Seyfarth Synopsis: On August 11, 2026, the Internal Revenue Service issued proposed regulations addressing nondiscrimination rules for dependent care assistance programs (“DCAPs”) under Section 129 of the Internal Revenue Code (the “IRC”). More than 45 years after DCAPs were enacted under IRC § 129, these proposed regulations provide long-awaited guidance on DCAP nondiscrimination testing and also address employer contributions and nondiscrimination rules for Trump Accounts. For additional information on Trump Accounts, see our blogs here and here.

Background:

A DCAP allows employees to pay eligible dependent-care expenses with pre-tax dollars. Employers may also contribute to an employee’s DCAP. For 2026, the maximum amount that may be excluded from an employee’s gross income is $7,500, or $3,750 for a married individual filing separately.

Eligible expenses generally include care for:

• A child under age 13; or
• A spouse or dependent who lives with the employee and is physically or mentally incapable of self-care

The proposed regulations confirm and elaborate on the four statutory nondiscrimination tests applicable to DCAPs:

• Contributions and benefits test
• Eligibility test
• Owner concentration test
• Average benefits test

For the first time, each test receives detailed regulatory guidance.

Updates

Contributions and Benefits Test

Under the proposed regulations, a DCAP fails the contributions and benefits test if the contributions or benefits available under the DCAP discriminate in favor of HCEs or their dependents. (The proposed regulations define a Highly Compensated Employee (“HCE”) by cross-reference to IRC §  414(q). A non-Highly Compensated Employee (“NHCE”) is any employee who is not an HCE.) A DCAP satisfies the test if contributions and benefits are available on the same terms to all eligible employees. The proposed regulations clarify that a DCAP does not fail the test merely because employees ultimately receive different benefit amounts due to different elections or different levels of benefit utilization.

Eligibility Test

The proposed regulations require that the eligibility classification must (1) be based on objective, reasonable business criteria, and (2) be nondiscriminatory in operation. That determination is based on all facts and circumstances. Reasonable and established business criteria may include job categories, compensation type, location, or other similar bona fide business criteria. The proposed regulations specify that listing eligible employees by name is not reasonable. No single factor is determinative, including the business reason for the classification, the percentage of employees eligible to participate, whether eligible employees are representative of compensation levels across the workforce, and the extent to which the plan’s ratio percentage differs from the employer’s safe harbor percentage.

The safe harbor looks to the plan’s “ratio percentage,” meaning the ratio of the NHCE eligibility rate to the HCE eligibility rate. The proposed regulations define an employer’s safe harbor percentage as 90%, reduced by 0.75% for each 1% of NHCEs over 60%. If the plan’s ratio falls within the safe harbor, the plan will be treated as nondiscriminatory.

Owner Concentration Test

Under IRC § 129(d)(4), no more than 25% of the amounts paid or incurred by the employer for dependent care assistance during the year may be provided to shareholders or owners who each own more than 5% of the stock, capital, or profits interest in the employer. Proposed Treasury Regulation § 1.129-2(c) restates this requirement.

Average Benefits Test

The proposed regulations note that the average benefits test “has been the subject of confusion for many years and has been challenging for taxpayers to apply.” The IRS clarifies that, under the proposed regulations, average benefits are calculated using only employees who actually receive DCAP benefits during the plan year. The average benefits provided to NHCEs must equal at least 55% of the average benefits provided to HCEs. The calculation is performed on the last day of the plan year. For benefits provided through a salary-reduction arrangement, the plan may disregard employees whose compensation is less than $25,000.

This clarification may be welcome news for some employers. Because the calculation excludes employees who do not receive benefits, employers that historically struggled to satisfy the average benefits test may find it easier to comply under the proposed methodology.

Excluded Employees

For purposes of the eligibility and average benefits tests, employers may generally exclude:

• Employees who have not attained age 21 or completed one year of service; and
• Certain collectively bargained employees, provided dependent-care benefits were the subject of good-faith bargaining

New Correction Opportunities

The proposed regulations create a potentially valuable correction mechanism. If a DCAP fails the average benefits test or owner concentration test, the employer may be able to correct the failure by including the applicable excess benefits in the affected individuals’ taxable income.

To use this correction, the amounts must be treated and reported as taxable income by the applicable deadline for furnishing Forms W-2 for the year in which the benefits were provided. This approach may allow the plan to preserve tax-favored treatment for the remaining benefits rather than causing all benefits provided to HCEs or affected owners to become taxable.

What Employers Should Do Now

Employers sponsoring DCAPs should consider:

• Reviewing eligibility classifications for objective and reasonable business criteria
• Confirming that contributions and benefits are offered on the same terms to similarly situated eligible employees
• Evaluating how the new average benefits methodology may affect testing results
• Coordinating with administrators and payroll providers regarding the proposed correction procedures
• Confirming whether current testing practices should be updated in reliance on the proposed regulations

Looking Ahead

The comment period for the proposed regulations ends on September 25, 2026, and a public hearing is scheduled for October 15, 2026. The regulations are proposed to apply to plan years beginning on or after final regulations are published. Employers may, however, rely on the proposed regulations before they are finalized.

If you sponsor, or are considering sponsoring, a DCAP, please reach out to your Seyfarth benefits attorney now rather than waiting for final regulations.