Potential Impact of COVID-19 on Dependent Care Flexible Spending Arrangements (FSAs)

Potential Impact of COVID-19 on Dependent Care Flexible Spending Arrangements (FSAs)

July 8, 2020
Potential Impact of COVID-19 on Dependent Care Flexible
Spending Arrangements (FSAs)
Dependent care flexible spending arrangements (FSAs) are
of an employee’s dependent that allow the employee to be
a benefit that employers may offer employees. They allow
gainfully employed (as defined for the child and dependent
employees to pay for certain dependent care services (e.g.,
care credit [IRC §21]). Dependents may include, but are not
child care, summer day camp, babysitting, and adult day
necessarily limited to, an employee’s children, elderly
care expenses) with pretax dollars. Dependent care FSAs
parents, or other dependent family members.
are also referred to as dependent care assistance plans
(DCAPs). Employees who participate in a dependent care
Cafeteria Plan
FSA choose to have a portion of their salary set aside on a
Under a cafeteria plan governed by IRC §125, employees
pretax basis (i.e., not subject to federal income or payroll
typically determine the amount they wish to contribute to
taxes), generally up to a maximum of $5,000 per year.
an FSA at the beginning of a plan year. Plan years are
There are other types of FSAs. Health FSAs, for example,
usually annual periods during which employees may
allow employees to pay for eligible health care expenses
contribute to and be reimbursed from an FSA. Once an
with pretax dollars. For a discussion of health FSAs in the
employee has set the amount he or she wishes to contribute
context of the Coronavirus Disease 2019 (COVID-19)
to an FSA for a plan year, changes are allowed only in
pandemic, see CRS In Focus IF11576, Potential COVID-19
limited circumstances (like the birth of a child or marriage),
Impacts on Health Flexible Spending Arrangements (FSAs)
generally referred to as a “qualifying life event.” Plan years
and Recent Health FSA Changes.
may begin and end at any point in the calendar year.
Overview of Dependent Care FSAs
Under a cafeteria plan, FSA contributions are subject to a
Dependent care FSAs are offered to employees as part of a
“use-or-lose” rule, whereby employees forfeit any unused
cafeteria plan. Under a cafeteria plan, employees are
contributions remaining in their dependent care FSA at the
offered the option to set aside a portion of their salary on a
end of the plan year. Specifically, when an employer
pretax basis. Employees then use these contributions to pay
chooses to offer a dependent care FSA, it generally must
for expenses incurred for a qualified benefit. Generally,
select one of two mutually exclusive options for handling
under a dependent care FSA, employees pay out of pocket
any unused balances at the end of the plan year:
for the expenses and are then reimbursed from their FSA.
By using an FSA, employees reduce the income and payrol
1. employees forfeit unused FSA balances,
taxes they owe. For example, an employee subject to a 22%
which then revert to the employer; or
income tax rate who has $1,000 of dependent care expenses
2. employees are given a “grace period” of up to
would save $296.50 in taxes ($220 in federal income taxes
two and a half months after the end of the plan
and $76.50 in Social Security and Medicare payroll taxes)
year. Employees can be reimbursed for
by paying for those expenses through an FSA rather than
dependent care expenses incurred during this
paying out of pocket (i.e., with after-tax dollars).
additional time. At the end of the grace period,
unused amounts are forfeited and revert to the
Dependent care FSAs must meet the requirements of both
employer.
Internal Revenue Code (IRC) §129 and IRC §125 for an
employee to receive the tax benefits associated with
The “use-or-lose” rule ensures that a cafeteria plan is not
contributing to a dependent care FSA. IRC §129 governs
used to defer compensation (and the taxes paid on that
employer-sponsored dependent care benefits broadly.
compensation) to a future date, which is generally
(Employer-sponsored dependent care benefits can be
prohibited under IRC §125.
provided in various forms, including as a dependent care
FSA, but also on-site child care and direct payments to
Under current law and regulations, employees are not able
dependent care providers.) IRC §125 governs cafeteria
to “cash out” the balance of an FSA, even if they were to
plans. These two sections are discussed in more detail
pay taxes on this amount. FSA contributions may only be
below.
used to pay for qualified expenses through the plan.
Dependent Care Assistance Program
Because cafeteria plans are offered by employers to their
Under an employer-sponsored dependent care benefit
employees, individuals may lose access to these benefits
governed by IRC §129, an employee may contribute up to
when they are laid off or choose to leave a job. Employers
$5,000 per year to a dependent care FSA (this maximum
may offer some flexibilities to departing employees.
applies to all taxpayers who file their taxes as single, head
Generally, employers may treat unused contributions in a
of household, or married filing jointly). This section also
departing employee’s dependent care FSA in the following
defines “dependent care assistance” as expenses for the care
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Potential Impact of COVID-19 on Dependent Care Flexible Spending Arrangements (FSAs )
ways: (1) any benefits in the departing employee’s
flexibilities to employers offering certain benefits through
dependent care FSA revert to the employer; (2) the
cafeteria plans (see IRS Notice 2020-29). These flexibilities
employer offers a run-off period, in which departing
