DCAP Testing

Summary

Generally, a dependent care assistance program (DCAP) reimburses an employee for qualified dependent care expenses on a tax-free basis. However, in order to provide such tax-free benefits, the DCAP must satisfy certain nondiscrimination tests.

DCAP Nondiscrimination Testing

There are basically four tests that a DCAP must satisfy to be considered nondiscriminatory. These tests are found under Internal Revenue Code (IRC) Section 129, and the basic idea is that the DCAP cannot discriminate in favor of highly compensated individuals (HCIs) as to plan eligibility, benefits or participation. For purposes of DCAP testing, an HCI is an employee whose compensation is greater than $115,000 (for 2012) or who was a more-than-5-percent owner in the current or preceding plan year. Below is a brief description of the four tests:

• Eligibility Test: The DCAP must not discriminate in favor of HCIs or their dependents regarding eligibility to participate. The test is designed to ensure that a reasonable percentage of non-HCIs are eligible to participate in the DCAP.
• Contributions and Benefits Test: A DCAP must not discriminate in favor of HCIs or their dependents as to contributions and benefits received under the plan. This test ensures that HCIs are not eligible to receive better benefits and are not authorized to make lower contributions for equal benefits.

• More-than-5-percent Owners Concentration Test: Not more than 25 percent of the amounts paid or incurred by the employer for the dependent care for a plan year may be provided to shareholders or owners who own more than 5percent in stock, capital or profits interest in the employer. This test is designed to ensure that certain HCIs (namely, more-than-5-percent owners) and their family members do not receive more than 25percent of the DCAP benefits.
• 55 Percent Average Benefits Test: The average DCAP benefits provided to the non-HCIs under all plans of the employer must be at least 55 percent of the average benefits provided to HCIs under all plans of the employer. This test ensures that HCIs do not participate disproportionately, and focuses on the average (per capita) benefit received by HCIs as compared to that received by non-HCIs. If the non-HCI average is not at least 55 percent of the HCI average, the plan fails this test.

The testing should be performed at various times throughout the year, including before, during and toward the end of the plan year. These times are described more fully in the Employer Action section below.

If a DCAP is discriminatory, then the benefits provided to the HCIs will be included in their gross income. The non-HCIs, however, would not suffer any adverse consequences, and the plan itself would not lose its qualified status as a result of failing any or all of the above DCAP nondiscrimination tests.

Avoiding DCAP Nondiscrimination Issues

There are some practical tips that may help to avoid nondiscrimination problems. To begin with, the cafeteria plan or the DCAP plan document should give the plan administrator authority to cut off any employee's salary reductions with respect to the DCAP, if necessary to comply with the nondiscrimination rules. At the beginning of the plan year, the plan administrator should know which employees are HCIs based on their income during the look-back year. By monitoring the benefits provided to the group of known HCIs and the group of known non-HCIs, the plan administrator can judge during the year whether the plan risks failing any tests. If the risk seems high enough, the plan administrator (if the plan so provides) can cut back the HCIs' salary reductions into the DCAP, thereby preserving the exclusion for all of the HCIs.

A more aggressive practice would be to re-characterize a portion of the HCIs' DCAP benefits as taxable (i.e., by imputing income and withholding applicable income and employment taxes) so as to enable the DCAP to pass the applicable test. An employer that takes this approach might re-characterize an equal percentage of each HCI's benefits or use a “bubble-down” approach under which re-characterizations are made beginning with the HCIs whose benefits are greatest. So long as this is done before the close of the year, such a correction would place a participant in a similar position to that of a prospective cutback in his or her DCAP salary reductions. The employer should notify affected HCIs, and the plan documents should be drafted to permit such an approach.

After the calendar year is closed, it is generally too late to take corrective action, and HCIs will be taxed on their total DCAP benefits. Consequently, employers should monitor nondiscrimination issues on an ongoing basis to maximize the employer's ability to make adjustments before year-end to bring the DCAP into compliance.

Note that a plan could be drafted to exclude all prohibited group members from participation to avoid having the plan administrator monitor benefits provided to these individuals throughout the course of the plan year. Other options for reducing the risk of DCAP nondiscrimination testing failures include capping HCI benefit elections at open enrollment (e.g., at an amount that is less than or equal to the prior year's average benefit maximum, to help the plan pass the 55 Percent Average Benefits Test), providing additional benefits to non-HCIs, and communicating the plan to increase non-HCI participation.

