Dependent care assistance unused balances are excluded from income

The IRS explained in a notice in May that dependent care assistance program balances carried forward under temporary COVID-19 relief provisions retain their exclusion from participating employees’ gross income and wages.

Dependent care assistance programs, authorized by Sec. 129, allow exclusion from gross income of employee amounts paid or incurred by the employer for dependent care assistance provided to the employee. Typically, this benefit is offered in a “cafeteria plan” as a dependent care flexible spending arrangement that pays or reimburses qualified dependent care expenditures of the employee. The income exclusion is limited in employees’ tax years beginning in calendar years other than 2021 to $5,000 ($2,500 for a married spouse filing separately) or, if less, the employee’s (or employee’s spouse’s) earned income for the tax year. For tax years beginning in 2021 only, those maximum dollar exclusions are increased to $10,500 and $5,250, respectively, by the American Rescue Plan Act (ARPA), P.L. 117-2. Benefits remaining unused at the end of a plan year may, if the plan elects under Notice 2005-42, be used during an ensuing 2½-month grace period.

Sections 214(a) and (b) of the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (TCDTRA), enacted as Division EE of the Consolidated Appropriations Act, 2021, P.L. 116-260, allow an extended carryover of unused benefits from 2020 plan years to 2021 and from 2021 to 2022. Alternatively, plans may allow a 12-month extension of their claims period for plan years ending in 2020 or 2021 under Section 214(c)(1) of the TCDTRA. In February, with Notice 2021-15, the IRS provided that unused amounts carried over from prior years or available during an extended period for incurring claims are not taken into account in determining the annual benefits limit for the following year (see “IRS Provides Cafeteria Plan Relief for the Pandemic,” JofA, Feb. 19, 2021).

The May guidance further clarified that dependent care assistance program benefits that would have been excluded from income if used during a tax year ending in 2020 or 2021 remain eligible for exclusion from the employee’s gross income and are disregarded for purposes of application of the limits for the subsequent tax years of the employee when they are carried over from a plan year ending in 2020 or 2021 or permitted to be used pursuant to an extended claims period. The notice also illustrated with examples the interaction of this relief with electing the maximum $10,500 benefit under ARPA for a plan year beginning in 2021 but ending in 2022.

• Notice 2021-26

— By Paul Bonner, a JofA senior editor.