On August 10, 2026, the Treasury Department and the IRS (together, the IRS) released proposed regulations addressing the long-awaited nondiscrimination rules that apply to dependent care assistance programs (“DCAPs”) under Code section 129. This is the first time the IRS has issued guidance on these rules, which were first effective over 45 years ago! The regulations are consistent with a common-sense approach that some employers have been applying in the absence of specific guidance, and welcome news. The regulations should also provide comfort to employers who have been reluctant to increase DCAP limits to $7,500 due to concerns about satisfying nondiscrimination rules. The proposed regulations closely track the companion nondiscrimination rules for Trump account contribution programs (see our alert here), but they retain several features unique to DCAPs.
As background, a DCAP must satisfy four nondiscrimination tests: (1) the contributions and benefits test; (2) eligibility test; (3) the owner concentration rule; and (4) the average benefits test. The proposed regulations provide detailed rules for all four tests.
The Contributions and Benefits Test
The proposed regulations restate the statutory requirement that contributions or benefits cannot discriminate in favor of HCEs or their dependents. The proposed regulations provide that a DCAP that provides benefits on the same terms for all eligible employees satisfies this requirement. For example, a DCAP that allows all non-HCEs to make salary reductions in the same amount as HCEs does not discriminate as to contributions or benefits, even if employees receive different amounts of DCAP benefits as a result of differing elections or utilization. But, a DCAP fails this test if its terms are more favorable to HCEs.
Groom Insight: The proposed regulations define an HCE by cross-reference to Code section 414(q), which generally defines HCE as an employee who: (1) was a 5-percent owner during the current or preceding plan year; or (2) had compensation in excess of $160,000 (adjusted for inflation) in the preceding plan year (unless the employer made the top-paid group election). Consistent with the statute, the proposed regulations provide that an “employee” for this purpose includes partners, sole proprietors, and 2-percent S corporation shareholders.
The Eligibility Test
A DCAP must benefit employees who qualify under a classification the employer establishes that does not discriminate in favor of HCEs or their dependents. The proposed regulations provide that a DCAP must benefit employees who qualify under an eligibility classification that the employer establishes that is reasonable and based on objective business criteria and is not discriminatory in favor of HCEs. An employee is eligible only if the employee has a meaningful opportunity to receive benefits, whether through salary reduction or otherwise, even if the does not actually receives benefits.
- Reasonable eligibility determination – Eligibility criteria must be reasonable, based on all of the facts and circumstances, and established under objective business criteria that identify the category or categories of employees eligible under the DCAP. Reasonable classifications include specified job categories, the nature of compensation (salaried or hourly), geographic location, and similar bona fide business criteria.
- Nondiscriminatory classification – The classification must be nondiscriminatory, which means that it must satisfy either (1) a facts-and-circumstances test or (2) a numerical safe harbor.
- Facts and circumstances test – A classification satisfies the facts and circumstances test if, based on all the facts and circumstances, the classification is nondiscriminatory. No one factor is determinative, and relevant factors include: (1) the underlying business reason for the classification; (2) the percentage of the employer’s employees eligible (the higher the percentage, the more likely the classification is nondiscriminatory); (3) whether the number of employees eligible in each salary range is representative of the number of employees in each salary range of the employer’s workforce (the more representative, the more likely the classification is nondiscriminatory); and (4) the difference between the plan’s ratio percentage and the safe harbor percentage (explained below).
- Numerical safe harbor – A classification satisfies the numerical safe harbor if the ratio percentage is greater than or equal to the safe harbor percentage. The plan’s “ratio percentage” is calculated by dividing the eligibility percentage of non-HCEs (the number of non-HCEs eligible divided by the total number of non-HCEs) by the eligibility percentage of HCEs (the number of HCEs eligible divided by the total number of HCEs). The plan’s “safe harbor percentage” is 90%, reduced by 3/4 of a percentage point for each percentage point by which the non-HCE concentration exceeds 60%.
