Dependent Care FSA Rules for Highly Compensated Employees
Understand how Dependent Care FSA rules impact highly compensated employees, including contribution limits, compliance requirements, and plan adjustments.
Dependent Care Flexible Spending Accounts (FSAs) allow employees to set aside pre-tax dollars for childcare and dependent care expenses. However, highly compensated employees (HCEs) face restrictions that can limit their contributions due to IRS nondiscrimination rules designed to ensure these benefits do not disproportionately favor higher earners.
Understanding these rules is essential for both employees and employers to avoid compliance issues and unexpected reductions in contributions.
Key Factors That Define Highly Compensated Status
The IRS sets criteria to determine whether an employee is highly compensated, affecting eligibility and contribution limits for employer-sponsored benefits, including Dependent Care FSAs. This classification is based on salary, ownership stakes, and family-based attribution rules.
Salary Thresholds
An employee qualifies as highly compensated by earning above a certain salary threshold. For 2024, the IRS defines an HCE as someone who earned more than $150,000 in 2023. This threshold is periodically adjusted for inflation.
Employers can apply a “top-paid group” election, limiting HCE status to the top 20% of earners rather than using the absolute salary threshold. This helps companies with many employees above the base salary limit but who are not in senior positions.
Employees who meet the compensation threshold in one year are considered HCEs for the next, even if their earnings decrease.
Ownership or Equity
An employee is also classified as highly compensated if they own more than 5% of the business at any point during the current or prior year, regardless of salary. This applies to corporations, partnerships, and sole proprietorships. Ownership is determined based on voting power or share value for corporations and capital or profit interest for partnerships and LLCs.
Unlike the salary-based test, there is no minimum earnings requirement for this rule. A business owner with little or no salary but significant equity still qualifies as an HCE.
Attribution Rules
The IRS enforces attribution rules that assign ownership from one individual to another based on family relationships. Under Section 318 of the Internal Revenue Code, stock owned by an employee’s spouse, children, parents, or grandparents is considered owned by the employee.
For example, if an employee’s spouse owns 6% of a company, the employee is also treated as a 6% owner, making them both HCEs. These rules are especially relevant for family-owned businesses, where ownership is often distributed among relatives. Employers must assess these relationships to ensure proper classification.
Contribution Rules for Dependent Care FSAs
HCEs face restrictions on Dependent Care FSA contributions due to IRS regulations aimed at preventing benefits from disproportionately favoring higher earners.
While the standard contribution limit for 2024 is $5,000 per household ($2,500 for married individuals filing separately), HCEs may have their contributions reduced if their employer’s plan fails nondiscrimination testing.
Employers must conduct annual compliance tests, including the 55% Average Benefits Test, to ensure Dependent Care FSAs remain equitable. If a plan fails, contributions for HCEs may be capped or refunded, with excess amounts becoming taxable income.
To prevent mid-year adjustments, some employers limit HCE contributions at the start of the plan year based on prior testing results. Employees affected by these limits should consider alternatives like the Child and Dependent Care Tax Credit, which may offer additional relief depending on income and expenses.
Nondiscrimination Testing Considerations
Employers must conduct nondiscrimination testing annually to ensure Dependent Care FSAs do not disproportionately benefit higher-paid employees. The 55% Average Benefits Test evaluates whether non-highly compensated employees (NHCEs) receive at least 55% of total plan benefits.
Testing includes all eligible employees, not just those who contribute. Even if an employer offers a generous Dependent Care FSA, low NHCE participation can cause the plan to fail, forcing adjustments for HCEs.
To improve compliance, employers encourage broader participation through communication, employer contributions, or automatic enrollment where permitted. Some set lower contribution limits for HCEs based on past testing data. Offering dependent care subsidies or matching contributions to lower-paid employees can also help balance participation rates.
Adjustments for HCEs During Plan Year
If a plan fails nondiscrimination testing, employers must reduce or refund excess HCE contributions, which then become taxable income. Affected employees must be notified promptly to prepare for financial changes.
Proactive employers monitor contributions throughout the year to anticipate compliance issues. Tracking participation and contribution levels quarterly helps identify risks early, allowing for gradual adjustments instead of abrupt reductions at year-end. Some organizations implement tiered contribution caps for HCEs based on past testing results to maintain compliance without sudden financial disruptions.
Clear communication is essential. Employers should outline potential mid-year changes in plan documents and provide updates on testing outcomes so employees can make informed decisions and explore alternative tax-saving strategies.
Documentation and Reporting
Proper documentation is essential for both employees and employers when managing Dependent Care FSAs, especially for HCEs who may face contribution adjustments. Employers must retain records of plan participation, contribution levels, and nondiscrimination testing results to demonstrate compliance with IRS regulations.
Employees should keep receipts and invoices for all dependent care expenses submitted for reimbursement, as the IRS requires proof that funds were used for eligible services. Documentation should include provider names, service dates, and amounts paid.
Employers must file Form 5500 if their plan meets the filing threshold and provide employees with year-end statements detailing any refunded contributions. Proper reporting helps prevent compliance issues and ensures both employers and employees remain in good standing with tax authorities.