Certainly I have some factual questions about this arrangement, but it clearly doesn't pass the smell test.
Although the questions about FICA/SUTA, compensations, etc., are valid, it seems that the first question is whether the individual is actually eligible to participate in a DCAP. There seems to be some doubt about that.
To participate in any tax-favored benefit plan, the individual must first be an employee. Owners or partners may or may not be employees. If they are determined to be employees, they must also be eligible to participate in the plan. However, an employee must also be eligible to participate a tax-favored benefit plan, and based on the facts described, these individuals aren't eligible to contribute to a DCAP.
IRC sec. 129 "Dependent care assistance programs" (DCAP) provides the rules for this program. The purpose of the DCAP is to exclude from gross income amounts for dependent care with respect to dependent care services not exceeding $5,000. IRC 129(a)(2)(A).
Dependent care and dependent care services are defined in IRC sec. 21 "Expenses for household and dependent care services necessary for gainful employment." Dependent care is limited 1) to qualifying individuals; so that 2) the employee may have gainful employment. An individual who doesn't satisfy these 2 elements isn't eligible for the exclusion and, therefore, participation in a DCAP.
A generic cafeteria plan doc that we use states: Dependent care expenses are defined as expenses incurred for the care of a qualifying individual. A qualifying individual is either: (i) a dependent who is under age 13, or (ii) the Participant's spouse or dependent who lives with the Participant and is physically or mentally incapable of caring for himself/herself. However, these expenses are dependent care expenses only if they allow the Participant to be gainfully employed.
Next, the right to an exclusion from gross income doesn't actually accrue until expenses for dependent care are paid or incurred. IRC 129(a)(2)(A). If the individuals do not pay for dependent care services, they cannot make a claim for the exclusion. The COVID crisis illustrated this principle. Families who were at home didn't incur expenses, so, through their no fault of their own, were in danger of forfeiting amounts already contributed to their DCAP.
In addition to potential forfeiture, IRC 129(a)(2)(B) requires that amounts that exceed the amounts actually used must be included in gross income in the taxable year in which the dependent care services were provided.
The Code slaps the hand reaching into the cookie jar for a second (or third) cookie. The worst case scenario is that the plan appears to have intentionally allowed ineligible individuals to participate and could be disallowed because of the employer's bad faith and lack of compliance. Disqualification could be retroactive for the period that these ineligible employees contributed to the DCAP. All funds contributed would then be subject to taxation.
Because these individuals weren't ever eligible to participate in the plan, it's possible that the plan could refund the amounts contributed. However, if the terms of the plan require forfeiture, it's also possible that the funds would be forfeited. Either way the amount of the contributions must be included in the employee's gross income for the tax year in which the contributions were made.
Because most tax-plans don't reconcile until after the end of the tax year, the employer would have to send the employee an amended W-2 (or other applicable doc) to account for the excess. If an employee has already filed their Form 1040, they must then file an amended return. If taxes aren't paid on excess contributions for that tax year, the taxpayer and/or the plan administrator may be subject to stiff excise taxes.
This type of process applies to any number of tax-favored employee benefit programs, such as HSAs, 401(k)s, IRAs, SARSEPs, etc.
As for the FSA, I'd apply the same analysis. So long as the individuals are employees and eligible to participate in the FSA, they can contribute up to the maximum amount. There is a broad range of medical expenses for which their FSA funds could be used, so the blatant abuse of the statute isn't readily apparent. If they don't use their FSA contribution, it's forfeited.
