IRS Proposes Rules for Dependent Care FSA Nondiscrimination Testing
On Aug. 11, 2026, the IRS issued proposed rules addressing nondiscrimination testing requirements for dependent care flexible spending accounts (FSAs). This marks the first set of regulatory guidance on the mechanics of nondiscrimination testing for dependent care FSAs. Importantly, the proposed rules do not create any new nondiscrimination requirements for dependent care FSAs; they simply clarify how decades-old statutory rules should be applied.
Employers with dependent care FSAs often struggle to pass nondiscrimination testing, especially the 55% average benefits test, because lower-paid employees are less likely to participate in these plans. The proposed rules would make the following key changes:
- Clarify how the 55% average benefits test applies to dependent care FSAs, including the methodology for calculating average benefits for highly compensated employees (HCEs) and non-highly compensated employees (non-HCEs)
- Allow employers to correct a failed 55% average benefits test by including excess benefits in HCEs’ gross income by the deadline for furnishing Form W-2 for the testing year (i.e., Jan. 31 of the following year)
- Establish a clear safe harbor for passing the eligibility test through a percentage-based approach, rather than a facts and circumstances analysis.
While the rules have not been finalized, employers may rely on the proposed guidance for plan years beginning before final rules are issued.
Dependent Care FSAs
Internal Revenue Code (Code) Section 129 allows employers to provide dependent care assistance benefits for their employees on a tax-free basis. These benefit plans are referred to as dependent care FSAs or dependent care assistance programs. Most dependent care FSAs are structured so that employees make pretax contributions through a Code Section 125 cafeteria plan. Married employees who file a joint tax return and unmarried employees may contribute up to $7,500 each year to their dependent care FSAs. The annual limit for married employees who file separate tax returns is $3,750. These limits do not receive annual adjustments for inflation.
In general, benefits that an employee receives from their dependent care FSA are nontaxable if:
- The expenses are for the care of one or more qualifying individuals (for example, a child under the age of 13)
- The employee incurs the expense in order to enable the employee (and the employee’s spouse, if applicable) to be gainfully employed.
Nondiscrimination Requirements
Code Section 129 imposes nondiscrimination requirements on dependent care FSAs to make sure they do not discriminate in favor of HCEs. An employee is generally an HCE if they are a more-than-5% owner at any time during the current or prior year, or if their prior-year compensation exceeded the applicable dollar threshold for that year ($160,000 for 2025 and 2026). In general, employers with dependent care FSAs have had difficulty with nondiscrimination testing, largely because non-HCEs tend to participate at lower rates, while HCEs are more likely to elect the maximum contribution.
Four Different Tests
To avoid adverse tax consequences for HCEs, a dependent care FSA must satisfy four nondiscrimination tests under Code Section 129. The proposed rules are intended to make the testing requirements clearer and easier to administer. The following chart describes each of these tests and summarizes the IRS’s proposed corresponding guidance:
Eligibility Test: Code Section 129(d)(3)
Statutory Description:
A dependent care FSA cannot discriminate in favor of HCEs as to eligibility to participate. The following employees are excluded for testing purposes:
- Employees who have not attained age 21 and completed one year of service
- Collectively bargained employees who are not included in the dependent care assistance program.
Proposed Rules:
This nondiscrimination test requires both that the employer’s eligibility classification be reasonable and that the classification be nondiscriminatory in operation. Reasonable classifications generally include specified job categories, nature of compensation (salaried or hourly), geographic location and similar bona fide business criteria. Listing employees by name, or by criteria having substantially the same effect, is not a reasonable classification.
A classification can establish nondiscriminatory operation in either of two ways:
- Facts-and-circumstances test: This test evaluates factors including the business justification for the classification, the percentage of the workforce covered, whether coverage is representative across salary ranges and how close the plan comes to the numerical safe harbor described below. In general, the greater the business justification for the classification, the broader the coverage under the plan, the more representative the classification is across salary ranges, and the smaller the difference between the plan’s ratio percentage and the employer’s safe harbor percentage, the more likely the classification is to be nondiscriminatory
- Numerical safe harbor: A dependent care FSA satisfies the safe harbor if its “ratio percentage” (the percentage of eligible non-HCEs compared to the percentage of eligible HCEs) is at or above the employer’s “safe harbor percentage.” The safe harbor percentage starts at 90% and is reduced by 0.75 percentage points for every whole percentage point by which the employer’s non-HCE concentration percentage exceeds 60%. The non-HCE concentration percentage is the percentage of all the employer’s employees who are non-HCEs. A classification that satisfies the safe harbor is treated as nondiscriminatory without the need to establish, based on all the relevant facts and circumstances, that the classification is nondiscriminatory.
Contributions and Benefits Test: Code Section 129(d)(2)
Statutory Description:
The contributions or benefits provided under a dependent care FSA cannot discriminate in favor of HCEs.
Proposed Rules:
To satisfy this qualitative test, a dependent care FSA cannot provide more favorable terms for HCEs than for other employees. However, a dependent care FSA that provides contributions and benefits on the same terms to all eligible employees satisfies this test, even if employees receive different amounts of contributions and benefits due to differing elections or utilization.
Owner Concentration Test: Code Section 129(d)(4)
Statutory Description:
Not more than 25% of the amounts paid or incurred by the employer for dependent care assistance during the year may be provided for the class of individuals who are shareholders or owners (or their spouses or dependents), each of whom (on any day of the year) owns more than 5% of the stock or of the capital or profits interest in the employer.
Proposed Rules:
The proposed rules restate the statutory requirement and do not provide additional guidance on this test.
