IRS Proposes New Dependent Care FSA Testing Rules for Employers
On August 11, 2026, the IRS proposed the first detailed guidance on how dependent care flexible spending account (FSA) nondiscrimination testing works under Section 129 of the tax code. The headline is good news: the most commonly failed test may become easier to pass.
Key Takeaways for Employers
Many employers may stop failing the 55% test
The averages would be based only on employees who actually participate, meaning employers that failed year after year may now pass without changing their plan design or reducing employee elections.
If a plan still fails, corrections are simpler
Employers could correct a failure by including the excess benefit amount in affected highly compensated employees’ taxable income on their Form W-2 for the year, even after the plan year ends.
The Full Set of Changes
1. How the 55% average is calculated (the big one)
The average benefit for each group would be calculated by dividing total benefits provided by the number of employees who actually received a benefit. Employees who were eligible but elected nothing would no longer be counted. Because non-participants previously reduced the average, this change alone could allow many plans pass.
2. Who counts as “eligible” vs. who counts in the average
These are two different questions. For the eligibility test, employees count if they had a meaningful opportunity to participate, regardless of whether they enrolled. For the 55% average benefits test, only employees who actually participated are counted. Keeping these straight matters when reviewing a plan’s results.
3. A clearer eligibility test with a safe harbor
Eligibility classifications must be based on objective business criteria, such as job category, hourly vs. salaried, or location rather than naming individuals, and must not favor highly compensated employees.
The proposal introduces a numerical safe harbor: if the share of non-highly compensated employees who are eligible is high enough relative to the share of highly compensated employees who are eligible, the classification is treated as acceptable automatically.
4. The owner concentration rule
No more than 25% of total dependent care benefits may go to more-than-5% owners (and their families). This limit itself is unchanged, but the proposal adds a correction path for a plan that fails it (see below).
5. Who is left out of testing (a restatement, not a change)
Employees under age 21 with less than a year of service, and certain union-represented employees, are excluded from the eligibility and average-benefits tests. These exclusions already exist under Section 129 but are restated and clarified in the proposal. In some cases, applying these exclusions could turn a failing result into a passing one.
6. Two ways to fix a failure
If a plan fails the 55% test, an employer can include each affected highly compensated employee’s excess benefit in their income and report it on their Form W-2 by the normal deadline for the year the benefits were provided. A similar Form W-2 correction is available for a failed owner concentration test. This is a predictable, IRS-recognized fix — no last-minute scramble to cut elections before year-end.
When Does This Take Effect?
These are proposed rules, so some details may change. They would formally apply to plan years beginning on or after the date the final rules are published. Importantly, the IRS says employers may rely on them now, for plan years beginning before the final version is published, and EBC will apply them accordingly. This proposal is subject to a public comment period, with a public hearing on October 15, 2026.
How EBC Helps
Nondiscrimination testing is included in the administration of an employer’s FSA plan with EBC. We gather the data, run the required tests, explain the results, and help employers understand their options if a test fails. EBC will be updating its nondiscrimination testing communications before the upcoming testing season for calendar-year plans to reflect this updated testing and correction guidance.
One More Thing: Employer “Trump Account” Contributions
The same IRS package also introduces rules for a new benefit created by the 2025 tax law: employer contributions to “Trump accounts,” a new type of savings account for children. Employers can generally contribute up to $2,500 per employee each year on a tax-free basis, subject to their own written-plan, notice, reporting, and nondiscrimination requirements. This is separate from dependent care FSAs, but we’re noting it here for awareness as the rules develop.
While these proposed changes may simplify dependent care FSA nondiscrimination testing for many employers, compliance requirements still apply and annual testing remains an important part of plan administration. For a broader overview of nondiscrimination testing requirements across employee benefit plans, including why testing matters and how the process works, explore EBC's guide to nondiscrimination testing.