The IRS gives and then again: New DCAP guidelines offer welcome tax breaks
June 04, 2021
Ogletree, Deakins, Nash, Smoak & Stewart
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Participants in dependent care support programs (DCAPs) will have the best of both worlds (at least in 2021) under the new guidance of the Internal Revenue Service (IRS).
In another seemingly endless list of unexpected events that have occurred as a result of the COVID-19 pandemic since the beginning of 2020, the IRS clarifies the rules for the tax treatment of DCAP transfers and extended grace periods in accordance with the Consolidated Appropriations in the 2021-26 notice Act 2021 (CAA) and the extended DCAP contribution limits under the American Rescue Plan Act of 2021 (ARPA). Below are some key takeaways from the new guidelines.
Transfers and Extended Grace Periods
Following the adoption of the CAA, there were concerns that unused DCAP amounts that became usable in a later year due to a carryover or an extended grace period cannot be excluded from the gross income of the participant. In short, Section 129 of the Internal Revenue Code limits the amounts that can be excluded from income under a DCAP (generally $ 5,000), and that limit has not been changed by the CAA. Because Section 129 did not consider CAA transfers or extended grace periods, these funds could be added to a subscriber’s income if the subscriber received more than $ 5,000 in DCAP reimbursement in one year. Perhaps in response to these concerns, in connection with the passage of the ARPA, Congress raised the 2021 DCAP limit to $ 10,500, ensuring attendees would not access unused 2020 DCAP amounts that were used in 2021 to be taxed.
The announcement gives attendees the best of all worlds. According to the notice, not only can a participant carry over the full unused amount from 2020 and use that amount tax-free in 2021, but the participant can choose to deposit up to $ 10,500 in 2021, resulting in an overall tax-free benefit of up to leads to $ 15,500 from DCAP in 2021.
Plan year vs. calendar year
The notice clarifies that the limit of USD 10,500 set in the ARPA is only available for 2021. For plans that run for a calendar year, the result is simple: a participant should use the full USD 10,500 in the plan year 2021 (calendar year) and, as discussed above, use the unused amount from 2020 without any adverse tax consequences.
However, the result is more complicated for plan years that are not calendar years. Example 2 of the notice shows that a subscriber with $ 15,500 in DCAP benefits ($ 5,000 carried over from 2020 and deposited $ 10,500 for the 2021 plan year) at the start of the plan year on July 1, 2021 will take advantage of the extended benefits . loses limit of USD 10,500 if the participant does not incur sufficient expenses from July 1, 2021 to December 31, 2021. Employers allowing attendees to choose the increased amount for 2021 may want to make sure attendees know that amounts above the regular limit of $ 5,000 will lose preferential tax treatment if not claimed in 2021. Depending on when the plan year begins (or when the employer allows a change of election in the middle of the year), the increase in 2021 may not be helpful for plan participants.
Previous IRS guidance indicated that unused DCAP amounts available in a subsequent year due to a transfer or an extended grace period will not be considered for the non-discrimination check in the year of the transfer or grace period. Accordingly, an employer need not worry that the adoption of the transfer or grace period will affect the exam. However, the communication does not provide for non-discriminatory relief for the increased contributions in 2021. Accordingly, employers may want to monitor their DCAPs in 2021 for high-paying participants who are taking advantage of this increased limit in ways that could pose problems with non-discrimination testing.
The content of this article is intended to provide general guidance on the subject. You should seek expert advice regarding your specific circumstances.
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