Proposed Rules Would Clarify DCAP Nondiscrimination Testing

Background on DCAPs and nondiscrimination testing

Section 129 of the Internal Revenue Code (IRC) allows employees to exclude certain dependent care benefits from taxable income through a DCAP, provided the program satisfies applicable legal requirements, including the Section 129 nondiscrimination rules. Under a DCAP, employees may exclude up to $7,500 from taxable income annually ($3,750, if married filing separately) to pay for eligible dependent care expenses. To qualify, the expenses must be for eligible household and dependent care services for qualifying individuals that are necessary to enable the employee and his or her spouse to work.

Section 129 establishes the nondiscrimination requirements a DCAP must meet. Until now, IRS guidance on what standards to use to meet these requirements has been limited. The law’s nondiscrimination requirements and the proposed rule’s standards for meeting the requirements are discussed in the next section.

Key provisions of the proposed rule on DCAP nondiscrimination testing

The proposed rule, published on August 11, 2026, would establish the first comprehensive framework for applying Section 129 DCAP nondiscrimination testing and addressing testing failures. The rule would provide greater certainty regarding application of the four existing DCAP nondiscrimination tests, as discussed below.

Contributions-and-benefits test

Under the law, a DCAP must not discriminate with respect to contributions and benefits provided under the plan in favor of highly compensated employees (HCEs). For DCAP testing, an HCE is defined pursuant to Section 414(q) of the IRC. For 2026, an HCE is any employee who earned more than $160,000 in 2025, or who qualifies as a 5 percent owner in 2025 or 2026.

The proposed rule would clarify that a DCAP satisfies this test if it provides benefits on the same terms for all eligible employees and their dependents, even if HCEs and non-highly compensated employees (NHCEs) receive different benefit amounts based on their individual elections or levels of utilization.

Eligibility test

The law provides that eligibility criteria for a DCAP must not discriminate in favor of HCEs. The proposed rule would clarify that to meet this nondiscrimination requirement eligibility criteria must be “reasonable” and must not in operation discriminate in favor of HCEs or their dependents.

For these purposes, an employee is considered eligible for the DCAP only if they had a meaningful opportunity to receive benefits via salary reduction or otherwise, regardless of whether any benefits were received. Nondiscrimination in eligibility must be reviewed each year.

Under the proposed rule, a DCAP’s eligibility criteria would be considered “reasonable” if they are based on objective business criteria. The proposed rule highlights that reasonable criteria generally include specified job categories, nature of compensation (such as salaried or hourly), geographic location, and similar bona fide business criteria. Criteria that distinguish based on specific employees by name or that have that effect would not be reasonable.

To be considered nondiscriminatory, the eligibility classification would also have to do one of the following:

• Satisfy a facts-and-circumstances test. Under this test, a classification would be considered nondiscriminatory only if, based on all relevant facts and circumstances, the IRS determines that it does not favor HCEs or their dependents. No single factor would be considered determinative. The IRS would evaluate all of the relevant facts, including the business reason for the classification, the percentage of employees eligible to participate in the plan (the higher the percentage, the more likely nondiscriminatory), whether eligible employees are representative of the employer’s workforce across pay levels and how closely the plan’s ratio percentage aligns with the safe harbor percentage.
• Qualify under a numerical safe harbor. A DCAP’s “ratio percentage” would have to meet or exceed the employer’s safe harbor percentage. The ratio percentage is determined by dividing the percentage of NHCEs eligible for the plan by the percentage of HCEs eligible for the plan. The safe harbor percentage is generally 90 percent, but it is reduced by 0.75 percentage points for each whole percentage point when the NHCE concentration percentage exceeds 60 percent of the workforce. Additional detailed rules for determining eligibility and concentration percentages are included in the proposed rule.

Owner concentration test

The proposed rule reiterates the law’s requirement that, to be nondiscriminatory, no more than 25 percent of the employer’s total dependent care assistance benefits for the plan year can be provided to owners who own more than 5 percent of the business (or their spouses or dependents). However, the proposed rule would provide guidance regarding how an employer could correct a testing failure by reporting “excess ownership concentration” as income, as discussed below.

Average benefits test

Under the law, to be nondiscriminatory, the average dependent care benefit provided to NHCEs must be at least 55 percent of the average benefit provided to HCEs under the plan. Notably, the proposed rule would clarify that average benefits would be calculated only among employees who receive DCAP benefits during the plan year.

The proposed rule would clarify that the "average benefits" provided to a group of HCEs or NHCEs is determined by dividing the total dollar amount of dependent care assistance provided to that group under all of the employer’s dependent care assistance programs during the plan year by the number of employees in that group who actually received dependent care assistance during the plan year through salary reduction or otherwise.

Further, the proposed rule would clarify that certain categories of employee would be excluded from the calculation entirely, as described below. In the case that any benefits are provided through a salary reduction agreement, employees whose compensation is less than $25,000 per year may also be excluded from the calculation.

The proposed rule would also establish that the average benefits test must be performed annually using full plan-year data and would have to include all non-excluded employees who received benefits at any point during the year.

Excluded employees

The proposed rule states that the following classifications of employees would be excluded for purposes of the eligibility test and average benefits test:

• Employees who have not attained age 21 and who have not completed one year of service
• Collectively bargained employees where DCAP benefits were the subject of good-faith bargaining

Failure and remediation

In the event of a failure to satisfy one or more of the nondiscrimination requirements, the proposed rule maintains the current result that the program and its tax benefits would not be a DCAP with respect to HCEs but would continue to be treated as a DCAP with respect to NHCEs — meaning that NHCEs would continue to receive the tax-favorable treatment of the excluded income.

However, the proposed rule would establish remediation measures allowing employers to fix failures to satisfy the ownership concentration and average benefits tests. By creating formal correction mechanisms, the proposed rule would provide employers with a clearer path to preserving the tax treatment of DCAP benefits when a nondiscrimination failure occurs. Specifically, the rules would permit an employer to include “excess-ownership concentration” amounts and “excess benefits” in the taxable income of affected owners and HCEs if reported on Form W-2 by the applicable reporting deadline.

Implications for plan sponsors

Once finalized, the new rules would apply for plan years beginning on or after the date of publication of the final rules; however, plan sponsors may rely on the proposed regulations for plan years before the final regulations are issued. In light of the proposed rule, plan sponsors may wish to revisit their current DCAP design and administration, including eligibility provisions, employee classifications and contribution strategies. Plans adopting approaches under the proposed rule may need to update nondiscrimination testing procedures and payroll and administrative systems to meet annual testing and remediation standards.

Plan sponsors should watch for final guidance. If finalized as proposed, the rule would provide greater certainty regarding DCAP nondiscrimination testing requirements and may allow more flexible testing approaches than many plan sponsors currently use.