Proposed IRS Rules for Dependent Care FSA Testing

The IRS and Treasury Department have released proposed regulations that would update key nondiscrimination rules for Dependent Care Assistance Programs (DCAPs), including dependent care FSAs. For employers that offer DCAPs, the proposed rules are important as they aim to modernize and clarify longstanding DCAP nondiscrimination testing requirements.

If finalized, the rules could make annual testing more predictable and give employers a clearer, more practical way to address certain failures before year-end tax reporting is complete. 

How Proposed IRS Rules Could Change DCAP Testing

DCAPs let employees set aside money tax-free for eligible dependent care expenses. But that tax benefit depends on meeting nondiscrimination testing rules. These rules are meant to ensure the plan does not mainly benefit highly compensated employees (HCEs) compared to non-highly compensated employees (NHCEs). 

Historically, these rules have been challenging for employers to administer, particularly when lower-paid employees are less likely to participate in DCAPs, while higher-paid employees are more likely to elect the maximum allowable amount. The proposed rules are intended to make the process clearer and easier to administer.  

Key Proposed Changes:  

Eligibility Safe Harbor: The proposed rules would provide a clearer “safe harbor” for the eligibility test. In general, if the plan’s eligibility rules treat NHCEs and HCEs similarly, you may have an easier time showing the plan is fair.  

Under the proposed safe harbor, an employee group would generally be treated as nondiscriminatory if the percentage of eligible NHCEs is at least 90% of the percentage of eligible HCEs.

The 90% threshold could be adjusted downward for workforces that are heavily weighted toward NHCEs.  

This gives employers a bright-line test instead of relying solely on a facts-and-circumstances analysis. 

Average Benefits Test Clarified: The proposal clarifies who counts in the 55% average benefits test. Only employees who actually receive more than $0 in DCAP benefits would be counted. This matters because it reduces uncertainty about how to treat employees who are eligible but don’t enroll or don’t receive reimbursements during the year. 

Built-In Fix for Failures: The proposal also offers a more practical way to fix certain failures. If a plan fails the average benefits test, the employer could correct it by reducing the amount treated as tax-free for HCEs before the Form W-2 deadline. For HR and payroll teams, this approach could reduce disruptive “after-the-fact” corrections and make it easier to line up testing with year-end reporting. 

What's Next 

The proposed rules are expected to apply to plan years beginning on or after the date the final regulations are published.  However, employers may rely on the proposed rules for earlier plan years.

The IRS has requested public comments on the proposed rules and will hold a public hearing on October 15, 2026.

Practical Implications for Employers 

Employers that sponsor dependent care FSAs should consider taking the following steps now: 

• Review plan design- Evaluate whether eligibility rules, exclusions, and participation requirements align with the proposed eligibility safe harbor.
• Model 2026 testing results- Consider how current and projected participation patterns may affect the 55% average benefits test, especially if HCEs are more likely to elect the maximum benefit.
• Encourage broader participation- Targeted education and communication to NHCEs may help increase enrollment and improve testing results.
• Coordinate payroll and tax reporting- Work with payroll teams and third-party administrators to identify potential testing issues early and, if needed, make HCE benefit adjustments before the Form W-2 furnishing deadline.
• Monitor final regulations- Because these rules are still proposed, employers should continue to watch for changes before making permanent plan administration decisions. 

These proposed rules aim to remove decades of employer frustration surrounding the DCAP average benefits test. Now is a good time for employers to talk with their benefits advisor about how the proposed rules can impact, and hopefully simplify, DCAP nondiscrimination testing. 

Prepare for Potential DCAP Testing Changes 

Connect with a OneDigital Benefits Consultant to review your dependent care FSA, assess how the proposed nondiscrimination rules may affect your testing results, and identify steps to prepare before year-end reporting.