IRS Proposes Changes to DCAP Nondiscrimination Testing

Overview

The Internal Revenue Service (“IRS”) and U.S. Treasury Department recently issued proposed regulations that, if finalized, would simplify and clarify nondiscrimination testing requirements for employers that offer a Dependent Care Assistance Program (“DCAP”), commonly referred to as a Dependent Care Flexible Spending Account (“DCFSA”).

Section 129 of the Internal Revenue Code (“Code”) requires DCAPs to satisfy certain nondiscrimination requirements designed to ensure the program does not disproportionately favor highly compensated employees or certain owners. These requirements generally look at who is eligible to participate, the benefits provided to highly compensated and non-highly compensated employees, and the concentration of benefits among certain owners.

Among the proposals are three employer-friendly changes that employers should know about:

• A more employer-friendly average benefits test
• New guidance for the eligibility test
• Employers can correct certain year-end failures by January 31 following the end of the plan year

The proposed regulations are welcome guidance—the first update in more than 45 years since the nondiscrimination requirements first took effect. They largely align with the approach many employers have already been using in the absence of updated rules. Importantly, employers can rely on the proposed regulations before final regulations are published.

Keep reading to learn more about these proposed changes and how they can help your organization.

A more employer-friendly average benefits test

Many employers struggle with meeting DCAP nondiscrimination testing requirements, specifically the Average Benefits Test. Under Section 129, employers must ensure that the average DCAP benefits provided to non-highly compensated employees (“NHCEs”) are at least 55% of the average benefits provided to highly compensated employees (“HCEs”). DCAPs are also subject to a separate Owner Concentration Test, which generally requires that no more than 25% of dependent care assistance be provided to certain more-than-5% owners, shareholders, and their spouses or dependents.

Under the proposed rules, the Average Benefits Test calculation would only include employees who received more than $0 in DCAP benefits during the plan year. In other words, employees who do not participate in DCAP, and therefore do not receive DCAP benefits during the year, are excluded from this calculation. This could make a meaningful difference for employers with lower DCAP participation among NHCEs. It may also ease some of the nondiscrimination concerns employers have had when considering whether to offer the full $7,500 DCAP limit for future plan years.

New guidance for the eligibility test

The proposed regulations also provide additional guidance on the DCAP eligibility test. Under Section 129, a DCAP generally cannot discriminate in favor of HCEs with respect to eligibility to participate.

Under the proposed rules, an employer could satisfy the eligibility test if the group of employees eligible for the DCAP is defined by a reasonable and objective business classification and if that group meets either a numerical safe harbor or a facts-and-circumstances test. An employee counts as eligible if they have the opportunity to receive benefits, whether or not they receive them. Together, these changes provide employers with a more defined framework for evaluating whether differences in DCAP eligibility among employee groups are permissible.

Employers that currently offer DCAP benefits to different employee classifications should review their eligibility structure with their administrator, testing vendor, or legal counsel under the proposed framework.

Increased flexibility if the plan fails testing

The proposal also gives employers a new way to address certain testing failures identified at the end of the year.

If the DCAP fails the 55% Average Benefits Test, the employer may be able to correct the failure by including the applicable excess benefit in the affected HCEs’ taxable income and reporting it by the Form W-2 furnishing deadline (January 31 following the end of the plan year). A similar correction would be available for a failure of the More-than-5% Owner Concentration Test.

This is helpful because a year-end failure would not necessarily mean the affected HCE or more-than-5% owner loses the tax exclusion for their entire DCAP benefit. Instead, only the amount needed to correct the failure may need to be treated as taxable.

Employer action items

• Talk with your DCAP administrator or testing vendor about how they plan to apply the proposed nondiscrimination testing rules and whether they intend to rely on the proposed regulations for 2026 testing.
• Review any differences in DCAP eligibility among employee groups under the proposed eligibility testing framework.
• Revisit the $7,500 DCAP limit if testing concerns previously made the employer hesitant to adopt the higher limit.
• Continue testing during the year when appropriate. The new correction option provides more flexibility, but early testing can help identify issues before year-end and avoid surprises during W-2 preparation.

Additional information and resources

• Federal Register Article