Compliance Update: DCFSA & COBRA Regulations

Insight By
Michael LoVasco
Topic
Employee Benefits

This update provides compliance highlights from two recently released IRS Notices:

IRS Offers Clarity on Taxation of 2021 and 2022 Dependent Care Assistance Program (DCAP) Benefits

On May 10, the IRS issued Notice 2021-26, which offered clarifying guidance on certain taxation issues related to employees’ participation in dependent care assistance programs (DCAPs)—including Dependent Care FSAs—during 2021 and 2022. Specifically, it addresses the temporary increase in the maximum gross income exclusion (the “annual limit”) to $10,500 for the 2021 tax year, and how it interacts with the special unlimited carry over and extended claims periods for plan years ending in 2020 and 2021.  

The primary guidance is that amounts attributable to previously issued carryover and extended grace period relief are generally NOT taxable for 2021 and 2022.

Background

Previously, unused DCAP funds were not allowed to be carried over to a subsequent plan year but could be subject to a 2.5 month grace period for incurring additional claims after the applicable plan year.

However, to address the change in dependent care demand during the pandemic, the Consolidated Appropriations Act of 2020 (the "CAA") offered new flexible options for unused DCAP funds, allowing employers to amend their plans to allow DCAP participants to carryover unused funds from plan year 2020 to 2021 and plan year 2021 to 2022.

Alternatively, employers could extend a DCAP grace period for the plan year ending in 2020 or 2021 up to a period of 12 months.

Some of the specific highlights include:

  • Calendar year Dependent Care FSAs that permitted unlimited carryovers from the 2020 to 2021 plan year can allow employees to make up to $10,500 in salary reduction contributions for the 2021 plan year. This means employees potentially can claim up to $15,500 in non-taxable reimbursements from Dependent Care FSAs for dependent care expenses incurred in 2021.
  • Calendar year Dependent Care FSAs that permit employees to make salary reduction elections up to the $10,500 maximum for the 2021 plan year, can also permit them to carry over the full unused amount from the 2021 plan year to use for dependent care expenses incurred in 2022. The full amount, plus any additional salary reduction contributions for 2022, can be used for dependent care expenses incurred in 2022 without causing the employee to recognize any taxable income.  This is true even if the annual gross income exclusion limit for employer provided DCAPs reverts to $5,000 in 2022, as current law provides.
  • Even though the same rules generally apply to non-calendar year Dependent Care FSAs, permitting employees to make salary reduction contributions of up to $10,500 for the plan year beginning in 2021 could result in unexpected tax consequences for participants in 2022.  This is because the annual limit applies on a tax-year basis, and the special rules relating to carryovers from plan years ending in 2021 do not apply with respect to amounts carried forward from one tax year to the next within the same plan year.
Potential Impact
  • Notice 2021-26 may give employers sponsoring calendar year Dependent Care FSAs the clarity needed to decide on adopting the $10,500 limit for 2021, if they have not already done so.  
  • Employers with non-calendar year Dependent Care FSAs should carefully consider Notice 2021-26’s implications before adopting the $10,500 limit. Those that do adopt the higher limit will need to be careful to ensure compliance with their tax reporting obligations and may want to help educate participants about potential unexpected tax consequences.
Example

Assume the following:

  • Employee elects to contribute $5,000 for DCAP benefits for the 2020 plan year but incurs no dependent care expenses during that plan year.
  • The employer amends its plan to allow the employee to carry over the unused $5,000 of DCAP benefits to the 2021 plan year.
  • The employee elects to contribute $10,500 for DCAP benefits for the 2021 plan year, incurs $15,500 in dependent care expenses for that plan year, and is reimbursed $15,500 by the DCAP.

Impact:

  • The $15,500 is excluded from the employee's gross income and wages because $10,500 is excluded as 2021 benefits.
  • The remaining $5,000 is attributable to a carryover permitted by the previously issued coronavirus-related relief.

IRS Issues Guidance on American Rescue Plan’s Cobra Subsidy

In much-anticipated guidance, the Internal Revenue Service has offered its insight on the implementation of the COBRA temporary premium subsidy provisions of the American Rescue Plan Act of 2021 (ARPA) in Notice 2021-31, issued May 18, 2021. The Notice discusses the background of the subsidy and includes 86 questions and answers (Q&As) about its application.

IRS Q&A Topics
  • Eligibility for COBRA premium assistance
  • Reduction in hours
  • Involuntary termination of employment
  • Coverage eligible for COBRA premium assistance
  • Beginning and end of COBRA premium assistance period
  • Extended election period
  • Extensions under the Emergency Relief Notices
  • Payments to insurers under federal COBRA
  • Comparable state continuation coverage
  • Calculating and claiming the COBRA premium assistance credit
The COBRA Subsidy

The ARPA subsidy covers 100% of COBRA and state mini-COBRA premiums from April 1–Sept. 30, 2021, for certain assistance-eligible individuals whose work hours were reduced or whose employment was involuntarily terminated. The subsidy is funded via a tax credit provided to employers, insurers or group health plans, according to the terms of the statute.

Plan administrators are subject to new requirements to notify individuals who may be eligible for this relief, including a notice that must be provided by May 31, 2021.

The IRS Guidance

Among the topics covered by the 40-page Notice are how to calculate and claim the tax credit, including when a third-party payer is involved. According to the guidance, employers must document individuals’ eligibility for COBRA premium assistance to claim the credit.  

The FAQs in Notice 2021-31 are helpfully organized by topic, starting with who is eligible for COBRA premium assistance, and ending with how employers claim the federal tax credit to pay for the subsidy. Given the expansive information covered by the Notice, this update includes just some key highlights of what the Q&A further clarifies, including:  

  • The subsidy is available for extended periods of COBRA coverage between April 1 and Sept. 30, 2021, due to a disability, second qualifying event, or extension under state mini-COBRA.
  • Involuntary termination includes constructive discharge and termination for cause, but not gross misconduct.
  • COBRA premium assistance is available for COBRA continuation coverage under vision-only plans, dental-only plans, and health reimbursement arrangements.

Employers must maintain documentation substantiating individuals’ eligibility for the subsidy.

This Legal Update is not intended to be exhaustive, nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel for legal advice.

Insight By
Michael LoVasco
Executive Vice President
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Not applicable

Topic
Employee Benefits
Published on

June 21, 2021

updated on

May 25, 2021

Disclosure

This article is for educational purposes only. The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that LoVasco Consulting Group is not engaged in rendering tax or legal services. If tax or legal advice is required, you should consult your accountant or attorney. LoVasco Consulting Group does not replace those advisors.

Securities and Investment Advisory Services offered through M Holdings Securities, Inc., a registered broker dealer and Investment Advisor, member FINRA / SIPC. LoVasco Consulting Group is independently owned and operated.

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