Dependent Care FSA Nondiscrimination Testing, Explained
A Dependent Care Assistance Program (DCAP) has to pass its own set of nondiscrimination tests under IRC §129 every plan year — on top of the general Section 125 tests that apply to the cafeteria plan as a whole. These exist to stop a DCAP from being structured (or simply used, by utilization patterns) in a way that disproportionately benefits higher earners.
Who counts as a Highly Compensated Employee (HCE)
For 2026 testing, an employee is generally an HCE if they earned more than $160,000 in 2025 compensation (this threshold is set annually and should be re-checked each plan year).
The 55% Average Benefits Test
This one is specific to DCAPs and is often the hardest to pass: the average benefit received by non-HCEs must be at least 55% of the average benefit received by HCEs. Unlike an eligibility test, this is a pure utilization test — it doesn't matter that the plan is open to everyone equally if HCEs simply use it more, on average, than non-HCEs do.
Key Employee Concentration Test
No more than 25% of the total nontaxable benefits provided under the cafeteria plan (across all component benefits, not just the DCAP) can go to key employees — officers and owners meeting specific compensation and ownership thresholds.
5% Owners Test
Specific to the DCAP: no more than 25% of dependent care benefits for the year can go to employees (or their spouses/dependents) who own more than 5% of the company's stock, capital, or profits interest.
What happens if a test fails
If the plan fails a test and isn't corrected within the plan year, the consequence generally falls on HCEs: their DCAP contributions become taxable income. That means retroactively correcting payroll withholding and amending affected W-2s — an administrative headache best avoided by testing early.
Practical ways to reduce testing risk
- Test using projected elections early in the plan year, not just actual utilization at year-end, so you have time to react.
- If the 55% test is consistently tight, consider whether a modest employer contribution or a targeted communication push to non-HCEs would meaningfully shift the average.
- Have your TPA or benefits consultant run testing as a standard part of annual administration — most include it, but confirm it's not an extra line item you're missing.
This is a general overview, not legal or tax advice — testing methodology and correction procedures should be reviewed with a benefits attorney, TPA, or CPA.