Groom Insight: The preamble notes that the IRS incorporated nondiscrimination concepts from Code section 410 (which generally applies to qualified retirement plans). This is similar to the test that applies for other health and welfare nondiscrimination tests, such as the Code section 105(h) eligibility test.
The Owner Concentration Test
The proposed regulations reflect the statutory test that not more than 25% of the amounts the employer pays or incurs for dependent care assistance during the year may be provided for the class of individuals who are principal shareholders or owners (an individual who, on any day of the taxable year, owns more than 5% of the stock or of the capital or profits interest in the employer). This test is straightforward and is calculated by dividing DCAP assistance provided to principal shareholders and owners (and their spouses and dependents) by all DCAP assistance provided by the employer. This number cannot exceed 25%.
The proposed regulations permit an employer to correct a testing failure through “remedial measures.” Specifically, a failing DCAP can still be treated as satisfying this test if the employer includes an “excess ownership concentration” (determined under a formula) amount in the principal shareholder or owner’s income and reports those amounts as wages on Form W-2.
The Average Benefits Test (The Best Part of the Proposed Regulations!)
Under the statute, the average benefits provided to non-HCEs “under all plans of the employer” must equal at least 55% of the average benefits provided to HCEs “under all plans of the employer.” There has been much confusion over the meaning of “all plans of the employer.” The proposed regulations make clear that this is limited to all DCAPs of the employer.
The proposed regulations clarify that the “average benefits” provided to a group of HCEs or non-HCEs for a plan year equals the total dollar amount of contributions provided under all of the employer’s DCAPs to employees in that group, divided by the number of employees in that group to whom the employer provided contributions during the year, whether through salary reduction or otherwise. The denominator counts only employees who actually receive contributions (and can exclude from testing employees whose compensation is less than $25,000).
Groom Insight: This portion of the proposed regulations is one that many employers have been anxiously awaiting. A significant number of DCAPs have struggled to pass this test because, under one interpretation, non-participating employees are treated as having contributed $0 – even though many of these employees may not have eligible dependents in the first place. This skews the results and makes the test harder to pass than it should be. The good news is that the proposed regulations adopt the interpretation some employers have already been using in practice, which is to count only the contributions of employees who actually participate in the DCAP.
The proposed regulations provide that test must be satisfied as of the last day of the plan year. The proposed regulations permit an employer to correct a testing failure by including an “excess benefit” (determined under a formula) received by an HCE in income and reporting those amounts on Form W-2.
Groom Insight: The preamble states that the IRS is: proposing these regulations to provide a practical correction mechanism for failures, while preserving the statutory focus on preventing HCEs from receiving the benefit of discriminatory arrangements. [The proposed regulations] are intended to allow employers to correct certain failures through income inclusion, rather than by requiring adjustment of benefits that have already been provided.
Employee Exclusions
The proposed regulations permit an employer to exclude two groups of employees from the eligibility and average benefits tests: (1) employees who have not attained age 21 and completed one year of service, subject to rules similar to those under Code section 410(b)(4); and (2) employees who are excluded from the DCAP and are covered by a collective bargaining agreement, where there is evidence that dependent care assistance benefits were the subject of good-faith bargaining.
Applicability Date
The proposed regulations would apply to plan years beginning on or after the date the IRS publishes final regulations. However, taxpayers can rely on the proposed regulations before the final regulations are published.
Groom Insight: The DCAP exclusion increased to $7,500 in 2026 (up from $5,000), and some employers have been concerned that adopting this increased limit would impact their ability to pass the average benefits test. Employers can breathe a sigh of relief knowing they can rely on the proposed regulations for 2026 testing.
Next Steps
The proposed regulations give employers the first true guidance for DCAP nondiscrimination testing ever and overall are good news for employers navigating these tests. Comments are due 45 days after the proposed regulations are published in the Federal Register. There is a public hearing on October 15, 2026, at 10:00 a.m. ET. Please reach out to any of the attorneys listed on this alert if you would like assistance with submitting comments or implementing the proposed regulations.
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