Dependent care FSA nondiscrimination testing gets easier under IRS proposal
Recently proposed regulations from the Treasury Department and IRS offer employers a favorable interpretation when it comes to testing requirements for dependent care flexible spending arrangements (FSAs). Although these rules are only proposed, employers may rely on them immediately.
The guidance addresses the nondiscrimination testing rules for Dependent Care Assistance Programs, including dependent care FSAs, under Internal Revenue Code § 129. The proposed regulations clarify that, for purposes of the historically difficult to pass 55% average benefits test, employers should include only employees who actually receive dependent care assistance benefits, including through employee pretax salary reductions, rather than the entire group of employees.
As background, Code Section 129(d)(8) requires that the average benefits provided to Non-Highly Compensated Employees under all of the employer’s plans equal at least 55% of the average benefits provided to Highly Compensated Employees under those plans. A strict reading of the statute would require employers to include all nonexcludable employees in this calculation, even if those employees are not eligible for dependent care assistance, or if eligible, never actually receive employer-provided dependent care assistance, whether through pretax contributions or otherwise.
Under that approach, each NHCE who does not receive dependent care assistance benefits, such as by not contributing to the dependent care FSA, reduces the average benefit for the NHCE group. In practice, this interpretation has caused many dependent care FSAs to fail the 55% average benefits test, resulting in limits on the amount of tax-free dependent care benefits available to HCEs.
The proposed regulations address this issue directly. Under the proposed regulations, the average benefit provided to a group of HCEs or NHCEs is determined by dividing the total dollar amount of dependent care assistance provided during the plan year to employees in that group by the number of employees in the group “to whom any dependent care assistance is provided during the plan year, via salary reduction or otherwise." The proposed regulations further clarify that an employee is included in the denominator for a group only if the employee receives dependent care assistance from the employer during the plan year and the employee is not otherwise an excluded employee.
This guidance is especially timely because, as we noted in a previous blog post, the One Big Beautiful Bill Act permanently increased the annual exclusion for dependent care assistance from $5,000 to $7,500, and from $2,500 to $3,750 for married individuals filing separately, for plan years beginning on or after January 1, 2026. Because HCEs may be more likely to take advantage of these higher contribution limits, the risk of failing the 55% test may also increase.
In a positive development, the proposed rule should make it easier for employers to satisfy that test. Employers should take these proposed rules into account when deciding whether to adopt the higher dependent care limits now permitted by law and whether it’s necessary to impose contribution caps on HCEs.
