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:
OR
To understand the impact, let’s look at an example of each.
Example Math
The Conservative/Letter of the Law Interpretation
| Population | DCAP Election | Average | |
| Non-HCEs | 80 |
$50,000 |
$625 |
| HCEs | 20 | $28,000 | $1,400 |
| Ratio of NCHEs Average to HCE Average |
44.6% |
||
| 44.6% is not greater than 55%, so... | Fail | ||
| Under this method, we divide the total HCE and NHCE elections by the total population of HCEs or NHCEs, regardless of whether they made any DCAP election. This version of the testing math often yielded a failing test for employers which required election cutbacks for HCEs. |
|||
The More Aggressive Interpretation
| DCAP Participants | DCAP Election | Average | |
| Non-HCEs | 10 |
$50,000 |
$5,000 |
| HCEs | 4 | $28,000 | $7,000 |
| Ratio of NCHEs Average to HCE Average |
71.4% |
||
| 71.4% is greater than 55%, so... | Pass | ||
| Under this method, we divide the total HCE and NHCE elections by the respective number of HCEs/NHCEs that elected to participate in the DCAP plan, NOT the entire populations. This version of the testing math is much easier to pass. | |||
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).
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.
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.