Paul Van Brunt, Sr. Associate Director Benefits Compliance
The Internal Revenue Service (“IRS”) and U.S. Treasury Department (“Treasury”) recently issued proposed regulations that would modernize and simplify the nondiscrimination testing rules applicable to Dependent Care Assistance Programs (“DCAPs”), commonly referred to as Dependent Care FSAs. The proposal represents the first significant regulatory update to these rules in more than 45 years and is intended to address longstanding administrative challenges employers face when testing DCAPs under Internal Revenue Code (“IRC”) Section 129. Importantly, employers may generally rely on the proposed regulations before final regulations are issued.
One of the most significant changes involves the “55% Average Benefits Test.” Under current interpretations, employers often struggle to satisfy this test because employees who do not participate in the DCAP are effectively included in the calculation with a $0 benefit amount. The proposed regulations would clarify that only employees who actually receive DCAP benefits or employer contributions during the plan year are included in the calculation. This change could make it considerably easier for employers to pass testing, particularly when participation among non-highly compensated employees is relatively low. The proposed regulations also provide additional guidance regarding the DCAP eligibility test, offering employers more certainty when determining whether eligibility classifications satisfy nondiscrimination requirements.
The proposed regulations also introduce a more practical correction mechanism for certain year-end testing failures. Rather than jeopardizing the tax-favored status of an employee’s entire DCAP benefit, employers may be able to correct the failure by treating only the excess amount necessary to satisfy the test as taxable compensation, provided corrections are made by January 31 following the end of the plan year. Collectively, these changes could reduce compliance burdens, increase flexibility, and encourage employers to continue offering valuable dependent care benefits to employees while maintaining compliance with the tax code.
Employer action items
- Review current DCAP nondiscrimination testing results with your third-party administrator or testing vendor to determine how the proposed rules could impact future testing outcomes.
- Reevaluate plan design decisions, including adoption of the increased $7,500 DCAP contribution limit, if prior testing concerns influenced benefit offerings.
- Continue performing annual DCAP nondiscrimination testing and identify potential failures early, even though the proposed correction method provides additional flexibility.
Additional resources
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