Dependent Care Assistance Programs: Nondiscrimination Testing

By: HUB’s EB Compliance Team

Dependent Care Assistance Programs (“DCAP”), also known as Dependent Care Flexible Spending Accounts (“DCFSA”) can be a valuable benefit for employers to offer to their employees. In each of the last two months, HUB wrote about how these benefits work and mid-year election changes respectively. This month, HUB’s series on DCAPs continues with an overview of the nondiscrimination rules applicable to these plans.

Nondiscrimination Rules

Many employer sponsored benefits, including DCAPs, include nondiscrimination provisions. Normally discrimination is viewed as a negative (i.e., discriminating against). However, for purposes of these rules, discrimination is viewed as a positive (i.e., discriminating in favor of). These rules are designed to prevent the plan from discriminating in favor of highly compensated employees (“HCE”). The applicable regulations prescribe a series of tests, which allow plan sponsors to determine if their plans are in fact favoring the HCEs.

Highly Compensated Employees

Before completing the applicable tests, plan sponsors must understand who the HCEs are under their plan. HCEs are those individuals who either are greater than 5% shareholders of the entity (in the current or previous plan year) or whose compensation in the previous plan year was greater than the threshold ($155,000 for 2024, $160,000 for 2025). Dependents of HCEs are also treated as HCEs for these testing purposes.

Plan sponsors should be aware that these definitions of HCEs are applicable only to DCAPs. Different benefits use other definitions to determine HCEs. Additionally, certain tests discussed here allow employers to exclude certain individuals for testing purposes. The excludable employees vary by test and are beyond the scope of this article.

Eligibility Test

This test looks at the eligibility to participate in the DCAP. In plan terms, this test asks whether enough non-HCEs are eligible to participate in the plan as compared to the HCEs. For many plans, this is not an issue since all full-time employees (or possibly all employees without regard to full-time or part-time status) are eligible for the DCAP. For plans that limit eligibility, such as only allowing corporate employees to be eligible while excluding field employees, or for entities sharing common control, excluding certain entities from eligible, this test may be problematic.

As an important distinction between DCAPs and health and limited-purpose Flexible Spending Accounts (“FSA”) is that DCAPs are not subject to the uniform coverage rule applicable to FSAs. This rule allows participants access to the entire elected amount as of the beginning of the plan year, which can result in a risk of potential loss due to overspent accounts for plan sponsors. Since this rule does not apply to DCAPs, plan participants can only use funds they have actually contributed. This fact may alleviate concerns for employers who have limited DCAP eligibility, potentially at the expense of the eligibility test.

Contributions and Benefits Test

This test looks at the actual benefits available to HCEs and non-HCEs alike. If HCEs are eligible for greater benefits or potentially the same benefits at a lower cost than non-HCEs, the employer may fail this test. As an example, if an employer allows hourly employees to contribute a maximum of $2,000 per year to the DCAP, but salary employees are allowed to contribute up to $5,000 the employer may fail this test. Likewise, if an employer provides a matching contribution to employees in Location A (which happens to be where all HCEs work) but no match in Location B, they may fail this test.

Just as with the eligibility test discussed above, the lack of a uniform contribution rule for DCAPs plays a role here too. Employers with different DCAP contribution limits for different classes of employees may find the absence of this rule reassuring.

More Than 5% Owners Concentration Test

While the eligibility test and contributions and benefits tests are fairly simple, the more than 5% owners concentration test is more complex. This test is designed to ensure that the more than 5% owners (and their dependents) do not receive more than 25% of the total benefits under the DCAP. This test requires an actual calculation to determine what percentage of the total benefits under the DCAP are going to more than 5% owners.

The example below contains the test results for a sample employer. This particular employer has low participation in their DCAP, with only five individuals participating. This is not uncommon. Unfortunately, 40% of their total participants are more than 5% owners (A and B). Together, the contributions from A and B comprise well over 25% of the total benefits under the DCAP, thus the employer fails this test.

Employers often find this test challenging because they may fail due to no fault of their own. This test depends on the specific elections made by plan participants. An employer may pass the eligibility and contributions and benefits tests without issue yet still fail this test. In particular, employers with low DCAP participation and those with multiple greater than 5% owners may experience challenges with this test.

55% Average Benefits Test

This test, like the more than 5% owners concentration test, is yet another test based on actual utilization under the plan. In order to pass this test, the average benefits provided to non-HCEs must be at least 55% of the average benefits provided to HCEs. Effectively for every $100 received in benefits by the HCE group, the non-HCE group must receive at least $55. If the non-HCE group receives less than $55 the employer would fail the test.

Below is a sample calculation of this test. Notably, this test looks at the total number of HCEs and non-HCEs rather than just those who are actually participating in the plan. Since many employers have significantly more non-HCEs than HCEs, this brings the average benefit for non-HCEs down, and thus, passing this test is a challenge.

Addressing Failed Tests

If an employer fails any of the tests described above, the benefits provided to HCEs become taxable (i.e., HCEs lose the tax benefit of the DCAP). Non-HCEs would not suffer any adverse effects from failed tests. Fortunately, correcting failed tests is allowed and often allows HCEs to maintain a portion of their original DCAP election and the associated tax benefit.

At a basic level, corrections are made by reducing the elected contributions of the HCEs to a point where the employer can pass the test(s) they originally failed. Using the 55% Average Benefits Test results above, if the HCE contributions were reduced from $80,000 to $56,103 the employer would pass this test. The DCAP administrator typically performs the testing and provides any election adjustments required to pass the tests.

Conclusion

This article is designed to provide an introductory overview of the DCAP nondiscrimination tests. Next month, HUB’s series on DCAPs will continue by highlighting strategies employers can utilize to potentially pass the nondiscrimination tests.

If you have any questions, please contact your HUB Advisor. View more compliance articles in our Compliance Directory.

NOTICE OF DISCLAIMER

Neither HUB International Limited nor any of its affiliated companies is a law or accounting firm, and therefore, they cannot provide legal or tax advice. The information herein is provided for general information only and is not intended to constitute legal or tax advice as to an organization’s or individual's specific circumstances. It is based on HUB International's understanding of the law as it exists on the date of this publication. Subsequent developments may result in this information becoming outdated or incorrect, and HUB International does not have an obligation to update this information. You should consult an attorney, accountant or other legal or tax professional regarding the application of the general information provided here to your organization’s specific situation in light of your or your organization’s particular needs.