IRS Provides Good News for Dependent Care Assistance Program Nondiscrimination Testing

The IRS has issued proposed regulations addressing the Internal Revenue Code Section 129 nondiscrimination requirements for dependent care assistance programs (DCAPs), including dependent care flexible spending accounts (FSAs). In general, eligibility to participate in DCAPs and contributions and benefits under DCAPs must not discriminate in favor of highly compensated employees (HCEs) or their dependents. This requirement is generally satisfied if the DCAP eligibility classification is not discriminatory and if the program provides benefits on the same terms for all eligible employees, even if employees receive different amounts due to differing elections or utilization. The guidance is good news for DCAP plan sponsors as it provides favorable clarifications regarding how the DCAP “55% average benefits test” should be conducted and should help more sponsors pass this test.

DCAPs and Nondiscrimination Testing Rules

Employers often choose to offer employees a DCAP/dependent care FSA option to elect to make pre-tax salary reductions to reimburse themselves for qualifying dependent care expenses. Amounts received under an employer-provided DCAP (up to $7,500, or $3,750 for married individuals filing separately) are generally excluded from an employee’s income if the DCAP meets four nondiscrimination tests (a contributions/benefits test, an eligibility test, a key employee concentration test and a 55% average benefits test). Little guidance has been available on how to apply these tests, and the 55% average benefits test in particular has historically been difficult for an employer to pass. To pass this test, the statute provides that the average benefits provided to non-HCEs must equal at least 55% of the average benefits provided to HCEs. The good news is that the proposed regulations clarify that the test’s denominator is to count only employees who actually receive contributions during the year. The proposed rules also provide that the test must be satisfied as of the last day of the plan year and permits an employer to correct a testing failure by reporting the “excess benefit” as wages on Form W-2 for the year of testing.

Applying the 55% Average Benefits Test

Employers and testing vendors have long struggled with determining the appropriate denominator to use in order to conduct the 55% average benefits test. Conservative approaches have either (1) divided total benefits by the number of all employees in each (HCE or non-HCE) group, or divided total benefits by the number of all eligible employees in each group. Under these more conservative testing approaches, the non-participating employees effectively counted as receiving $0, which typically decreased the non-HCE average and made passing difficult. A conservative tester was typically not dividing by all actual participants, which would have typically garnered the best result. The proposed regulations now confirm that employees who do not participate are not to be counted in the denominator, meaning the “average benefits” are to be calculated using only employees who actually receive DCAP contributions during the plan year. This clarification is good news for plan sponsors as it will make passing the 55% average benefits test easier to pass.

Test Failure Correction Process

Test failures and corrections have historically resulted in the need for mid-year DCAP election reductions and in some cases returning benefits that have already been provided. More good news is that the proposed regulations also provide for a revised test correction process that should significantly eliminate the need to run preliminary testing during the plan year. Now under the proposed rules, if a DCAP fails the 55% average benefits test, an employer can correct the failure by including the excess benefit amount in HCE income and reporting it on the Form W-2. The deadline for corrections is January 31 of the year following the testing year. This means a 2026 testing failure can be corrected by January 31, 2027 (which is the deadline for issuing the Form W-2 for the 2026 year).

Next Steps for DCAP Sponsors

The proposed regulations apply to plan years beginning on or after the date final regulations are published. However, thankfully, employers can rely on the proposed regulations immediately. The good news is that some plans that have been advised they are in danger of failing in 2026 may now pass using the “actual participants” methodology endorsed in the proposed rules. DCAP sponsors are advised to confirm which denominator methodology is being used by their testing vendor in 2026 to run the 55% average benefits test. DCAP sponsors may also want to revisit any HCE exclusions or lower HCE benefit limits recently adopted to avoid testing issues.

Please contact your Conner Strong & Buckelew account representative toll-free at 1-877-861-3220 with any questions. For a complete list of Legislative Updates issued by Conner Strong & Buckelew, visit our online Resource Center.

IRS Provides Good News for Dependent Care Assistance Program Nondiscrimination Testing - A.

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