A dependent care flexible spending account (DCFSA) allows employees to pay for eligible dependent care services on a pre-tax basis. There are many advantages to DCFSAs but it is important that employers, as DCFSA sponsors, are aware that DCFSAs are subject to nondiscrimination testing requirements.
DCFSAs must pass several nondiscrimination tests to ensure the DCFSA benefit does not favor highly compensated employees (HCEs) and certain owners.[1] Traditionally, the 55% Average Benefits test has been the most difficult. Recently proposed regulations could help some employers pass the testing.
Eligibility Test
The eligibility test ensures that HCEs are not favored in terms of eligibility to participate in the DCFSA. If all employees are eligible for the DCFSA this test will not be an issue.
Contributions and Benefits Test
The contributions and benefits test ensures that HCEs cannot receive better benefits under the written plan terms than non-HCEs. This can be an issue if HCEs are permitted by plan design to make greater elections or only HCEs are able to receive employer DCFSA contributions.
Owner Concentration Test
The owner concentration test is meant to ensure that specific HCEs cannot disproportionately use the DCFSA. Specifically, the test determines if more-than-5% owners and their spouses and dependents receive more than 25% of the total DCFSA benefits.
55% Average Benefits Test
The 55% average benefits test is meant to ensure that HCEs are not disproportionately participating in the DCFSA in comparison to non-HCEs. The test looks to see if the average DCFSA benefit provided to non-HCEs is at least 55% of the average benefit to HCEs. Historically, there was little guidance on how to apply this test, and it was often the cause of DCFSA nondiscrimination issues.
Recently, proposed regulations[2] clarify that for purposes of the 55% average benefits test, only employees participating in the DCFSA are included when running the 55% average benefits test. This clarification may help some plans pass the 55% average benefits test when they had previously failed due to counting all DCFSA eligible employees for testing purposes and not just those participating.
Consequences of Failing DCFSA Testing
If any of the above nondiscrimination tests are failed, DCFSA benefits for HCEs become taxable. Non-HCEs are not impacted by a testing failure.
Adjusting DCFSA elections within the plan year to pass the testing is one strategy to mitigate the impact of a failed nondiscrimination test. The proposed rules will also treat a plan that failed the owner concentration or 55% average benefits test as passing DCFSA nondiscrimination testing overall if the excess benefits provided to HCEs are treated as gross income on the HCE’s W-2.
Key Takeaway
Dependent Care FSAs are required to complete nondiscrimination testing and should ensure it is completed on an annual basis. Recently proposed changes to the testing may make it easier for employers to pass the testing if they have struggled in the past.
[1] For the 2026 plan year, an HCE is an employee who earned more than $160,000 in 2025 or was more-than-5% owner during the current or preceding plan year.
[2] While only proposed, the regulations indicate they can be relied upon until final regulations are issued.
The information provided is a summary of laws and regulations relating to employee benefit plan compliance. This information should not be construed as legal advice. In all cases, employers should consult with their own legal counsel.