allow, but do not require, employers to change some
employees may submit for reimbursement expenses that
policies related to dependent care FSAs.
were incurred prior to the employee’s departure; or (3) the
employer offers a spend-down period, which allows
First, the IRS notice gives employers the option of allowing
departing employees to continue being reimbursed from
employees to make prospective, mid-year amendments to
funds in their dependent care FSA until the end of the plan
their FSA contributions without the need for a qualifying
year. Employers have the ability to offer departing
life event during calendar year 2020. This option would
employees both a run-off period and a spend-down period.
allow employees experiencing reduced dependent care
expenditures to lower their FSA elections for the remainder
Impact of COVID-19 on Dependent Care of the plan year, or stop their elections entirely. In the case
FSAs
of the employee in Example 1, this flexibility (if offered by
The COVID-19 pandemic has considerably affected the
their employer) would allow the employee to stop
market for dependent care. Many child care providers,
contributions to the dependent care FSA for the remainder
summer camps, adult day care providers, and other forms of
of the plan year, limiting the total balance the employee
dependent care have been forced to close or reduce the
might forfeit at the end of the plan year.
number of individuals they serve due to concerns about the
spread of COVID-19. Employees may be working less as a
Second, the IRS notice gives employers the ability to
result of the pandemic, or have had work conditions
extend grace periods for using FSA balances until
change, reducing their need for dependent care.
December 31, 2020. This flexibility applies to dependent
care FSAs with either a plan year or a grace period ending
The laws and regulations governing dependent care FSAs
in 2020. For example, if a plan year ended on March 31,
normally offer little flexibility to employees whose
2020, an employer could normally offer a grace period up
dependent care expenditures change. Under most
to June 15, 2020. After June 15, employees would forfeit
circumstances, employees are not given the opportunity to
any balance remaining in a dependent care FSA. The IRS
reduce or stop their dependent care FSA contributions
notice allows employers to extend that grace period until
midyear. If reduced dependent care expenses cause
December 31, 2020, which would benefit employees with
employees to have contributions remaining in their FSA s at
existing dependent care FSA balances who expect to have
the end of the plan year (or grace period, if applicable), they
additional dependent care expenses before the end of 2020.
would stand to forfeit that balance.
In the case of the employee in Example 2, this flexibility (if
offered by their employer) would allow the employee to use
Employees whose dependent care circumstances have
any remaining balance in the FSA for dependent care
changed due to COVID-19 may be at risk of forfeiting FSA
expenses incurred between July 15, 2020, and December
contributions. Consider the following two examples of how
31, 2020.
employees with dependent care FSAs may be impacted by
the pandemic:
Legislation
Members of Congress have introduced legislation to
Example 1. An employee contributes $3,000 per year to a
address issues related to dependent care FSAs and the
dependent care FSA to pay for their child’s summer day
COVID-19 pandemic. Several bills , including H.R. 6800,
camp. The contributions are made in equal payroll
H.R. 6958, H.R. 7008, and S. 3972, would give employers
deductions each pay period. Due to the COVID-19
the flexibility to allow employees to roll over all
pandemic, the camp announced that it will not open at any
contributions to a dependent care FSA from a plan year
point this summer. The employee is still slated to make
ending in 2020 to a plan year ending in 2021. If offered by
contributions to their dependent care FSA for the
employers, this change would prevent employees from
remainder of the plan year. The camp is the employee’s
forfeiting unused contributions made to a dependent care
only dependent care expense, and they now stand to forfeit
FSA in 2020. In the case of the employee in Example 1, if
their $3,000 in contributions at the end of the plan year.
allowed by their employer, this change could allow them to
apply their 2020 plan year FSA balance toward 2021 plan
Example 2. An employee contributes the maximum $5,000
year expenses. Section 20155 of H.R. 6800 would also
per year to a dependent care FSA to pay for full-time child
allow employers to extend grace periods for a dependent
care for their two children. The FSA plan year ran from
care FSA for up to 12 months after the end of a plan year
May 1, 2019, to April 30, 2020. The employee began
ending in 2020. This change would allow the employee in
work ing remotely as a result of the pandemic, and has not
Example 2 to use plan year 2020 FSA balances until April
used child care for several months. As a result, they had a
30, 2021.
$1,000 balance remaining at the end of the plan year. Their
employer offers a grace period until July 15, 2020, but the
Conor F. Boyle, Analyst in Social Policy
employee does not anticipate additional dependent care
Margot L. Crandall-Hollick, Acting Section Research
expenses before that date.
Manager
Recent Executive Branch Activity
IF11597
To address the impacts of the COVID-19 pandemic, the
Internal Revenue Service (IRS) provided temporary
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Potential Impact of COVID-19 on Dependent Care Flexible Spending Arrangements (FSAs)

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https://crsreports.congress.gov | IF11597 · VERSION 1 · NEW