Failed DCAP 55% Average Benefits Test

[rocknrolls2]

Company X has a DCAP FSA as part of its cafeteria plan. For 4 recent plan years, the plan failed the 55% average benefit test. Is there any design change that can be made that will make it more likely for the plan to pass (other than excluding HCEs)? What if the company provides a matching contribution to NHCEs? Also what about tax reporting for the prior years? Any thoughts?

[LRDG]

The criteria for the DCAP 55% average benefits test is ambeigious(sp). At best, 10% of the employee population has 'qualified' dependents. Not all 10% will incur DC expenses, others will have expenses that do not qualify for a variety of reasons.

The regs do allow employees under a certain age (18?) to not be considered when applying the 55% ABT, but the result is fewer NHC employees included in the test.

I have encountered a few employers who established a seperate DCAP for HC employees. Because these were existing plans, I used a hold harmless/disclaimer in the event of IRS problems with this type of arrangement.

I'm not aware of an easy solution, other than reducing HCE DC elections.

Providing a matching contribution to NHC might improve NHC participation, but I have no clue what impact that will have.

Amended returns for prior year W-2's, employee/employer taxes paid, and 5500 will have to be amended.

I'm curious to hear other suggestions.

[Bob R]

I can't think of any other solutions - other than one idea I've tossed around.

Can you design the plan to exclude employees who have no dependents? Or who have no qualifying dependent care expenses? This would allow you to exclude them from the 55% average benefit test. You'd then have to worry about nondiscrimination as to eligibility. I could argue that this is a nondiscriminatory classification. This would also create additional work to adiminster the plan (i.e., to determine who is eligible).

It's food for thought - but I haven't heard of anyone actually trying this approach.

[rocknrolls2]

I can't think of any other solutions - other than one idea I've tossed around.

Can you design the plan to exclude employees who have no dependents? Or who have no qualifying dependent care expenses? This would allow you to exclude them from the 55% average benefit test. You'd then have to worry about nondiscrimination as to eligibility. I could argue that this is a nondiscriminatory classification. This would also create additional work to adiminster the plan (i.e., to determine who is eligible).

It's food for thought - but I haven't heard of anyone actually trying this approach.

Bob R,

Even assuming you could administratively do what you are proposing, the fact remains that the statute does not specifically permit such exclusions. One problem on the NHCE side is that some of the dependent care providers do not want to report the cash payments and there are those hiring illegal aliens who would not want to have tax reporting under any circumstanes. At least the affected HCEs get to make pre-tax deductions to the FSA even if they are subject to tax when received.

[Bob R]

I don't believe the statute prohibits this. I can design the plan to exclude whomever I want as long as it's non-discriminatory. So, it would be a matter of testing to make sure the plan is not discriminatory as to eligibility. Below is from Code Section 129:

(3) Eligibility

The program shall benefit employees who qualify under a classification set up by the employer and found by the Secretary not to be discriminatory in favor of employees described in paragraph (2), or their dependents.

If I exclude those who have no dependents, the issue is whether that's a nondiscriminatory classification. I'd use the rules under code section 410 (the portion of the average benefits test relating to nondiscriminatory classifications). Even if this exclusion is nondiscriminatory, it's not perfect - as you pointed out some NHCEs with dependents won't participate.

But, I guess you do save on the payroll taxes for the HCEs even though there is no income tax savings. However, the payroll taxes won't be a significant amount since the HCEs probably earn over the TWB. And, the employer payroll tax savings may be offset by the chaos of trying to figure out how you correct the failed test.

[rocknrolls2]

Bob R,

Thanks for your observations. I wanted to respond to two of the points you raised:

(1) I agree that you can limit participation in the DCAP so long as you cover a nondiscriminatory classification of employees. However, I disagree that you can exclude those who meet the eligibility rules and I disagree that those who actually elect the benefit should be included in the test. Instead, I am concluding that, unless the employer elects to test on a "separate line of business" basis, the average benefits test has to include all employees other than those excludable under Section 129(d)(9) and those earning $25,000 or less. I am rejecting the notion that only eligible employees should be included because Section 401(k)(3)((A)(ii) refers to "eligible highly compensated employees" and Section 129(d)(8) does not limit the group of employees taken into account for the average benefit test to "employees taken into account for purposes of paragraph (3)." I am rejecting the notion that only those employees actually participating should be taken into account because Section 129(d)(8) is not limited to "those employees participating in the plan."

(2) The other point I wanted to make is on the treatment of employees when the test is violated. According to the Employee Benefits Answer Book, Section 8:18, if a dependent care plan is provided under a cafeteria plan, "then any failure under Code Section 129 [will result in highly compensated employees being taxed on the benefits received from the program]; however, failing the nondiscrimination requirements of Code Section 129 will not disqualify the cafeteria plan." In other words, all employees get to make pre-tax contributions to the plan under Code Section 125. Upon receiving benefit payments, however, highly compensated employees are taxable on the amount of benefits received.

I don't believe the statute prohibits this. I can design the plan to exclude whomever I want as long as it's non-discriminatory. So, it would be a matter of testing to make sure the plan is not discriminatory as to eligibility. Below is from Code Section 129:

(3) Eligibility

The program shall benefit employees who qualify under a classification set up by the employer and found by the Secretary not to be discriminatory in favor of employees described in paragraph (2), or their dependents.

If I exclude those who have no dependents, the issue is whether that's a nondiscriminatory classification. I'd use the rules under code section 410 (the portion of the average benefits test relating to nondiscriminatory classifications). Even if this exclusion is nondiscriminatory, it's not perfect - as you pointed out some NHCEs with dependents won't participate.

But, I guess you do save on the payroll taxes for the HCEs even though there is no income tax savings. However, the payroll taxes won't be a significant amount since the HCEs probably earn over the TWB. And, the employer payroll tax savings may be offset by the chaos of trying to figure out how you correct the failed test.

[jmor99]

Let's face it folks: Congress doesn't really care if HCEs don't get a tax break on daycare. The simplest way for an employer to fix this problem (assuming it's a "nagging" problem from a few HCEs), is to simply gross up the wages of the HCE to give them extra income to "replace" the tax savings they could have realised if they had been participants.

[Guest Marie]

How often do you test for decap FSA? We failed the test in April of this year for 2006. We didn't do refunds yet. I was told we have to pass the 55% test every day of the 2006 year, but if so, do we wait until right at the end of December 2006 to do refunds? Or are the refunds done after the end of the year for 2006, like a 401(k) plan nond testing?

We're trying to minimize the claims our HCEs submit for naught if their pretax contributions are disallowed.

Help!

[jmor99]

Marie: When you fail the test, you immediately either 1)take the HCEs out, i.e., stop pre-tax deductions. OR 2) you reduce HCE contributions to the point they become non-discriminatory (you pass the test). In either case, you have to add any excess contributions back to their W-2 wages at the end of the year to ensure they pay taxes on that money.

You might want to consider running the test prior to the first payroll deduction in the new plan year. That way, you can advise the HCE's whether or not they'll be able to participate and if so, to what extent BEFORE payroll deductions start.

[elissa]

I see that there are different ways that we can correct a failure.  

We have 24 employees that are affected and we were going to do the Pro Rata Method but I am trying to figure out if there is a way to correct without impacting ALL