On August 10, 2026, the IRS released proposed regulations that would update key non-discrimination testing (NDT) rules applicable to dependent care assistance programs (DCAPs).  Although these rules are not final, the IRS has indicated that employers can rely on the proposed regulations for plan years beginning before final rules are published.​

Background:​

IRC Section 129 allows employees to exclude from gross income up to $7,500 per year ($3,750 for married individuals filing separately) in employer-provided dependent care assistance, provided the DCAP satisfies nondiscrimination requirements.

If a DCAP fails to satisfy these requirements, the tax-free treatment is lost for highly compensated employees (HCEs), but non-highly compensated employees (NHCEs) continue to receive the exclusion.

The DCAP must satisfy four non-discrimination tests (NDT):

• Contributions and Benefits Test. The plan’s contributions and benefits must not discriminate in favor of HCEs.
• Eligibility Test. The plan must benefit employees who qualify under a classification established by the employer that is not discriminatory in favor of HCEs or their dependents.
• Owner Concentration Test. No more than 25% of the amounts paid by the employer for dependent care assistance during the year may be provided to the class of individuals who are 5% or more shareholders or owners (or their spouses or dependents).
• Average Benefits Test. The average benefits provided to NHCEs under all DCAPs of the employer must be at least 55% of the average benefits provided to HCEs.

Proposed Changes:​

The proposed regulations would provide welcome guidance in several areas:

• Contributions and Benefits Test – Clarifies that a DCAP will satisfy this test if it provides benefits on the same terms for all eligible employees, even if HCEs and NHCEs elect or use the benefit at different rates.​

• Eligibility Test – Establishes a numerical “safe harbor” and a “facts and circumstances” test for eligibility.​
  • Numerical Safe Harbor:   A DCAP will satisfy this test if the percentage of eligible NHCEs divided by the percentage of eligible HCEs meets a “safe harbor” threshold. That threshold starts at 90% and decreases by three-fourths of a percentage point for each whole percentage point by which the NHCE concentration percentage exceeds 60%.
  • Facts and Circumstances:   If the numerical safe harbor is not met, the classification can still pass if eligibility is based on a reasonable classification, which may include specified job categories, hourly vs. salaried status, geographic location, or other similar bona fide business criteria.​ When evaluating a classification, the IRS may consider the underlying business reasons for the classification as well as other factors.

• Average Benefits Test – Resolves long-standing ambiguity around who is included in the average benefits test.  The proposed regulations clarify that employees who were eligible but did not contribute to the plan are not included in the average benefits calculation.  Under prior practice, many employers included all eligible employees in the calculation, driving down the NHCE average and making the test harder to pass. The proposed rules provide that the average benefits test is measured as of the last day of the plan year and takes into account anyone employed on any day of the plan year who is not an excluded employee and who received benefits during the year.  Additionally, employees contributing through salary reduction may be excluded from the average benefits test if their earnings are less than $25,000.​

• Excluded Employees – Formalizes the categories of employees who are excluded from the eligibility and average benefits tests: (1) employees under age 21 who have not completed one year of service, and (2) collectively bargained employees not participating in the DCAP where dependent care benefits were the subject of good-faith bargaining.

• Formal Correction Process – Establishes a formal correction process for DCAPs.  Plans that fail the average benefits or the owner concentration test as of the last day of the plan year can correct the failure by reporting the excess benefit amounts (or excess ownership concentration) as wages on the affected HCE or owner’s Form W-2 by the W-2 filing deadline. ​

Client Actions:

• Review current DCAP testing practices, eligibility classifications and year-end corrective procedures in light of the proposed rules.​
• Confirm whether your NDT provider will be adopting the proposed rules methodology for 2026 testing.​
• Employers who did not adopt the increased DCAP limit of $7,500 in 2026 due to NDT concerns may wish to evaluate existing limits.

Your Piper Jordan account team is available to answer any questions.​

Information contained in this email is intended for general information purposes only and should not be considered legal or tax advice or legal or tax opinion on any specific facts or circumstances. Recipients are urged to consult their legal counsel and tax advisor concerning any legal or tax questions that may arise.