Finally, for an extreme solution, the sponsor could simply exclude some or all HCIs from participating in the DCAP. This approach may be preferable to annually frustrating HCIs’ expectations with year-end DCAP re-characterizations.

Employer Action Required

Employers should consider the DCAP nondiscrimination rules when designing or amending their DCAP plans, particularly with respect to eligibility for the DCAP. Eligibility and contributions, among other things, should be consistent for all employees, and should not favor HCIs.

In addition, employers should have testing performed on the DCAP plan to ensure that the plan is not discriminating in favor of HCIs. IRC Section 129 does not address when DCAP nondiscrimination testing must be performed. As a general rule, though, testing should be performed at each of the following times:

• Before the beginning of the plan year (based on projected data). This is when the employer can first predict, based on estimates of participation levels, whether the plan will be in danger of failing any of the nondiscrimination tests. Such early testing is especially valuable because anticipated problems may be resolved with election or plan design changes. (It may be useful to perform the testing after open enrollment, to determine whether actual participation reflects projected participation.)
• Several months before the end of the plan year (using year-to-date data, plus projections). At this point, the employer can take into account actual data for the year, including new hires, midyear election changes for change in status, terminations of employment, etc. If any testing problems appear at this point, the employer will still have time to make corrections before the end of the plan year.
• After the close of the plan year. The employer will have its final year-end data to use for testing purposes. Final plan testing with year-end numbers should be documented and retained so that the employer can show, upon audit, that the plan passes the appropriate tests.
• Before completing any business acquisition or reorganization. Election changes, new hires and forfeitures should also be monitored.

Finally, if the employer is having difficulty passing the DCAP nondiscrimination testing, the employer could consider one or more of the following actions (outlined in more detail above) to prevent or reduce the likelihood of testing failures in future years.

• Limit HCIs' DCAP elections during open enrollment
• Increase and improve plan communications to help non-HCIs understand the value of DCAP participation
• Reduce HCIs' DCAP elections during the plan year based on preliminary and interim testing
• Offer matching contributions to non-HCIs who participate in the DCAP

Penalties for Noncompliance

There are no specific civil penalties associated with a plan that is considered discriminatory. However, there are some taxation consequences that will result. Namely, if a dependent care FSA, or DCAP, discriminates in favor of the HCIs, then the benefits provided to the HCIs for that year will be included in their gross income; that is, the HCIs will lose their IRC Section 129 exclusion from income. The DCAP nondiscrimination rules require the HCI to include in income those amounts that were actually received as dependent care assistance (unlike the cafeteria plan nondiscrimination rules, which require HCIs to include in income any amount that could have been received as cash — the total salary reduction amount). If the DCAP is discriminatory, the non-HCIs, however, do not lose the exclusion, and the plan does not lose its qualified status.

Frequently Asked Questions

Q1. Where does the employer report the discriminatory amounts under a DCAP?
A. Discriminatory amounts under a DCAP are reported as wages in Box 1 of the Form W-2 for the HCI in the year in which the amounts are considered discriminatory. So, if the plan was discriminatory in 2012, then the amounts must be included on the HCI’s Form W-2s for 2012. If the nondiscrimination testing failure is not discovered until after Form W-2s have been issued, it will be necessary to issue amended Form W-2s to report the taxable amounts.

Q2. Does the employer have any withholding responsibilities in connection with discriminatory DCAP amounts?
A. It depends. An employer’s obligation to withhold income and employment taxes (including FUTA and FICA) should not be affected if it was reasonable for the employer to believe that the benefits should be excludable. But it is not entirely clear how this “reasonable to believe” standard is applied. If a plan is out of compliance based on projected elections at the time the testing is performed, then this requirement may not be satisfied. However, where plans are in compliance based on projected elections as of Jan. 31 of each year, then this requirement should be satisfied. Thus, based on whether the plan had “reason to believe” that the benefits should be excludable (i.e., that the plan was not discriminating in favor of HCIs), there may also be employment tax consequences for a discriminatory plan.

Q3. An employee has elected a $5,000 DCAP through his employer’s Section 125 cafeteria plan. The employer runs midyear nondiscrimination tests, determines that the plan is discriminatory and ceases the employee’s contributions to his DCAP. Is the employee’s spouse permitted to elect a DCAP under her employer’s Section 125 cafeteria plan for the remainder of the year?
A. Yes, assuming that the employee’s spouse’s employer permits midyear election changes on account of and corresponding with a change made under another employer’s plan.

Additional Resource

• IRS Publication 503

Citations

• IRC 129
• IRC 414(q)

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