for employer-provided dependent care benefits from $5,000 to $10,500 for the 2021 taxable year under the American Rescue Plan Act.

Taxability of Dependent Care Expenses

IRS Notice 2021-26 addresses the taxability of dependent care assistance programs (DCAP) for 2021 and 2022, clarifying that amounts attributable to carryovers or an extended period for incurring claims generally are not taxable. The guidance also illustrates the interaction of this standard with the one-year increase in the exclusion for employer-provided dependent care benefits from $5,000 to $10,500 for the 2021 taxable year under the American Rescue Plan Act (ARPA).

Carryovers of unused DCAP amounts generally are not permitted (although a 2½ month grace period is allowed). However, the Consolidated Appropriations Act (CAA), passed in January 2021, allowed 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.

The notice clarifies that if these dependent care benefits would have been excluded from income if used during taxable year 2020 (or 2021, if applicable), these benefits will remain excludible from gross income and are not considered wages of the employee for 2021 and 2022.

Interaction with Annual Contribution Limits

Notice 2021-26 also clarifies that these amounts will not be taken into account for purposes of the application of the contribution limits under § 129 to the other dependent care benefits made available for the taxable years ending in 2021 and 2022.  This is a change from how the § 129 exclusion has been applied to grace period amounts in years prior to the CAA; in those years (and as a continuing general rule), reimbursements of dependent care benefits in excess of the $5,000 statutory amount attributable to a grace period were taxable to recipients.

Non-Calendar Year Plans and the Temporary Contribution Limit Increase

The guidance also explains how the temporary increase in the maximum DCAP contribution under the ARPA affects non-calendar-year plans. Under ARPA, the maximum amount of DCAP benefits that can be excluded from income is temporarily increased from $5,000 to $10,500 (or from $2,500 to $5,250 for taxpayers who are married filing separately) for 2021. Because the increase applies to an individual’s taxable year and not the plan year, the increased exclusion amount will not apply to a non-calendar-year DCAP’s reimbursements for expenses incurred in the 2022 portion of the 2021 plan year. If a non-calendar-year DCAP reimburses more than $5,000 for the 2021 plan year, a portion of the employee’s DCAP contributions for that plan year may become taxable if used to reimburse expenses incurred in 2022. According to the guidance, DCAP benefits from one taxable year that are used to reimburse expenses incurred in the next taxable year but during the same non-calendar plan year that spans those two taxable years are not carryover benefits or benefits available under an extended claims period; thus, the guidance does not apply to those benefits. The guidance does not provide any clarity on what non-calendar plans that want to adopt the increased contribution limit should do.

Next Steps

No actions are required as a result of the new guidance, it is informational in nature to help employers and taxpayers understand some of the tax implications of the various COVID-19 related relief.

Thank you for choosing Paylocity as your Payroll Tax and HCM partner. This information is provided as a courtesy, may change, and is not intended as legal or tax guidance. Employers with questions or concerns outside the scope of a Payroll Service Provider are encouraged to seek the advice of a qualified CPA, Tax Attorney or Advisor.