Dependent Care Flexible Spending Accounts or Dependent Care Assistance Programs (DCAP), however you refer to them, offer a valuable way for workers to set aside pre-tax dollars for childcare or eldercare expenses. However, the IRS will never miss an opportunity to make things more complicated than necessary… enter Nondiscrimination Testing!
Nondiscrimination Testing (NDT) is a set of guidelines detailed in the IRS Code intended to protect the interests of non-highly compensated employees (non-HCEs) by ensuring that highly compensated employees (HCEs) are not disproportionately advantaged under the same lines of coverage. Section 129 of the IRS Code governs the NDT rules for DCAPs, mandating four separate tests that must meet various standards. It is common for employers to fail the test, and a recent legislative update could make the threshold that much more difficult to meet.
Again, the testing exists to prevent highly compensated employees from receiving disproportionate favor under the plans, either through eligibility or benefits received. With DCAP, most employers seamlessly pass the eligibility and benefits tests when waiting periods and election opportunities are uniform. However, the utilization test, known as the 55% Average Benefits Test, is a common source of failure. It requires that the average benefits received by non-HCEs be at least 55% of the overall benefits received by the HCEs. It’s a difficult standard to meet as it is a pure measure of participation and election amounts, including all eligible employees, even those who have waived coverage.
Since its inception, the statutory maximum for DCAP contribution elections has been set at $5,000 per year ($2,500 for married individuals filing separately). A typical test would reveal that an employer has a small population of HCEs, and from that population, those who elect DCAP will max out the contribution election. Meanwhile, a large population of non-HCEs will either waive coverage or elect well below the $5,000 threshold, resulting in a failure to meet the requisite 55% ratio by nearly 40% in many cases.
In 2026, the legislative updates from the One Big Beautiful Bill became effective. One of those legislative changes was increasing the statutory maximum for DCAP from $5,000 ($2,500 for married filing separately) to $7,500 ($3,750 for married filing separately). This increase is optional for employers. However, if adopted, it must apply to all employees. If history shows anything, it’s that HCEs max out their elections more often than non-HCEs. This has the potential to widen the already extensive gap that can exist between the HCE and Non-HCE elections and possibly result in failures with higher rates of taxable income attributed to HCEs.
If your client has adopted the DCAP increase, we recommend testing DCAPs as soon as possible. The earlier it can be determined whether failure is relevant and the extent of the remedial measures required, the greater the chance of preserving a portion of the tax advantage for the HCE participants.
