Vorys Benefits Brief: Discrimination Testing for Dependent Care Assistance Programs
Dependent Care Assistance Programs are subject to the nondiscrimination rules that are set forth in Internal Revenue Code Section 129 (Section 129). The statutory test has not changed since Dependent Care Assistance Programs were first adopted by Congress as part of the Economic Recovery Tax Act of 1981. For the first time since DCAPs inception, the IRS has proposed regulations clarifying the application of those non-discrimination requirements. Employers that provide Dependent Care Assistance Programs (including allowing employees to contribute to dependent care flexible spending accounts through a cafeteria plan) will want to review the new proposed regulations. In many instances employers may be able to lift limitations that they have previously imposed.
Background
Section 129 includes four basic non-discrimination tests:
- Benefit Availability Test – The contributions or benefits provided under the plan must not discriminate in favor of Highly Compensated Employees (HCEs) or their dependents. If the benefits available under the plan are the same for non-HCEs as for HCEs, this test would be satisfied.
- Eligibility Test – The eligibility standard defining who is eligible to participate under the plan must not discriminate in favor of HCEs or their dependents. The new guidance clarifies how this test will apply.
- 25% Limit for Owners – Not more than 25% of the total dependent care assistance benefits provided under the plan can be provided for owners.
- 55% Average Benefits Test – The average benefits for non-HCEs must be at least 55% of the average benefits for HCEs. The proposed guidance clarifies how this test applies.
How the Proposed Regulations Affect Employers
Eligibility Testing
Testing eligibility requires first determining the testing group. In testing, employers can exclude any employee: (a) who is under age 21, (b) who has less than 1 year of service, (c) who earns under $25,000, and (d) who is covered by a collective bargaining agreement that does not bargain for inclusion in the benefit.
Once the testing group is determined, that group is divided between HCEs and non-HCEs. HCE status is determined using the test for qualified retirement plans under Internal Revenue Code Section 414(q). In general, HCEs include (a) any employee whose compensation exceeds an amount indexed for inflation ($160,000 for 2026), (b) anyone who owns 5% or more of the equity of the employer without regard to their compensation, and (c) the spouse or dependents of anyone identified under (a) or (b).
The proposed guidance regarding eligibility borrow many of concepts from the eligibility rules for qualified retirement plans so the rules will look familiar to those who work with retirement plans. The proposed guidance clarifies how the eligibility test applies if the plan is not available for all non-HCEs.
55% Average Benefits Test
Historically, employers have assumed that the average benefit for each group (HCE and non-HCE) was calculated by dividing the total amount contributed by all employees in that group by the total number of employees in that group. This proved especially problematic for employers that had a high percentage of their non-HCEs who did not have eligible children because including those individuals with $0 contributions in the denominator drove down the non-HCE benefit percentage so that many plans failed to pass the 55% average benefits test.
The proposed regulations permit employers to only count the participating employees when calculating the benefit percentages, effectively ignoring all of the non-contributors. Many employers that have excluded HCEs from eligibility may want to reconsider that position in light of this proposed guidance.
Correction
If the DCAP fails the non-discrimination tests, all or part of the benefits becomes taxable for the HCEs, unless the employer corrects the testing failure before IRS Form W-2s are issued for the failing year. The proposed regulation specifies correction alternatives. Employers with failing benefits should consider taking corrective actions consistent with the proposed regulations.
Next Steps for Employers
Employers that offer dependent care assistance benefits will want to model the impact of this new guidance on their benefit. Many employers that have excluded HCEs may be able to re-open the benefit to their HCEs. These changes will apply to plan years that begin on or after date of publication of the final rule in the Federal Register, but employers are permitted to rely on the proposed regulations until that date.
Contact Legal Counsel
For questions or additional information about this Vorys Benefits Brief and its application, consult with legal counsel.
