Dependent Care FSA Nondiscrimination Testing Requirements

A Dependent Care Flexible Spending Account (DCFSA) allows employees to set aside pre-tax money from their paychecks to cover qualified dependent care expenses. These accounts reduce an employee’s taxable income, providing a financial benefit for costs such as daycare, preschool, and summer camps. To ensure these tax advantages are not unfairly concentrated among a company’s highest earners, the Internal Revenue Service (IRS) mandates annual nondiscrimination testing. This testing verifies that the DCFSA plan benefits a broad cross-section of employees and does not disproportionately favor those with higher incomes or ownership stakes.

Key Definitions for Testing

The primary employee classifications for testing are Highly Compensated Employee (HCE) and Non-Highly Compensated Employee (NHCE). For 2025 testing, an HCE is an individual who earned more than $155,000 in 2024. An employee is also an HCE if they were a 5% owner of the business at any time during the current or preceding year. Any employee who does not meet the HCE definition is automatically classified as an NHCE.

A separate classification is “Key Employee,” which is used for a specific concentration test. A Key Employee is defined as an employee who, during the prior plan year, was an officer with compensation over a certain limit ($220,000 for 2024), a more-than-5% owner of the business, or a more-than-1% owner with compensation exceeding $150,000.

Information Required for Testing

Before beginning the tests, an employer must compile specific data for the entire employee population for the plan year. This information includes:

• A complete employee census listing every individual employed for any part of the plan year.
• Total compensation data for each employee to identify HCEs and NHCEs.
• Each employee’s annual DCFSA election amount, including zero-dollar elections for those who waived participation.
• Detailed business ownership information to identify 5% owners and Key Employees.

The Required Nondiscrimination Tests

A DCFSA must pass a series of tests outlined in Section 129 of the Internal Revenue Code to maintain its tax-favored status. These tests analyze eligibility, contributions, and the concentration of benefits among different employee groups.

Eligibility Test

This test ensures the plan does not make it harder for NHCEs to become eligible to participate compared to HCEs. The plan must benefit a classification of employees that the IRS finds to be nondiscriminatory. While there are complex mathematical safe harbors, a common rule of thumb is that the percentage of NHCEs eligible for the plan must be at least 70% of the percentage of HCEs who are eligible. This test focuses only on who is allowed to join the plan, not who actually enrolls.

Contributions and Benefits Test

This test requires that all participants have uniform access to the benefits offered. It is satisfied if all eligible employees can elect up to the statutory maximum of $5,000 per household per year ($2,500 if married and filing separately), an amount not indexed for inflation. The plan cannot have different election limits or employer contribution formulas for HCEs versus NHCEs.

More-Than-5% Owners Concentration Test

This test restricts the benefits paid to significant owners. No more than 25% of the total benefits paid by the DCFSA during the plan year can be for shareholders or owners who hold more than 5% of the company’s stock or capital. The test is calculated by dividing the total benefits paid to these 5% owners by the total benefits paid to all employees. If this ratio exceeds 25%, the test is failed.

55% Average Benefits Test

The 55% Average Benefits Test is often the most difficult to pass. It compares the average benefit received by NHCEs to the average benefit received by HCEs. To pass, the average benefit for the NHCE group must be at least 55% of the average benefit for the HCE group.

All eligible employees are included in this calculation, even those who do not participate and have a zero-dollar election. For example, if the average HCE benefit is $4,000, the average NHCE benefit must be at least $2,200. Because HCEs often have higher utilization rates, this test can be challenging for many employers to meet.

Consequences of a Failed Test

If a DCFSA plan fails nondiscrimination testing and is not corrected, the consequences affect only the HCEs. The entire amount each HCE received in dependent care reimbursements for the year becomes taxable income. This loss of tax-free status applies to all HCEs in the plan.

The tax-advantaged status of benefits for NHCEs is not affected by a failed test. The employer must report the HCEs’ benefits as taxable wages in Box 1 of their Form W-2, subjecting the amount to federal income, Social Security, and Medicare taxes. This can result in an unexpected tax liability for the HCEs, which underscores the importance of monitoring plan data throughout the year.

Corrective Actions for a Failed Test

If a plan is failing a nondiscrimination test, an employer must take corrective action. The standard method is to reduce the annual elections of HCEs until the test passes. This process starts by reducing the election of the HCE with the highest amount and continues with the next-highest HCE until the test’s requirements are met.

The amounts by which the HCEs’ elections are reduced are then treated as taxable income for those employees. For instance, if an HCE’s election is lowered from $5,000 to $3,000, the $2,000 difference is added to their taxable wages on their Form W-2. This differs from a wholesale failure where all HCE benefits become taxable, as only the corrected portion is taxed here. Plan documents should grant the employer the authority to make these reductions.

To avoid these corrections, employers can perform preliminary testing mid-year. If a failure seems likely, the employer can freeze or limit further HCE contributions for the rest of the year, preventing the need for more complicated corrections after the plan year has concluded.