Question: What happens when the cafeteria plan nondiscrimination pre-test results show that only highly compensated employees (HCEs) have elected the dependent care FSA?
Compliance Team Response:
Unfortunately, there is no way to pass the nondiscrimination testing requirements for the dependent care FSA if only HCEs participate. The employees’ remaining contributions in the FSA will simply be returned as taxable compensation. Any amounts already reimbursed will be recharacterized as taxable income. This will effectively eliminate the dependent care FSA for that plan year.
The affected employees likely can instead claim the child and dependent care tax credit instead (which provides a portion of the same tax advantage available through the FSA) on their individual tax return. A short IRS summary of the tax credit is available here: https://www.irs.gov/taxtopics/tc602. They should consult their personal tax advisor for more information.
A few other items though that may be helpful:
Alternative Testing Method: Top-Paid Group Election
The top-paid group election can be an option to take a look at where the plan is having difficulty passing the dependent care 55% Average Benefits Test (the most commonly failed nondiscrimination test). This is because in some cases the election will reduce the number of HCEs taken into account for the test.
Under this top-paid group election, HCE status is generally based on whether employees are in the top-paid group (the top 20%) of employees. This is in contrast to the standard approach where generally employees with compensation in excess of the applicable threshold (currently $120,000) are considered an HCE. The election can be made for any determination year and, once made, the election applies for all subsequent years unless changed by the employer.
Under this testing approach, it is possible that some of the dependent care FSA participants who are currently listed as HCEs will be recategorized as non-HCEs. If that’s the case, the employer would simply need to follow the standard correction process of reducing the HCEs’ elections by the end of the plan year to a passing level (rather than eliminating the FSA for that plan year.)
The issue is that the top-paid group election cannot be used in the dependent care FSA context unless it is also applied to the company’s retirement plans, including 401(k). It’s possible that utilizing the top-paid group election could cause the 401(k) plan to fail its nondiscrimination tests, which do not necessarily benefit from this election. So if the company considers using the top-paid group election, it would need to coordinate the testing with the 401(k) nondiscrimination testing vendor provider to ensure that a top-paid group election doesn’t affect the nondiscrimination testing status under the 401(k) plan.
Enrolling in Spouse’s Dependent Care FSA Mid-Year
If the above approach still results in a NDT failure, the affected employees may be able to enroll in their spouse’s dependent care FSA mid-year. The IRS has informally blessed this approach if the spouse’s cafeteria plan permits it.
How to Prevent this From Happening in the Future
One option to limit HCE participation is having the plan impose a preemptive reduced dependent care FSA limit for HCEs at the outset of each plan year. For example, non-HCEs may elect $5,000, but HCEs may elect only $3,000.
However, we generally do not recommend that approach. It most cases it would either a) result in HCEs not being able to take full advantage of the maximum permitted pre-tax election, or b) simply require a slightly smaller correction. It’s a guessing game that will never be entirely accurate, and therefore it results in many of the same issues.
In any case, that would not have prevented the failure in this situation unless the HCE contribution limit was $0 (because no non-HCEs participated).
The only other option that could have worked here is to offer an employer matching contribution to non-HCEs to entice greater participation. Only a small percentage of employers take this approach because of the increased cost, but it generally is very effective in increasing non-HCE participation. An example would be a dollar-for-dollar matching contribution for non-HCEs of up to $500 in dependent care FSA contributions.
Treas. Reg. §1.414(q)-1, Q/A-9:
Q-9. How is the top-paid group determined?
A-9. (a) [Reserved] See §1.414(q)-1T, Q&A-9(a) for further guidance.
(b) Number of employees in the top-paid group.(1) Exclusions. The number of employees who are in the top-paid group for a year is equal to 20 percent of the total number of active employees of the employer for such year. However, solely for purposes of determining the total number of active employees in the top-paid group for a year, the employees described in §1.414(q)-1T, A-9(b)(1)(i), (ii) and (iii)(B) are disregarded. Paragraph (g) of this A-9 provides rules for determining those employees who are excluded for purposes of applying section 414(r)(2)(A), relating to the 50-employee requirement applicable to a qualified separate line of business.
(i) through (iii) [Reserved] See §1.414(q)-1T, Q&A-9(b)(1)(i) through (iii) for further guidance.
(2) Alternative exclusion provisions. (i) and (ii) [Reserved] See §1.414(q)-1T, Q&A-9(b)(2)(i) and (ii) for further guidance.
(iii) Method of election. The elections in this paragraph (b)(2) must be provided for in all plans of the employer and must be uniform and consistent with respect to all situations in which the section 414(q) definition is applicable to the employer. Thus, with respect to all plan years beginning in the same calendar year, the employer must apply the test uniformly for purposes of determining its top-paid group with respect to all its qualified plans and employee benefit plans. If either election is changed during the determination year, no recalculation of the look-back year based on the new election is required, provided the change in election does not result in discrimination in operation
ABA Joint Committee on Employee Benefits, Meeting with IRS and Treasury Officials, Q/A-6 (May 2007):
- § 125 – Cafeteria Plans: Dependent Care
Husband has elected a $5,000 dependent care flexible spending account (FSA) through his employer’s Code § 125 cafeteria plan. Husband’s employer runs mid-year nondiscrimination tests and ceases husband’s contributions to his dependent care FSA. Is wife permitted to elect a dependent care FSA under her employer’s Code § 125 cafeteria plan for the remainder of the year?
Proposed Response: Yes, provided wife’s employer permits mid-year changes on account of and corresponding with a change made under another employer’s plan. See Treasury Regulation § 1.125-4(f)(4).
IRS Response: The Service representative agrees with the proposed response.
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).