3625 / What are the income tax consequences of an employer-sponsored dependent care assistance program?

Editor’s Note: The American Rescue Plan Act (ARPA) allowed employers to increase contribution limits for dependent care assistance programs (DCAPs) or dependent care FSAs to $10,500 for 2021. The 2021 CAA also allowed participants to carry over unused DCAP benefits from 2020 or 2021 into the following plan year. Initially, there was some confusion over the tax consequences if a participant took advantage of both the increased contribution limit and carryover relief. Notice 2021-26 clarified the issue by providing that participants could take advantage of both (1) tax-free reimbursements of contributions made during the 2021 plan year up to the maximum $10,500 limit and (2) tax-free reimbursements of amounts carried over from the prior year. In other words, a participant with a $5,000 carryover amount from 2020 and a $10,500 contribution in 2021 could take tax-free distributions up to $15,500 in 2021 if that participant incurred enough qualifying expenses during the 2021 plan year.

A dependent care assistance program (DCAP) is a separate written plan of an employer for the exclusive benefit of providing employees with payment for or the provision of services that, if paid for by the employee, would be considered employment-related expenses under IRC Section 21(b)(2).¹ Employment-related expenses are amounts incurred to permit the taxpayer to be gainfully employed while he or she has one or more dependents under age 13 (for whom he or she is entitled to a personal exemption deduction under IRC Section 151(c) (note, however, that the exemption was suspended for 2018-2025)) or a dependent or spouse who cannot care for themselves. The expenses may be for household services or for the care of the dependents.² The plan is not required to be funded.³

Nonhighly compensated employees may exclude from income a limited amount for services paid or incurred by the employer under such a program provided during a taxable year.⁴ For highly compensated employees to enjoy the same income tax exclusion, the program must meet the following additional requirements:

(1)   Plan contributions or benefits must not discriminate in favor of highly compensated employees (as defined in IRC Section 414(q) ( Q 3930)) or their dependents.

(2)   The program must benefit employees in a classification that does not discriminate in favor of highly compensated employees or their dependents.

(3)   No more than 25 percent of the amounts paid by the employer for dependent care assistance may be provided for the class of shareholders and owners each of whom owns more than 5 percent of the stock or of the capital or profits interest in the employer (certain attribution rules under IRC Section 1563 apply).

(4)   Reasonable notification of the availability and terms of the program must be provided to eligible employees.

(5)   The plan must provide each employee, on or before January 31, with a written statement of the expenses or amounts paid by the employer in providing such employee with dependent care assistance during the previous calendar year.

(6)   The average benefits provided to nonhighly compensated employees under all plans of the employer must equal at least 55 percent of the average benefits provided to the highly compensated employees under all plans of the employer.⁵

If benefits are provided through a salary reduction agreement, the plan may disregard any employee with compensation less than $25,000 for purposes of the 55 percent test.⁶ For this purpose, compensation is defined in IRC Section 414(q)(4), but regulations may permit an employer to elect to determine compensation on any other nondiscriminatory basis.⁷