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May 11, 2021

IRS guidance clarifies taxes on benefits under dependent care assistance programs

In Notice 2021-26, the IRS clarifies the temporary changes made to dependent care assistance programs (DCAPs) by the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (Disaster Relief Act) and the American Rescue Plan Act of 2021 (ARPA). Under Notice 2021-26, unused funds remaining in an employee's DCAP in 2020 or 2021 that are carried over to plan years ending in 2021 or 2022 will remain excludible from gross income and wages for 2021 or 2022 to the extent that the amounts would have been within the exclusion limits for the years from which the amounts were carried over. Notice 2021-26, however, also clarifies that reimbursements in 2022 will be taxed to the extent that the reimbursements exceed the 2022 applicable exclusion limit if the amounts do not derive from a grace period or carryover, which could occur for a non-calendar plan year that began in 2021.


Under IRC Section 129, employees may generally exclude amounts received under a DCAP up to $5,000 annually from income and wages. Because IRC Section 129's limits apply based on the individual's tax year, the limits operate on a calendar-year basis for reimbursements. Accordingly, reimbursements that exceed the $5,000 limit in a calendar year are ordinarily taxed. Section 9632 of ARPA increased the excludable amount to $10,500 for 2021. The exclusion applies whether the dependent care assistance is provided directly through a DCAP or a dependent care flexible spending arrangement (FSA) under a cafeteria plan.

Because of the COVID-19 emergency, many employees were unable to use their DCAP benefits either because they worked from home and did not require dependent care, or they were unable to access daycare due to business closings. The Disaster Relief Act, which was enacted as part of the Consolidated Appropriations Act, 2021, allows employers to amend health and dependent care FSAs to allow participants to carry over to the plan year ending in 2021 any unused amounts that would have been forfeited at the end of a plan year ending in 2020 (see Tax Alert 2020-2938). Similarly, any unused amounts that would have been forfeited at the end of a plan year ending in 2021 may be carried over to the plan year ending in 2022. Alternatively, the Disaster Relief Act permits employers to amend their FSAs to provide a grace period of up to 12 months after the end of a plan year ending in 2020 or 2021 to use the benefits.

Notice 2021-15 clarified that unused amounts paid under a grace period or carried over from 2020 or 2021 count toward the exclusion limit in the year of contribution rather than the year of reimbursement.

Notice 2021-26 further clarifies that 2022 reimbursements paid under a non-calendar-year plan that crosses from calendar-year 2021 to calendar-year 2022 due to the non-calendar design of the plan, rather than a carryover or grace period, are taxed based on the timing of reimbursement and the applicable limit in 2022. However, 2022 reimbursements derived from a carryover or grace period are eligible for the limit that applied in the year of contribution: "DCAP benefits that would have been excluded from income if used during the [tax] year ending in 2020 or 2021, as applicable, remain eligible for exclusion from the participant's gross income and are disregarded for purposes of application of the limits for the subsequent [tax] years of the employee when they are carried over from a plan year ending in 2020 or 2021 or permitted to be used pursuant to an extended claims period." This nuanced rule is demonstrated with several examples in the notice.

2022 amounts

The increase in the excludable amount to $10,500 under ARPA applies to the 2021 calendar year. As a result, if a DCAP has a non-calendar plan year beginning in 2021 and ending in 2022, the increased exclusion amount will not apply to expenses incurred in or carried over to the 2022 portion of the plan year, and those amounts will be taxable income and wages to the extent the 2022 DCAP exclusion limit of $5,000 is exceeded.


Notice 2021-26 allows the exclusion limit from the contribution year to accompany carried-over DCAP benefits. The notice highlights issues, however, for non-calendar-year plans that end in 2022. For these plans, the portion of the plan year falling in the 2022 calendar year will revert to the previously standard DCAP limit of $5,000. It is relatively uncommon for cafeteria plans or DCAPs to have non-calendar year plan years, but employers maintaining such arrangements may want to limit DCAP pretax contributions for the plan year ending in 2022 (which could be approaching open enrollment shortly) to $5,000.


Contact Information
For additional information concerning this Alert, please contact:
Compensation and Benefits Group
   • Christa Bierma (
   • Stephen Lagarde (
   • Rachael Walker (
   • Bing Luke (
Workforce Tax Services - Employment Tax Advisory Services
   • Kristie Lowery (
   • Kenneth Hausser (
   • Debera Salam (