Not seeing your return, this is what I believe is happening. NOTE: the general rule is that the carryover must be used in the grace period (which is temporarily one year) and not carried over indefinitely.
1. You contributed $10,500 to your FSA in 2021.
2. You also carried over $40 in unused FSA funds from 2020.
3. Your actual expenses in 2021 were only $5,636
4. The actual expenses were taken from the current year contributions (line 1). This meant that your $40 carryover (line 2) was not applied to any expenses, so became taxable income.
5. The remaining 2021 amount ($4,864) will carry over to 2202, to be applied to expenses then.
6. NOTE:
A. According to IRS Notice 2021-15, any expenses from 2021 must be used in 2022; the normal grace period of 2.5 months (if any is allowed by the employer) resumes after the end of 2022.
B. While IRS Notice 2021-15 allows employer to extend the carry over period for up to one year for 2020 and 2021, it does not require employers to do this – you must check with your employer to see if their Dependent Care FSA rules were modified.
C. You may want to consider how much (if any) you exclude from income for your Dependent Care FSA in 2022. You will want to make sure that there is room for all of your carryover to be applied to expenses as well as your current year (2022) contributions.
@riteden
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