IRS Guidance Clarifies Taxability of Dependent Care FSAs Through 2022

The IRS addressed confusion over the taxability of dependent care flexible spending account (DC-FSA) funds for 2021 and 2022, clarifying that it won't tax amounts that COVID-19 relief provisions allowed to be carried over from year to year, or that are used during an extended period for incurring claims.

DC-FSAs are also referred to as dependent care assistance programs (DCAPs) or dependent care reimbursement accounts (DCRAs). Regardless of what they're called, under these plans employees set aside a certain amount of pretax wages to pay for dependent care expenses.

Because of the pandemic, many people couldn't use the money they set aside in their DC-FSAs in 2020 and 2021.

IRS Notice 2021-26, issued May 10, clarifies that if DC-FSA funds would have been excluded from participants' income if used during taxable year 2020 (or 2021, if applicable), these benefits will be excluded from gross income and aren't considered taxable wages for 2021 and 2022.

Carrying over unused DC-FSA amounts from year to year is usually not permitted, although plans may include a two-and-a-half-month grace period to spend funds into the new year. COVID-19 relief legislation allowed employers to permit the carryover of unused DC-FSA amounts to plan years ending in 2021 and 2022.

[Related SHRM article: Stimulus Act Raises Dependent Care FSA Limits, Adjusts Tax Credit]

Relief Measures

The guidance addresses questions that arose under the following COVID-19 relief provisions:

• The Consolidated Appropriations Act, 2021 (CAA), signed into law at the end of 2020, allows employers that sponsor health or dependent care FSAs to permit participants to roll over all unused amounts in these accounts from 2020 to 2021 and from 2021 to 2022.
  

• IRS Notice 2021-15, issued Feb. 18, clarified that employers may extend the DC-FSA claims period for a dependent who "ages out" by turning 13 years old during the COVID-19 public health emergency. The limiting age remains at 14 for the 2021 plan year, but this relief only applies to dependent care FSA funds that remained unspent at the end of the 2020 plan year.
  

• The American Rescue Plan Act, signed into law on March 11, included a one-year increase in the tax-excluded contribution limit for DC-FSAs from $5,000 to $10,500 for the 2021 taxable year.

[Related SHRM article: IRS Clarifies Relief for FSA Carryovers]

Caregiving Challenges

"2020 messed up everyone's ability to use DCAPs as schools and day care facilities closed and parents stayed home from work or worked from home," wrote Jay Kirschbaum, vice president of compliance services at Lockton, an employee benefits advisory and brokerage firm based in Kansas City, Mo. "The funds set aside in employees' DCAPs were stranded under the traditional rules that govern DCAPs under Sections 129 and 125 of the Internal Revenue Code."

Relief provided by the IRS and Congress permitted, but did not require, "employers to amend their DCAPs to provide a full carryover of unused amounts to be used in succeeding tax years (that is, into 2021 and 2022) or extending the claims period to 12 months for the years 2020 and 2021 and increase the total tax-free benefits that will be available," Kirschbaum noted. "According to new IRS guidance, amounts that would have been nontaxable if used in the original year will remain nontaxable if carried over."

Alex Mattingly, an attorney at law firm Graydon in Cincinnati, explained that although it was clear that participants could contribute and be reimbursed from their accounts tax-free for $10,500 in 2021, "it was not clear what the participant's tax consequences would be if the participant carried over a DCAP balance from the prior year in addition to making contributions up to the $10,500 limit."

He added, "the IRS has now answered this question."

Actions to Consider

Gary Kushner, president and CEO of Kushner & Company, an HR strategy and employee benefits consulting firm in Portage, Mich., recommends that employers take the following actions:

• Decide if the plan will allow a carry-over of unused benefits from the plan years ending in 2020 or 2021 (or both) to the following plan year.
  

• Decide whether to allow the increased benefit election amounts of plan years ending in 2021 and 2022 to $10,500 for individual and joint filers (and $5,250 for married taxpayers filing separately).
  

• If employers decide on either of these options, amend plan documents, and communicate the change to eligible participants.

"Note that even if the plan year has already begun, the plan can allow the employee to make a contribution change midyear in order to reach these new limits," Kushner noted. "Unlike a health care flexible spending account, there is no employer risk of an employee being reimbursed for greater than their to-date contributions (and carry-over amounts) in a DCRA."

Unanswered Questions

"With so many overlapping extension deadlines and varying IRS-mandated contribution limits that can come into play, DCAP plan administration may be more involved in the near term," wrote Jackson Lewis attorneys Kellie M. Thomas and Brian M. Johnston.

Notably, they pointed out, the relief "does not address nondiscrimination testing issues or provide any relief for testing failures under Section 129 of the Internal Revenue Code, which have become more frequent given the ability to allow midyear changes to elections in 2020, 2021 and 2022."

Looking Ahead to 2023

"Both employers and employees will likely need to plan carefully as they consider DC-FSA elections and benefits for 2022 and 2023," advised attorneys at law firm Troutman Pepper. "If the new higher exclusion limit under ARPA is not extended by future legislation to apply to years after 2021, then the prior $5,000 limit will apply again for 2022, 2023, and future years."

Absent additional legislation or IRS guidance in the future, "it seems any unused DC-FSA amounts available at the end of 2022 that are used during a regular two-and-a-half month grace period at the beginning of 2023 will be includable in the employee's gross taxable income for 2023 to the extent the total amount used in 2023 exceeds the 2023 exclusion limit of $5,000," the attorneys noted.

Related SHRM Articles:

2022 Health FSA Contribution Cap Rises to $2,850, SHRM Online, November 2021

IRS Clarifies Relief for FSA Carryovers, SHRM Online, March 2021