Welcome Relief for Dependent Care FSA Nondiscrimination Testing

The IRS has issued proposed regulations which provide clarification for Dependent Care Assistance Programs (DCAP) discrimination testing, commonly referred to as Dependent Care FSAs. This guidance reflects the first comprehensive regulatory framework for Dependent Care FSA nondiscrimination rules. Plan sponsors have long operated with limited guidance and significant uncertainty about how Dependent Care FSA nondiscrimination testing should be applied. The proposed regulations provide welcome clarity by establishing a comprehensive framework and addressing ambiguities that have persisted for decades.

The 55% Average Benefits Test Clarification

The 55% average benefits test requires that the average Dependent Care FSA benefit provided to Non-Highly Compensated Employees (NHCEs) be at least 55% of the average benefit provided to Highly Compensated Employees (HCEs).

Historically, the text of the law (without regulatory clarification) left two possible interpretations of how to do the math in the 55% average benefits test. The ambiguity was in how to calculate the denominator of the average calculation:

• Should the total HCE and NHCE elections be divided by the entire population of HCEs and NHCEs?
• Should the total HCE and NHCE elections be divided by just those HCEs and NHCEs who have elected to participate in the DCAP plan?

OR

To understand the impact, let’s look at an example of each.

Example Math
The Conservative/Letter of the Law Interpretation

The More Aggressive Interpretation

And the Winner Is... 

The proposed regulations clarify that the math can be done using only the number of HCE and NHCE participants electing Dependent Care FSA benefits (not the entire HCE and NHCE populations).

Historically, in the absence of clarity, most employers used the more conservative approach which caused the 55% average benefits test to be the most frequently failed by employers. This clarification will make it easier to pass this test (and thus avoid cutbacks for HCEs).
 

What if We Already Tested?

Many employers have already completed preliminary testing for the 2026 plan year. Employers that failed the 55% average benefits test under previous testing methodologies may benefit from the clarification provided in the proposed regulations. For Dependent Care FSAs administered by Vita Flex, affected clients have already been contacted regarding available retesting opportunities. Employers whose Dependent Care FSA is administered by another provider should consult their administrator or broker regarding the potential impact of this guidance.
 

Effective Date

The proposed regulations take effect for plan years beginning on or after publication of final regulations.  However, the IRS allows plan sponsors to rely on the proposed rules for plan years prior to finalization.  

References

• Proposed Regulation (REG-101355-26)