DCA Failure-Can the "after-tax" reclassified amount be pulled out of the Plan?

For those owners who are having some DCA contributions reclassified as after-tax in order to pass the Average Benefits Test, can the employer pull that money out of the funding account and just give it back to the employee? Or, does the employee still need to use those funds for qualified DCA expenses?

It sort of makes sense to give those dollars back to the employee since they aren't really getting any pretax benefits from it anymore. 

Thanks

@dmwe Yes, I agree.  My position is the excess contributions (i.e., amounts contributed in excess of the reduced cap caused by the NDT) are no longer dependent care FSA balance amounts. 

Therefore, any amounts not already distributed prior to the reduction need to be directly returned or made available without the need to submit qualifying dependent care expenses.

Here's a summary:

https://www.theabdteam.com/blog/failing-dependent-care-55-average-benefit-test-2/

Excess Contributions Not Distributed: Refunded as Taxable Income or Recharacterized as Taxable Income

The amount of HCE contributions in excess of the reduced limit that have not yet been reimbursed to the HCEs must also be made taxable income before the end of the year.

There are two possible approaches:

Refund/Return: Have the TPA refund the excess contributions to the company (skip if amounts are not held by the TPA), and then the company will distribute the excess back to the HCEs through payroll as standard taxable wages included in gross income and subject to withholding and payroll taxes by the end of the year.

Recharacterize: Recharacterize the excess contributions as taxable income in the same manner as the excess distributions.  Then inform HCEs that they may take a distribution of the excess contributions (which no longer have pre-tax status) from the FSA without the need to submit qualifying dependent care expenses.

That's the answer I was looking for. Thanks for the link too.

@Brian Gilmore This was really helpful.  Our provider just alerted us to the need to refund $2000 in excess contributions to an HCE that were for the 2020 plan year, but in my eyes that year has closed, and this would be considered taxable in the year of receipt 2021.  Would we have to do a 2020 W-2c and correct the 941, or would it be considered taxable for the 2021 year?  Everything I am reading online seems to lean towards the latter because the funds are being made available in the current year.

19 hours ago, Cheryl Carder said:

@Brian Gilmore This was really helpful.  Our provider just alerted us to the need to refund $2000 in excess contributions to an HCE that were for the 2020 plan year, but in my eyes that year has closed, and this would be considered taxable in the year of receipt 2021.  Would we have to do a 2020 W-2c and correct the 941, or would it be considered taxable for the 2021 year?  Everything I am reading online seems to lean towards the latter because the funds are being made available in the current year.

Unfortunately, I think you have bigger fish to fry in that scenario.  I assume you mean that this $2,000 amount was not properly recharacterized as taxable in 2020 before the end of the year.  That's a problem because adjustments to pass the 55% average benefits test can't be made after year end.  So if this amount caused the plan to fail the 55% average benefits test, all HCEs would theoretically need to have their full elections recharacterized as taxable in 2020.

If on the other hand you already recharacterized that $2,000 as taxable in 2020, and the FSA TPA is just stating that the recharacterized balance remains in the account, then you would simply distribute those funds to the employee.  I take the position that once they've been recharacterized as taxable they really aren't FSA funds anymore, and they can be distributed without qualifying expenses.  There would be no taxation on the distribution because they were already taxed in 2020.