The American Rescue Plan Act of 2021 (ARPA) is a massive stimulus measure signed into law by President Biden on March 11, and it includes a few benefits-related items. One such item is a temporary change to the maximum permissible amount that can be excluded from an individual's income on account of employer-provided dependent care assistance, the most popular form of which is a dependent care FSA. (Another benefits-related ARPA development, COBRA subsidies, is discussed here.)
While on its face, the tax law change that ARPA made to dependent care assistance programs seems straightforward, it is not. Employers should be very cautious about increasing the contribution limit on their dependent care FSAs.
What's the 30,000-foot overview?
ARPA added a special rule to Code Section 129 that increases the maximum amount that can be excluded from an individual's income on account of employer-provided dependent care assistance for dependent care services provided in 2021. ARPA did not increase the maximum permissible dependent care FSA contribution amount for 2021. (There is no such rule to begin with.) ARPA also did not increase the amount of reimbursements that can be made from a dependent care FSA in 2021. (Technically that's not how the rule works.) The income exclusion then resets in 2022 back to $5,000.
Is the dependent care tax change limited to dependent care FSAs?
No. While dependent care FSAs are the most popular vehicle, the Code Section 129 income exclusion also applies employer-provided on-site childcare and direct employer payment or reimbursement of dependent care expenses (i.e., no salary reduction contributions).
Is ARPA's dependent care tax change mandatory or optional?
Both, really. ARPA changed the income exclusion amount, which is related to, but not the same thing as, a dependent care FSA plan's contribution maximum and reimbursement maximum. The increase in the amount an employee can exclude from income in 2021 occurs by operation of law. Because the income exclusion is higher for 2021, an employer could opt to increase either its contribution maximum or its reimbursement maximum (or more likely, both), but for reasons explained below, employers may not want to do either.
So what if Section 129 is an income tax exclusion. Why would an employer not increase its contribution or reimbursement maximums?
This takes a bit of explanation, but stick with us.
Forget about ARPA for a minute. Here's how taxation of dependent care FSAs normally works. Consider a cafeteria plan that sets its maximum annual contribution and maximum annual reimbursement at $5,000, which matches the Code Section 129 income exclusion. In 2005 IRS gave employers the option of adding a grace period of up to 2 1/2 months. The 2 1/2 month grace period allows employees additional time to incur expenses that can be reimbursed with prior-year contributions. This is not the same thing as a claims run-out period. A claims run-out period is just the amount of time after the end of the plan year during which employees can submit expenses incurred in the prior year (or prior year plus grace period, if the plan has a grace period).
Under our hypothetical cafeteria plan, if an employee elects to contribute $5,000 in 2018, the employee would have to incur $5,000 in expenses during 2018 in order to make full use of his/her salary reduction contributions. Any amounts left over from 2018, once claims are finally adjudicated after the claims run-out period, are forfeited. So if only $4,500 worth of dependent care services were provided in 2018, the employee would forfeit $500. With a grace period, though, dependent care services rendered between January 1, 2019, and March 15, 2019, can be reimbursed from the 2018 year-end balance.
The grace period has nothing to do with the Code Section 129 income exclusion, and here's where things go sideways. No matter how much is contributed to or reimbursed by the dependent care FSA, the employee can only get tax-free treatment of $5,000 in dependent care expenses incurred—meaning the service is provided—in any particular calendar year. It doesn't matter whether the dependent care FSA is a calendar or fiscal year or whether there is a grace period or not. The Code limits preferential tax-treatment of employer-provided dependent care assistance to $5,000 per calendar year.
As as result, if the employee in our example also elected $5,000 for 2019, and if the employee incurred $5,000 in dependent care expenses between March 15, 2019, and December 31, 2019, the plan's grace period provision results in the employee being reimbursed for $5,500 in dependent care expenses during calendar year 2019. The employee's W-2 won't reflect any excess reimbursement because of how the W-2 reporting rules work. Instead, other tax forms that are required on an individual's tax return will result in a true-up of dependent care expenses, and the employee will pay income tax on the $500 excess. The practical effect of a grace period, then, is only to get the money out of the cafeteria plan and avoid forfeiture; it does not avoid taxes.
