IRS addresses how extended carryovers and increased benefit limit will work
Due to the 2020 pandemic restrictions, many employees who participated in their employers’ dependent care spending accounts (DCAPs1 ) could not use the pretax amounts that they contributed. In response, the IRS and Congress adopted rules to permit flexibility to spend down those unused amounts.
Employers may – but are not required to – amend their DCAPs to permit participants to carry over unused DCAP amounts to a subsequent year (2020 to 2021 and 2021 to 2022), or to extend the claims period for 2020 or 2021 for 12 months and/or to increase the total amount available in 2021 to $10,500. Thus, an employer could permit employees to use as much as $15,500 for dependent care reimbursement expenses in 2021 (i.e., up to $5,000 carried over from 2020 and up to $10,500 for 2021). We discussed these rules in our prior alert (opens a new window).
According to new IRS guidance, amounts that would have been nontaxable if used in the original year will remain nontaxable if carried over pursuant to the new guidance.
Lockton comment: Our expectation had been that the legislative intent of increasing the nontaxable amount for 2021 was to incorporate any carryover amounts with the 2021 elections for a total nontaxable benefit up to $10,500. We were pleasantly surprised by this provision that is providing the more generous nontaxable treatment. However, the application of the rules is not intuitive for noncalendar year plans and can result in additional taxable income in surprising ways. Those communication challenges will be quite vexing for those affected employers.
Relief for unspent DCAP amounts
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. 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.
The IRS and Congress provided some relief to those rules with a series of statutory and regulatory guidance. Those rules permit – but do 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.
Unfortunately, although the flexibility was welcome, the application of the rules was quite confusing. Left unanswered was the question as to the taxation of reimbursements that exceed the tax law’s limits of $10,500 for calendar year 2021 and $5,000 thereafter. Now the IRS has clarified that DCAP amounts that would be taxfree in 2020 or 2021 but are carried forward into a subsequent year are disregarded in determining if the annual dollar threshold is exceeded.
The IRS explains the rule by the following examples that assume a calendar year plan year for a dependent care flexible spending account (FSA).
Example: Jamie elects to contribute $5,000 to the DCAP for 2020 but has no eligible expenses that year. The plan is amended to permit Jamie to carry over the $5,000 to the following year and to contribute $10,500 for 2021. Jamie incurs $15,500 in eligible dependent care expenses in 2021. Jamie can be reimbursed the full $15,500 ($5,000 carryover and $10,500 for 2021) and the full amount will be nontaxable.
What about non-calendar year FSAs?
Because the increase to $10,500 applies to calendar year 2021 (and reverts to $5,000 in 2022), this creates an issue for non-calendar year DCAP plans. Specifically, it’s possible that pretax contributions made in 2021 will be used for 2022 expenses incurred in 2022, resulting in reimbursements in excess of $5,000 in 2022 expenses being taxable. However, any amounts carried over from prior years that would have been nontaxable, retain that characterization if used in subsequent years and does not affect the annual nontaxable limit the following year. Yes, this is as confusing as it sounds for non-calendar year DCAPs. The following example illustrates the IRS views.
Example: Blake participates in a DCAP that has a July 1 to June 30 plan year. Blake did not elect any DCAP benefits for the year starting July 1, 2020 and has no unused benefits. Blake elects to contribute $10,500 to the employer DCAP for the plan year starting July 1, 2021. Blake has $5,000 of eligible expenses from July 1, 2021 to Dec. 31, 2021. The reimbursement of $5,000 is nontaxable to Blake.
Blake has $5,500 of eligible expenses from Jan. 1, 2022 to June 30, 2022. The plan reimburses Blake the full $5,500 (to get to the full $10,500 that was contributed). The IRS dollar limit reverts to $5,000 for the 2022 calendar year. On July 1, 2022, Blake elects the full $5,000.Blake incurs $2,500 of eligible expenses from July 1, 2022 to Dec. 31, 2022 and is reimbursed the full $2,500 for a total of $8,000 in calendar year 2022.
Blake has $5,000 of nontaxable reimbursements in 2022 but he must account for $3,000 of taxable reimbursements when he files his Form 1040 for calendar year 2022.
Although employees won’t be happy about being taxed, the affected employees will at least have had the taxfree exclusion up front so they will not be disadvantaged in the aggregate. Employers with non-calendar year plans who adopt the carryover and the higher maximum benefit will need to communicate the options carefully to their employees.
Lockton comment: The good news, if any, is that employers are not liable for withholding taxes on these taxable reimbursements. The IRS will need to revise the Form 24441 (the form attached to the Form 1040 for DCAP reimbursements) to show the machinations individuals will need to go through to show taxable and nontaxable DCAP reimbursements.
1 The IRS guidance refers to DCAPs which includes both the typical spending account variation and the rarer type of account that is fully funded by the employer. The spending account version is the one that caused the concerns addressed by the guidance, but we will use the broader DCAP reference to conform to the IRS usage.
Not legal advice: Nothing in this alert should be construed as legal advice. Lockton may not be considered your legal counsel, and communications with Lockton's Compliance Services group are not privileged under the attorney-client privilege.