By: HUB’s EB Compliance Team

Higher annual contribution limits for Dependent Care Assistance Programs ("DCAP")—sometimes referred to as Dependent Care Flexible Spending Accounts ("DCFSA")—included in the One Big Beautiful Bill Act ("OBBBA") have sparked renewed interest in these programs. After examining how these accounts operate, when plan year election changes are permitted and nondiscrimination testing requirements, this final article in the series addresses plan design strategies employers can consider when faced with nondiscrimination testing failures.

Nondiscrimination Failures

As a reminder, nondiscrimination rules are designed to prevent plans from discriminating in favor of highly compensated employees (“HCE”). Employers are often surprised to learn they have failed one or more DCAP nondiscrimination tests. In fact, failing one or more of these tests is not as uncommon as employers may believe. Even when DCAP benefits are offered to all employees, employers can still fail testing based on whom elects the plan in any particular year and what elections they make. Several factors then commonly contribute to nondiscrimination test failures. Understanding these factors, outlined below, may also then help employers take preventive action.

First, employee demographics and compensation may limit who has a need for a DCAP, as well as the ability to contribute to one. Not all employees will have a qualifying dependent and therefore, will not have any need for a DCAP. While this factor is technically age-agnostic, younger employees who have yet to have children and older employees whose children are no longer eligible may be most likely to fall into this category. Likewise, lower-paid employees may have eligible dependents, but may not have the financial ability to make DCAP contributions and then await reimbursement.

Second, low participation rates among non-HCEs can skew the benefits distribution. If rank-and-file employees who are not HCEs do not utilize the DCAP at meaningful levels, the percentage of benefits going to HCEs increases.

Third, employers with a high proportion of HCEs or owners relative to their total workforce face structural challenges in passing the concentration test. This is particularly common in professional services firms, startups with significant equity holdings among founders and family-owned businesses.

Finally, inadequate communication and education about the DCAP can depress participation among those who would benefit most from the program. Employees may not understand how the DCAP works, may be confused about eligible expenses or may be unaware of the tax savings available. Employees who don’t understand DCAPs are unlikely to enroll in them.

Strategies to Consider

Employers who consistently struggle to pass nondiscrimination testing may want to consider certain changes that could potentially increase the likelihood of passing. Before considering such changes, employers must understand that employee populations, individual circumstances, and thus, DCAP elections may vary considerably from year to year. Thus, without actual plan elections already made, evaluating strategies to pass testing involves making certain assumptions about those elections. The more accurate the assumptions, the more likely the plan is to pass testing.

Strategy 1: Consider Alternative Plan Structures

One approach is to offer the DCAP benefit only to non-HCEs. By excluding HCEs from eligibility entirely, the plan eliminates the risk of discrimination in their favor. Since this requires that HCEs lose access to the tax benefit, employers will need to weigh whether the benefit of passing testing outweighs the cost of potentially upsetting HCEs.

Employers might also consider allowing HCEs to participate, but at a lower contribution limit as compared to non-HCEs. For example, HCEs could be limited to annual elections of $2,500 while non-HCEs may contribute up to the IRS limit of $7,500. This strategy has the advantage of allowing HCEs to participate, however it is not foolproof as (a) the plan may still fail and thus have to further reduce elections by HCEs in order to pass; and (b) an employer-established limit risks being lower than what could be allowed and is therefore only set in order to pass testing.

Strategy 2: Offer Employer Contributions or Matching

Providing employer contributions to DCAPs can significantly boost participation among non-HCEs. While employer contributions increase plan costs, they can make participation more attractive to employees who might otherwise decline to participate. Such an approach may also help an employer attract and retain employees who may see significant value in an employer DCAP contribution.

Employer contributions can be structured as either a flat amount or as a matching contribution. Employers contributing flat amounts would contribute that amount, such as $500 or $1,000 per year (or even more) to all employees, or possibly only to non-HCEs. This approach provides immediate value and reduces the amount employees need to contribute from their own compensation to reach meaningful benefit levels. Matching contributions are handled similar to retirement plans. For example, the employer might match 50% of employee contributions up to a specified dollar amount. This approach incentivizes employee participation while controlling employer costs.

When implementing employer contributions, sponsors should ensure the contribution structure itself does not create discrimination issues. Contributions should be offered on a uniform basis or according to a classification that satisfies the eligibility test requirements.

Strategy 3: Adjust Plan Design Elements

Certain plan design features can encourage broader participation and help with nondiscrimination testing. Employers should review their current plan design to identify potential barriers to participation.

Reducing or eliminating minimum contribution requirements makes the plan more accessible to lower-paid employees who may have budget constraints. Even low required contribution levels can deter participation among those who could benefit from the tax savings.

Shortening or eliminating waiting periods for new employees to become eligible can expand the participant base. Immediate eligibility upon hire ensures that all employees can take advantage of the benefit throughout the year.

Strategy 4: Enhance Communication and Education

One of the most effective strategies for improving test results is increasing participation among non-HCEs through better communication. Many employees who could benefit from a DCAP do not participate simply because they do not understand the program or its value.

Employers should develop comprehensive communication campaigns that explain how DCAPs work in clear, accessible language. This includes creating materials that outline eligible expenses, provide examples of potential tax savings based on different income levels and walk through the enrollment process step-by-step.

Targeted outreach to employees with young children or elderly dependents can also be particularly effective. Employers can use demographic data to identify employees who are most likely to incur dependent care expenses and then provide personalized communications to these groups.

Year-round education, rather than communication limited to open enrollment periods, helps keep the benefit top of mind. Employers can share reminders about eligible expenses, success stories from participants and tips for maximizing the benefit throughout the year.

Conclusion

The strategies covered here provide options that employers who fail DCAP nondiscrimination testing can consider that may allow them to pass testing. Some strategies may work better for certain employers than others. This concludes HUB’s series on DCAPs.

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.