IRS Notice Addresses Taxation of Dependent Care Benefits
On May 10, 2021, the IRS released Notice 2021-26, which addresses the taxation of dependent care benefits available during taxable years ending in 2021 or 2022 because of a carryover or extended claims period enacted under the Consolidated Appropriations Act, 2021 (CAA). This notice clarifies that amounts that would have been excluded in the prior tax year remain excludable from income in the subsequent tax year. In particular, Notice 2021-26 provides three examples to illustrate when amounts carried over or available under an extended claims period are excludable from income, as follows.
Example 1: Calendar Plan Year
For the 2020 plan year, the employee elects to contribute $5,000, but incurs no dependent care expenses. The employee is permitted to carry over $5,000 into the 2021 plan year. For the 2021 plan year, the employee elects to contribute $10,500 to the plan. The employee is reimbursed for $15,500 in expenses during the 2021 plan year. The entire amount, $15,500, is excludable from income.
Example 2: Noncalendar Plan Year (July 1 to June 30)
For the 2020 plan year, the employee elects to contribute $5,000, but incurs no dependent care expenses. The employee is permitted to carry over $5,000 into the 2021 plan year. For the 2021 plan year, the employee elects to contribute $10,500 to the plan. The employee does not incur any dependent care expenses during the 2021 plan year. Beginning on January 1, 2022, the employee has $15,500 in available benefits. For the 2022 tax year, only $10,000 is excludable from income because $5,000 is the maximum carryover and $5,000 is the permitted contribution for the 2022 tax year. The remaining amount, if reimbursed is taxable. The example also includes another piece detailing the two-and-a-half-month grace period.
Example 3: Noncalendar Plan Year (July 1 to June 30)
For the 2020 plan year, the employee does not elect to participate or contribute in the dependent care plan. For the 2021 plan year, the employee elects to contribute $10,500 to the plan. The employee incurs $5,000 in dependent care expenses for the period July 1, 2021, to December 31, 2021. The $5,000 incurred is excludable from income. Beginning January 1, 2022, the employee has $5,500 available, but only $5,000 is excludable from income because $5,000 is the permitted contribution for the 2022 tax year. The remaining $500, if reimbursed, is taxable. The example also includes another piece detailing an additional employee contribution and incurred expenses.
Finally, this notice provides that an amount carried over or available under the extended claims period is not taken into account when determining the applicable limit.
Notice 2021-26 will be published in the Internal Revenue Bulletin 2021-21 on May 24, 2021.
