On August 11, 2026, the U.S. Treasury Department and Internal Revenue Service (IRS) issued proposed regulations that aim to resolve confusion around how employers must apply the 55% Average Benefits Test for Dependent Care Flexible Spending Accounts (DC FSA), clarifying who to include as part of the testing. As described below, this has the potential to make nondiscrimination testing easier for many plan sponsors. Although the regulations are not yet final, plan sponsors may rely on the guidance now.
Background
Dependent Care FSAs (DC FSAs, or DCAPs) are subject to nondiscrimination testing (NDT), including the 55% Average Benefits Test. This test is designed to ensure that highly compensated employees (HCEs) do not receive disproportionately favorable benefits compared to non-highly compensated employees (NHCEs). For 2026 testing purposes, HCEs are defined as employees who earned more than $160,000 in 2025, as well as 5% owners.
The math is straightforward when it comes to this test. The plan passes testing when NHCEs receive, on average, at least 55% of the average benefits received by HCEs. However, because HCEs tend to utilize DC FSAs at higher rates, often contributing and spending closer to the annual maximum, the average benefits gap between HCEs and NHCEs can widen quickly, causing NDT failures. We often find this is the most common type of NDT failure. When the test fails, the consequences fall on HCEs (their DC FSA benefits lose their tax-favored status and become includible in gross income).
While the math behind the test is relatively straightforward, the question of who belongs in the testing population has been a persistent source of confusion for plan sponsors. For purposes of this test, vendors generally use one of two methods: (1) they include all benefit-eligible employees or (2) they include only employees participating in the DC FSA. Before this proposed rule was released, guidance was unclear on this issue, and many employers took a conservative approach by including all nonexcludable employees in testing, even those excluded from DC FSA participation by plan design. Because the selected testing method will often produce different results, this rule clarification is helpful and has been long awaited by both plan sponsors and testing vendors.
Proposed Rules
The IRS clarifies in its proposed rules that only employees who actually receive dependent care assistance benefits during the plan year are included in the 55% Average Benefits Test.
Under the proposed rule, the average benefit for each group (HCEs and NHCEs) is calculated by dividing the total dependent care assistance provided during the plan year by the number of employees in the group who actually received dependent care assistance benefits during that year. Employees who are eligible for a DC FSA but elect not to participate, or who contribute nothing during the plan year, are excluded from the testing calculation entirely.
In addition, if a plan fails the 55% Average Benefits Test, employers correct the failure by reducing pre-tax elections or by recategorizing HCEs contributions as taxable income. The proposed rules clarify that any correction must be made by January 31 of the year following the testing year, which aligns with the IRS deadline for issuing Forms W-2 for the prior year (e.g., corrections for the 2026 plan year must be made by January 31, 2027, and reflected on the 2026 Form W-2). Importantly, best practice remains to test the plan mid-year to allow time to adjust pre-tax elections, if needed. However, this clarification is welcome news because it gives employers additional time to make necessary plan corrections.
Given the challenges of passing the 55% Average Benefits Test, coupled with the administrative burden of administering corrections, the proposed rules are a welcome change for employers that have had difficulty passing this test.
Employer Takeaways
- The IRS has indicated that employers may rely on the proposed regulations immediately for testing purposes, without waiting for final rules. Note that the IRS will receive comments on the proposed rules through September 25, 2026, intending to issue final guidance in the future.
- Employers sponsoring a DCFSA should review their current testing methodology with their NDT vendor directly to confirm alignment with the proposed rules; we have seen many testing vendors already reaching out to employers on this topic.
Employers may find it easier to satisfy the 55% Average Benefits Test by excluding eligible employees who do not participate. This may be particularly beneficial where a significant portion of eligible NHCEs have historically declined coverage. While employers can rely on these proposed regulations now, the rules are not yet final. The IRS will take comments on these proposed rules through September 25, 2026. Sequoia will continue to monitor IRS guidance and communicate updates on this proposed rule as they become available.
Additional Resources
Connect with a Sequoia consultant to learn how Sequoia’s compliance services are integrated in our benefits services and tailored solutions. And if you’re already a Sequoia client, stay on top of your employer obligations with your Compliance Checklist that highlights important compliance dates, action items, and resources.   