Now things get interesting. In December 2020 Congress passed the Consolidated Appropriations Act 2021 (CAA21), which created two new ways for employees to roll dependent care FSA funds from 2020 to 2021 and from 2021 to 2022: a year-long grace period or a 100% carryover. Regardless of which mechanism is used, the result is the same: employees who couldn’t spend their dependent care FSA balances because childcare facilities had been closed due to the pandemic won’t have to forfeit those funds. Yay! There was only one problem with Congress' plan, though. It didn't change the income tax effects. Boo! ARPA fixes that...to some extent.
Following passage of CAA21, it dawned on Congress that dependent care FSA balances in 2021 would be very, very high, and come tax time in April 2022, employees would be in for quite a shock when they realized that they would have to pay income tax on upwards of $5,000 in dependent care expenses they thought would be tax-free. The solution Congress came up with to solve this sticker shock problem was to increase the income exclusion of Code Section 129.
This is the point: ARPA was designed to solve a problem caused by CAA21; it was not designed to expand dependent care FSA benefits.
Understood, but is it still possible to take advantage of this change in Code Section 129 to expand dependent care FSA benefits?
Sure. In the abstract, think of dependent care benefits as a glass. Each year is a different glass. The 2020 glass is 5oz. ARPA made the 2021 glass a little bigger, so it's 10.5oz. The 2022 glass is 5oz. Think of the grace period/carryover relief from CAA21 as a liquid. If you fill the 2021 glass with CAA21, there's no room to further use ARPA to expand benefits; there's no room for more liquid. Conversely, if you don't use CAA21 at all, or if you use less of it, there's room.
Now, to bring this home, let's take the metaphor a step further. Each dependent care FSA participant has his/her own glass, and you're not the one filling the glass. Instead, you're just a rule-maker that establishes the maximum amount of liquid that can be used. That adds quite a bit of complexity to the problem because while there are certain things you can control, there are a lot of things you can't. The question then becomes, is it worth the complexity to change the rule and allow participants to put more liquid in their glasses?
If it's really, really important to expand dependent care FSA benefits, notwithstanding all the complexity, will a plan amendment be required?
Probably yes. If because of the increased tax income exclusion an employer wanted to increase its dependent care FSA contribution maximum and/or reimbursement maximum, and if an employer is willing to take on the complexity, then an amendment to the cafeteria plan is likely required. We say "likely" because it depends on what the plan document language says. If a dependent care FSA plan document establishes its maximums simply by reference to the Code Section 129 income exclusion amount, then if the employer does nothing, the plan's maximum will increase and an amendment is required to opt out and keep the limit at $5,000.
Conversely, if a dependent care FSA plan document contains a specific dollar amount (e.g., $5,000), then if the employer does nothing, the plan's maximum will stay at $5,000, and a plan amendment is required to raise the limit to $10,500.
Can a fiscal year cafeteria plan increase the dependent care FSA limit for the plan year beginning in 2021, or the plan year ending in 2021?
Neither, because that's not how Code Section 129 works. The Code Section 129 income exclusion limit applies to the taxpayer's—that is, the employee's—tax year, which is the calendar year. It has nothing to do with the cafeteria plan's plan year. If an employer with a fiscal year plan is taking advantage of the grace period/carryover relief from CAA21, then—continuing our glass/liquid metaphor—participants' 2021 glasses are either full or nearly full.
If an employer with a fiscal year plan did not take advantage of the grace period/carryover relief from CAA21, then there might be room to increase the dependent care FSA contribution and/or reimbursement maximum for the 2020-21 and/or 2021-22 plan years, but doing so will require considerable payroll and benefits administration gymnastics. This is because, to avoid income tax sticker shock for employees, dependent care FSA participants should not be reimbursed:
- For dependent care services provided during calendar 2020 in excess of $5,000;
- For dependent care services provided during calendar 2021 in excess of $10,500; and
- For dependent care services provided during calendar 2022 in excess of $5,000.
Furthermore, to comply with employer W-2 reporting rules:
- The employee's 2021 W-2 will need to report the total of dependent care FSA contributions made during 2021 payrolls in box 10, with any excess above $10,500 included in income in boxes 1, 3 and 5; and
- The employee's 2022 W-2 will need to report the total of dependent care FSA contributions made during 2022 payrolls in box 10, with any excess above $5,000 included in income in boxes 1, 3 and 5.
Some employers may be able to pull it off, but we suspect many won't.