Dependent Care Assistance Programs

March 13, 2024

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

<div class="Section1">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.<div class="Section1"> 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).<a href="#_ftn1" name="_ftnref1">1</a> 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.<a href="#_ftn2" name="_ftnref2">2</a> The plan is not required to be funded.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> For highly compensated employees to enjoy the same income tax exclusion, the program must meet the following additional requirements: <blockquote>(1)   Plan contributions or benefits must not discriminate in favor of highly compensated employees (as defined in IRC Section 414(q) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3930">3930</a>)) 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.<a href="#_ftn5" name="_ftnref5">5</a></blockquote> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> For purposes of the eligibility and benefits requirements (items (2) and (6) above), the employer may exclude from consideration (1) employees who have not attained age 21 and completed one year of service (provided all such employees are excluded), and (2) employees covered by a collective bargaining agreement (provided there is evidence of good faith bargaining regarding dependent care assistance).<a href="#_ftn8" name="_ftnref8">8</a> A program will not fail to meet the requirements above, other than the 25 percent test applicable to more than 5 percent shareholders, or the 55 percent test applicable to benefits, merely because of the utilization rates for different types of assistance available under the program. The 55 percent test may be applied on a separate line of business basis.<a href="#_ftn9" name="_ftnref9">9</a> Grace Period An employer may, at the employer’s option, amend its plan document to include a grace period, which must not extend beyond the 15th day of the third calendar month after the end of the immediately preceding plan year to which it relates (i.e., the “2½ month rule”). If a plan document is amended to include a grace period, a participant who has unused benefits or contributions relating to a particular qualified benefit from the immediately preceding plan year, and who incurs expenses for that same qualified benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. The effect of the grace period is that the participant may have as long as 14 months and 15 days (i.e., the twelve months in the current plan year plus the grace period to March 15) to use the benefits or contributions for a plan year before those amounts are “forfeited” under the “use-it-or-lose-it” rule.<a href="#_ftn10" name="_ftnref10">10</a> (For the clarified Form W-2 reporting requirements, which apply when an employer has amended a cafeteria plan document to provide a grace period for qualified dependent care assistance immediately following the end of a cafeteria plan year, see Notice 2005-61.)<a href="#_ftn11" name="_ftnref11">11</a> Coordination with Dependent Care Credit The amount of employment-related expenses available in calculating the dependent care credit of IRC Section 21 is reduced by the amount excludable from gross income under IRC Section 129.<a href="#_ftn12" name="_ftnref12">12</a> Employer’s Deduction The employer’s expenses incurred in providing benefits under a dependent care assistance program generally are deductible by the employer as ordinary and necessary business expenses under IRC Section 162. Sole Proprietors and Partners An individual who owns the entire interest in an unincorporated trade or business is treated as his or her own employer. A partnership is treated as the employer of each partner who is an employee under the plan.<a href="#_ftn13" name="_ftnref13">13</a> A self-employed individual (within the meaning of 401(c)(1)) is considered an employee.<a href="#_ftn14" name="_ftnref14">14</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 129(d)(1), 129(e)(1). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 21(b)(2). <a href="#_ftnref3" name="_ftn3">3</a>.   IRS § 129(d)(5). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 129(d)(1). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 129(d). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 129(d)(8)(B). <a href="#_ftnref7" name="_ftn7">7</a>.   IRC § 129(d)(8)(B). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 129(d)(9). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 414(r). <a href="#_ftnref10" name="_ftn10">10</a>.   Notice 2005-42, 2005-23 IRB 1204. <a href="#_ftnref11" name="_ftn11">11</a>.   2005-39 IRB 607, amplifying, Notice 89-11, 1989-2 CB 449. <a href="#_ftnref12" name="_ftn12">12</a>.   IRC § 21(c). <a href="#_ftnref13" name="_ftn13">13</a>.   IRC § 129(e)(4). <a href="#_ftnref14" name="_ftn14">14</a>.   IRC § 129(e)(3). </div></div>

March 13, 2024

3626 / What exclusion is available for employee participants in an employer-sponsored dependent care assistance program?

<div class="Section1">Editor’s Note: For 2021, employers had the option of amending DCAPs to offer up to $10,500 in tax-preferred benefits ($5,250 for married individuals who file separate returns).</div> <div class="Section1"> An employee may exclude up to $5,000 paid or incurred by the employer for dependent care assistance provided during a tax year.<a href="#_ftn1" name="_ftnref1">1</a> For a married individual filing separately, the excludable amount is limited to $2,500. Furthermore, the amount excluded cannot exceed the earned income of an unmarried employee or the lesser of the earned income of a married employee or the earned income of the employee’s spouse.<a href="#_ftn2" name="_ftnref2">2</a> An employee cannot exclude from gross income any amount paid to an individual with respect to whom the employee or the employee’s spouse was entitled to take a personal exemption deduction under IRC Section 151(c) (prior to the suspension of the personal exemption from 2018-2025) or who is a child of the employee under 19 years of age at the close of the taxable year.<a href="#_ftn3" name="_ftnref3">3</a> Additionally, the employee cannot reimburse the child's other parent for child care provided to their qualifying child. With respect to on-site facilities, the amount of dependent care assistance excluded is based on utilization by a dependent and the value of the services provided with respect to that dependent.<a href="#_ftn4" name="_ftnref4">4</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 129(a). The dependent care maximum limit is set by federal statute. It is not subject to inflation-related adjustments as many other benefits. The limits have not been raised in several years. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 129(b). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 129(c). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 129(e)(8). </div>