October 22, 2024

There are four nondiscrimination tests specific to dependent care assistance programs (DCAPs), which are also sometimes referred to as dependent care flexible spending accounts (or “DCFSAs”).

They are:

• An “eligibility test,” under which the DCAP must benefit employees who qualify under an eligibility classification that does not discriminate in favor of highly compensated employees (HCEs).
• A “benefits and contributions test,” under which the benefits or contributions provided under the DCAP must not discriminate in favor of HCEs.
• The “5% owner test,” under which not more than 25% of the total benefits under the DCAP can be provided to individuals who own more than 5% of stock, capital, or profit interest of the employer company.
• The “55% average benefits test,” under which the average benefits provided to non-HCEs must be at least 55% of the average benefits provided to HCEs.

DCAPs that do not plainly discriminate in favor of HCEs, exclude certain categories of employees from participation, or limit availability only to certain member employers of controlled groups should generally face few difficulties satisfying the first three of these tests, all of which are similar to tests required for cafeteria plan testing under Code section 125.

The 55% average benefits test, however, is particular to DCAPs, and can be challenging for many otherwise nondiscriminatory DCAPs to pass. This is because the test is a pure utilization test with an especially high threshold for passage. Under this test, the average DCAP benefits provided to non-HCEs must be at least 55% of the average benefits provided to the HCEs. Thus, on average, for every $100 reimbursed to HCEs, at least $55 in benefits must be reimbursed to non-HCEs.

That may not seem at first glance like too steep a hill to climb, but there’s a catch: All DCAP elections must be thrown into the calculation mix, including the elections of those who choose not to participate in the DCAP at all. For many groups, this is the vast majority of employees, HCE and non-HCE alike. (The test may exclude employees whose compensation is less than $25,000, certain employees who are under age 21 or who have not completed a year of service, and certain collectively-bargained employees.)

This means a DCAP can fail the 55% average benefits test, even when the average benefit enjoyed by HCEs and non-HCEs who actually participate in the plan is exactly the same, as the following example illustrates:

Suppose an employer has seven employees — A, B, C, D, E, F, and G. A and B are HCEs; C, D, E, F, and G are non-HCEs. All employees are eligible to participate in XYZ’s DCAP as of their date of hire. A, B, C, and D participate in the DCAP through the cafeteria plan, using salary reduction agreements, but E, F, and G do not participate in the DCAP at all. A, B, C, and D have each reduced their salaries by $5,000 and are each provided benefits worth $5,000 under the plan.

Under the 55% average benefits test, XYZ must compare the average benefits of the HCEs with those of the non-HCEs. The average benefit provided to the HCEs is $5,000 [($5,000 + $5,000) ÷ 2]. The average benefit provided to the non-HCEs is $2,000 [($5,000 + $5,000 + $0 + $0 + $0) ÷ 5]. The average benefit provided to the non-HCEs is 40% of the average benefit provided to the HCEs ($2,000 ÷ $5,000 = 0.4), which is well under than the required 55% threshold, and, consequently, this employer’s DCAP would fail the test.

Employers that struggle to pass the 55% average benefits test but still want to provide the benefit can address the issue in various ways, including but not necessarily limited to:

Encouraging Greater Participation: Employers can increase communication efforts (e.g., educational sessions) to non-HCEs to encourage their participation in the DCAP or offer matching contributions or seed money to participating non-HCEs.

Capping HCE Elections as Needed: Employers should perform nondiscrimination testing early in the plan year as well as during open enrollment before the plan year even begins to identify potential issues, and then, if warranted, the plan could cap HCEs after the tests are conducted. Note that the cafeteria plan or the DCAP plan document should give the plan administrator authority to reduce or discontinue participants’ salary reductions as may be necessary to comply with nondiscrimination requirements.

Making the DCAP Available for Non-HCEs Only: The most certain way to address the issue would be to simply prohibit HCEs from participating in the DCAP altogether, thus ensuring passage of the 55% average benefits test (because the average benefit for HCEs would be $0).

Naturally, many employers balk at this option, and it can be a tough sell in a space where decision makers often either report to HCEs or are HCEs themselves. But this can sometimes be a result of a misunderstanding of how DCAPs are treated for tax purposes. DCAPs do not offer $5,000 in potential tax savings, as many people mistakenly believe. Rather, they provide for a potential $5,000 reduction in taxable income, with a resultant lowered income tax liability amount that is much less than a $5,000 benefit amount.

As an example, consider an employee who is an HCE with an annual salary of $160,000. The employee has a preschool-aged child for whom they pay $10,000 a year for dependent care, and they participate in the employer’s DCAP, electing the maximum amount of $5,000 to help pay for that care. The employee will file their 2024 taxes as a single filer.

For 2024, the marginal tax rate on $160,000 for single filers is 24%. If this employee is able to reduce their salary for the whole $5,000 amount, the estimated resultant estimated tax savings to them would be $1,582.50 (calculated by adding the marginal tax rate of 24% and the FICA rate of 7.65% on $5,000 together ($1,200 + $382.50 = $1,582.50)).

Thus, the estimated effect of this HCE’s prohibition from participating in their employer’s DCAP would be the inability to reduce their taxes by $1,582.50. While this is not insubstantial, they would not be missing out on $5,000 in tax savings.

(Please note that this example is intended for illustrative purposes only and is simplified for that purpose. It is not intended to reflect any specific individual’s tax situation, nor should it be relied upon as tax advice by any individual or entity.)

Notwithstanding the above, employers are often understandably reluctant to prohibit their HCEs from participating in their DCAPs outright. Such employers should therefore become familiar with the consequences of failing the 55% average benefits test, which, as it happens, are somewhat less severe for HCEs than those for some other forms of nondiscrimination failures. Most notably, while the cafeteria plan nondiscrimination rules require HCEs to include in gross income any amount that could have been received as cash (e.g., the total salary reduction amount), the DCAP nondiscrimination rules only require an HCE to include in gross income those amounts (or reimbursements) that were actually received as dependent care assistance.

Furthermore, the DCAP itself is not disqualified. Non-HCEs are not adversely affected in any way, nor are there any additional monetary penalties for employers providing a discriminatory plan (though discriminatory amounts included in income for HCEs may, of course, be subject to payroll taxes and the like). In the event of a discriminatory plan, it is incumbent upon employers to consult with their tax advisors to determine the appropriate amount of income and tax reported and whether Forms W-2 need to be amended.

For further information, please ask your broker or consultant for a copy of the PPI publication Section 129 Dependent Care Assistance Program Nondiscrimination Rules: A Guide for Employers.