Dependent Care Assistance Programs: IRS Issues Welcome Non-Discrimination Testing Guidance

By: HUB’s EB Compliance Team

Employers that sponsor Dependent Care Assistance Programs ("DCAPs"), also known as Dependent Care Flexible Spending Accounts ("DCFSAs"), have long operated without formal guidance on how to apply the stringent nondiscrimination rules that govern these plans. That changed on August 11, 2026, when the Department of the Treasury and the IRS published new proposed regulations related to DCAPs.

This article is intended to provide an overview of the relevant portions of the proposed regulations related to DCAPs and what employers should be doing in response.

As proposed, these rules are largely employer-friendly, codifying some common-sense approaches used by many employers over the years. Importantly, employers can rely on the proposed regulations immediately, before the rules are formally finalized. Given that, the application of these rules is especially important for employers that offer DCAPs as they approach year-end (when many employers conduct the said discrimination testing of their DCAPs).

Background: The Four Tests

As discussed in prior HUB articles, a DCAP must satisfy four nondiscrimination tests to preserve the tax-advantaged status of the DCAP for highly compensated employees ("HCE"). If the plan fails any of the four tests, HCEs lose the favorable tax benefits under the DCAP. Nondiscrimination failures have no impact on the favorable tax benefits of the DCAP for other, non-HCEs.

THE CONTRIBUTIONS AND BENEFITS TEST

This test generally requires that the contributions or benefits provided under the DCAP do not discriminate in favor of HCEs. The proposed regulations confirm that a plan satisfies this requirement if benefits are provided on the same terms for all eligible employees — even if employees end up receiving different dollar amounts due to varying elections or utilization. A plan fails the test only if its terms are more favorable to HCEs, such as allowing HCEs a higher contribution limit than non-HCEs.

THE ELIGIBILITY TEST

This test asks whether enough non-HCEs are eligible to participate in the DCAP relative to HCEs. The proposed regulations clarify that eligibility classifications must be: (1) reasonable (based on objective business criteria such as job category, geographic location, or salaried vs. hourly status) and (2) nondiscriminatory. An employee is considered eligible if they have the opportunity to receive/elect benefits under the DCAP, regardless of whether they actually choose to participate in the plan.

To determine whether a classification is nondiscriminatory, the proposed regulations provide a numerical safe harbor. Under this safe harbor, the plan's "ratio percentage" (i.e. the percentage of eligible non-HCEs compared versus the percentage of eligible HCEs) must meet or exceed a designated threshold, generally 90%.

For employers whose DCAPs cover all full-time employees, or all employees regardless of status, this test is typically straightforward to satisfy. On the other hand, employers who exclude certain portions of their workforce (whether by employee class, location, department, etc.) should pay particular attention to whether those classifications satisfy the new standards.

THE MORE THAN 5% OWNERS CONCENTRATION TEST

This test limits the amount of DCAP benefits that can be attributed to principal shareholders and owners. Specifically, the benefits provided to this group cannot exceed 25% of the total DCAP benefit for the entire plan.

THE 55% AVERAGE BENEFITS TEST

This test requires that non-HCEs receive at least 55% of the benefits HCEs receive under the DCAP. Previously, it was ambiguous whether the calculation included all employees in each group (even those that did not participate in the DCAP), or just those that participated.  If using all employees, the test was very difficult to pass.

The proposed regulations resolve the ambiguity by counting only employees who actually participate in the DCAP when calculating the averages. This should help to ensure that testing results are reflective of the actual DCAP benefits provided under the plan since the analysis is now limited to actual participants of the plan.

Testing Timing and Corrections

The DCAP nondiscrimination test is most accurately assessed as of the last day of the plan year. A testing failure means that HCEs lose the tax-advantaged status of their DCAP contributions for the entire plan year.  In practice then, employers often run the discrimination test throughout the year to project whether a failure may be likely. This gives employers an opportunity, if failure is imminent, to provide advanced notice to HCEs that the employer may be taking some corrective measures within that same year, such as HCEs having their remaining DCAP elections reduced for the year. If not corrected before the end of the year, employers would have to notify HCEs that they would have the entire value of the benefit added as income on their Form W-2 for the applicable tax year. 

The proposed regulations formalize a simplified correction approach. Failures can now be addressed by calculating an "excess benefit" amount attributable to HCEs (or owners) and include that amount in the individual's income as wages on Form W-2.

What Employers Should Do Now

• As mentioned above, the proposed rules can be relied upon immediately. For employers conducting testing for the 2026 plan year, these rules can be applied now. If the plan fails the 55% benefits average test for 2026, the employer may now calculate only excess contributions made by the HCEs on their W-2s for the 2026 calendar year.
• Work with your TPA (or other vendor) to determine whether testing will occur on the last day of the plan year or whether it makes sense to run multiple tests throughout the year, and determine whether the items addressed in the proposed regulations will be included in their testing methodology.
• Update policies and procedures to account for the new correction method for testing failures.
• Use data gleaned from tests to project DCAP contributions for subsequent years.

If you have any questions, please contact your HUB advisor. View more compliance articles in our Compliance Directory.

NOTICE OF DISCLAIMER

Neither Hub International Limited nor any of its affiliated companies is a law or accounting firm, and therefore they cannot provide legal or tax advice. The information herein is provided for general information only and is not intended to constitute legal or tax advice as to an organization's or individual's specific circumstances. It is based on Hub International's understanding of the law as it exists on the date of this publication. Subsequent developments may result in this information becoming outdated or incorrect and Hub International does not have an obligation to update this information. You should consult an attorney, accountant, or other legal or tax professional regarding the application of the general information provided here to your organization's specific situation in light of your or your organization's particular needs.