This article is updated to incorporate IRS guidance from Notice 2021-26.
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 cautious about increasing the contribution limit on their dependent care FSAs, especially those with non-calendar (that is, fiscal) year plans.
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 services provided in calendar year 2021 to $10,500; it then resets in 2022 back to $5,000. ARPA did not increase the maximum permissible dependent care FSA contribution amount for 2021. (There is no such rule to begin with.) And ARPA also did not increase the amount of reimbursements that can be made from a dependent care FSA in 2021 or 2022 (but IRS guidance did change how the income exclusion applies to dependent care FSA claims paid from grace period or carryover balances).
Is the dependent care tax change made by ARPA 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 the dependent care tax change made by ARPA and IRS guidance 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. IRS guidance changed how it will apply the income exclusion of Code Section to carryover and grace period balances. Basically, so long as the expanded carryover or extended grace period amounts would have been excludable from income if spent in the year contributed, they will be excludable from income if carried over to future years or spent in a future year grace period, and the expanded carryover/extended grace period claims will not count toward that year's income exclusion cap.
This increase in the amount an employee can exclude from income in 2021 (and to a lesser extent 2022) occurs by operation of law. Because of ARPA, the statutory income exclusion is higher for 2021. Because of IRS guidance regarding tax treatment of carryover and grace period balances, more reimbursements can be made on a tax-free basis in 2021 and 2022.
Employers with calendar year plans could safely increase the maximum contribution and reimbursement amount for 2021, but for reasons explained below, they may not want to do so for 2022. Employers with fiscal year plans may not want to do either, depending on when the plan year ends.
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 fixed that to some extent, but it was a very partial fix, so then IRS had to reinterpret things and fix it a bit more. ARPA increased the income exclusion for calendar year 2021, which helped a bit, but it was a very ill-fitting fix. IRS then fixed the problem more directly (and more completely) by reinterpreting how it would apply the income exclusion of Code Section 129 to dependent care FSA carryover and grace period balances. As mentioned earlier, IRS guidance provides that, so long as the carryover or grace period amounts would have been excludable from income if spent in the year contributed, they will be excludable from income if carried over to future years or spent in a future year grace period. In other words, extended grace period and expanded carryover claims will not count toward the income exclusion cap.
For calendar year plans, the IRS guidance is a boon. No more worries about income exclusion effects of having increased carryover maximums or extended grace periods, plus the 2021 contribution and reimbursement maximums can be increased to $10,500 without causing adverse tax consequences for employees.
For fiscal year plans, the fact that the Code Section 129 income exclusion is based solely on the calendar year is problematic. Example 2 from the IRS guidance is illustrative of this.
In Example 2, IRS considers a July to June fiscal cafeteria plan. An employee elects to contribute $5,000 to the DCAP for 2020-21 but incurs no dependent care expenses. Under CAA21, the employer may amend its cafeteria plan to allow that employee to carry over $5,000 to the 2021-22 plan year. The employee then elects to contribute $10,500 to the DCAP for the 2021-22 plan year. The employee incurs no dependent care expenses from July 1, 2021, through December 31, 2021, leaving the employee with $15,500 in available benefits on January 1, 2022. For the 2022 calendar tax year, only $10,000 is excludable from the employee’s income, though—$5,000 as an allowable carryover and $5,000 as a permitted contribution during the 2022 tax year. The remaining $5,500, plus any amount elected by the employee for the plan year beginning July 1, 2022, that is used on or before December 31, 2022, can be reimbursed to the employee but will be taxable.
If it's really, really important to expand dependent care FSA benefits for part or all of 2021, 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?
It depends on how much of the fiscal plan year occurs in 2021. 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. So if an employer with a fiscal year plan really wants to increase the dependent care FSA limits for one of its plan years, it should be done to the year that has the most months occurring in 2021. An employer with an October to September fiscal year plan will want to increase the limit on the 2020-21 plan year, whereas an employer with a March to February fiscal year plan will want to increase the limit on the 2021-22 plan year.
It may not be desirable to increase the limit, though, 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.