Compliance, General

New Proposed IRC Rule: Dependent Care FSA Nondiscrimination Testing

by GBS Benefits
September 22, 2026
9:54 am

Health Benefits Compliance

New Proposed IRC Rule:

Dependent Care FSA Nondiscrimination Testing

The IRS has issued proposed rules to provide guidance on the Internal Revenue Code (IRC) nondiscrimination testing requirements for dependent care FSAs.
Dependent care FSAs are subject to four nondiscrimination tests under IRC Section 129: the eligibility test; the contributions and benefits test; the owner concentration test; and the 55% average benefits test.
This long-anticipated guidance may make it clearer and easier for dependent care FSAs to satisfy the nondiscrimination tests, especially the 55% average benefits test.
The proposed rules can be relied upon for plan years beginning before final guidance is issued.

On Aug. 11, 2026, the IRS issued proposed rules addressing nondiscrimination testing requirements for dependent care flexible spending accounts (FSAs). This marks the first set of regulatory guidance on the mechanics of nondiscrimination testing for dependent care FSAs. Importantly, the proposed rules do not create any new nondiscrimination requirements for dependent care FSAs; they simply clarify how decades-old statutory rules should be applied.

Employers with dependent care FSAs often struggle to pass nondiscrimination testing, especially the 55% average benefits test, because lower-paid employees are less likely to participate in these plans. The proposed rules would make the following key changes:

Clarify how the 55% average benefits test applies to dependent care FSAs, including the methodology for calculating average benefits for highly compensated employees (HCEs) and non-highly compensated employees (non-HCEs);
Allow employers to correct a failed 55% average benefits test by including excess benefits in HCEs’ gross income by the deadline for furnishing Form W-2 for the testing year (i.e., Jan. 31 of the following year); and
Establish a clear safe harbor for passing the eligibility test through a percentage-based approach, rather than a facts and circumstances analysis.

While the rules have not been finalized, employers may rely on the proposed guidance for plan years beginning before final rules are issued.

Dependent Care FSAs

Internal Revenue Code (Code) Section 129 allows employers to provide dependent care assistance benefits for their employees on a tax-free basis. These benefit plans are referred to as dependent care FSAs or dependent care assistance programs. Most dependent care FSAs are structured so that employees make pretax contributions through a Code Section 125 cafeteria plan. Married employees who file a joint tax return and unmarried employees may contribute up to $7,500 each year to their dependent care FSAs. The annual limit for married employees who file separate tax returns is $3,750. These limits do not receive annual adjustments for inflation.

In general, benefits that an employee receives from their dependent care FSA are nontaxable if:

The expenses are for the care of one or more qualifying individuals (for example, a child under the age of 13); and
The employee incurs the expense in order to enable the employee (and the employee’s spouse, if applicable) to be gainfully employed.

Nondiscrimination Requirements

Code Section 129 imposes nondiscrimination requirements on dependent care FSAs to make sure they do not discriminate in favor of HCEs. An employee is generally an HCE if they are a more-than-5% owner at any time during the current or prior year, or if their prior-year compensation exceeded the applicable dollar threshold for that year ($160,000 for 2025 and 2026). In general, employers with dependent care FSAs have had difficulty with nondiscrimination testing, largely because non-HCEs tend to participate at lower rates, while HCEs are more likely to elect the maximum contribution.