55% Average Benefits Test: Code Section 129(d)(8)
Statutory Description:
The average benefits provided to non-HCEs under the dependent care FSA must be at least 55% of the average benefits provided to HCEs. The following employees are excluded for testing purposes:
- Employees who have not attained age 21 and completed one year of service
- Collectively bargained employees who are not included in the dependent care assistance program
- For benefits provided through a salary reduction agreement, employees whose compensation is less than $25,000.
Proposed Rules:
The proposed rules provide a framework for applying this test. In general, the average benefits provided to a group of HCEs or non-HCEs for a plan year equals the total dollar amount of such contributions and benefits provided during the plan year to employees in that group, divided by the number of employees in that group to whom such contributions and benefits in a dollar amount greater than zero are provided during the plan year, via salary reduction or otherwise. For purposes of this calculation, an employee is taken into account in the denominator only if the employee is provided with contributions and benefits under a dependent care FSA in an amount greater than zero during the plan year. Employees who were eligible but did not elect or receive any benefits are not included in the denominator.
Compliance with this test is determined as of the last day of the plan year, taking into account any individual employed on any day of the plan year who is not an excluded employee and who was provided dependent care FSA benefits, via salary reduction or otherwise, on any day during the plan year.
Testing Failures
If a dependent care FSA fails nondiscrimination testing, the benefits provided to HCEs will be taxable, but benefits for non-HCEs will not be affected. To avoid tax issues, employers often test their dependent care FSAs early in the plan year and reduce HCEs’ pretax contributions, as necessary, to get the plan to pass by the end of the year.
The proposed rules would also provide a correction method for failures of the 55% average benefits test and the owner concentration test. If a dependent care FSA fails either of these tests, the plan may nonetheless be treated as satisfying that testing requirement if, on or before the deadline for furnishing Form W-2 for the year in which the benefits were provided, the employer includes the amount of excess benefits in the gross income of affected HCEs. For example, corrections for 2026 must be made no later than Jan. 31, 2027, and included on HCEs’ 2026 Forms W-2.
In addition, the proposed rules would allow dependent care FSAs to allocate excess benefits for HCEs as follows:
- Average Benefits Test: In general, if all HCEs have benefits in excess of the amount that would satisfy the 55% average benefits threshold, the excess benefit amount for each HCE is determined by reference to that threshold. If not all HCEs have benefits in excess of that amount, the employer would be permitted to allocate the excess benefit and required reduction among HCEs in any reasonable manner.
- Owner Concentration Test: A similar allocation would be permitted when a dependent care FSA fails to satisfy the owner concentration test. In that case, the permitted concentration amount is subtracted from the benefit provided to participating shareholders or owners to determine the amount to be included in income. The permitted concentration amount is 25% of the total dependent care benefits provided by the employer to all participants during the year, divided by the number of participating shareholders or owners.
Employer Takeaway
The proposed rules may make it easier for dependent care FSAs to pass nondiscrimination testing, especially the 55% average benefits test. Employers who have not completed this year’s testing should check in with their vendors to confirm their methodology will take into account the new guidance, while those who already failed testing may want to consider running it again under the proposed rules.
Federal Agencies Issue FAQs Addressing Key Issues in Health Plan Tobacco Surcharge Lawsuits
On Aug. 26, 2026, the U.S. Departments of Labor, Health and Human Services, and the Treasury (Departments) released FAQs addressing topics that have been the focus of numerous class-action lawsuits challenging health plan surcharges for tobacco users. The FAQs:
- Provide that the Departments will not take enforcement action against a wellness program just because it provides a reward corresponding to the period after the reasonable alternative standard is satisfied (but not retroactively to the beginning of the plan year) for individuals who qualify for the reward partway through the year
- Address the requirement to notify employees about the existence of a reasonable alternative standard for qualifying for a wellness program reward (or avoiding a surcharge).
Tobacco Surcharge Litigation
Over the past several years, numerous class-action lawsuits have been filed against employers alleging that health plan premium surcharges related to tobacco use violate federal requirements for workplace wellness programs. These lawsuits have been filed by current and former employees of major U.S. companies who have paid more in premiums due to their tobacco use. In general, the lawsuits assert that the wellness programs violated federal law by:
- Not properly offering or disclosing a reasonable alternative standard to avoid the tobacco surcharge, including failing to provide a specific notice about physician-approved alternatives to earn the reward
- Not providing the full reward to participants who complete the reasonable alternative standard midyear by only applying the premium reduction on a prospective basis (instead of reimbursing participants for surcharges paid for the entire year)
The lawsuits request various forms of relief, including reimbursing employees who paid the surcharges with interest, disgorging any benefits or profits, and paying all attorney fees and costs. Although some courts have allowed tobacco surcharge lawsuits to proceed, the growing trend has been for employer-favorable rulings that dismiss plaintiffs’ claims.
Federal Requirements for Wellness Programs
Wellness programs that impose a health plan premium surcharge (or provide a reward) based on a health-related standard (e.g., using tobacco) must adhere to the following five standards for health-contingent wellness programs:
- Frequency: Eligible individuals must have an opportunity to qualify for the reward at least once per year
- Size of reward: The total reward offered to an individual cannot exceed 30% of the total cost of employee-only coverage under the plan. However, for wellness programs that are designed to prevent or reduce tobacco use, the total reward cannot exceed 50% of the total cost of coverage under the plan
- Availability of full reward (reasonable alternative standard): The full reward under the program must be available to all similarly situated individuals. To satisfy this requirement, the program must provide a reasonable alternative standard (or waiver of the otherwise applicable standard) to qualify for the full reward for anyone who does not meet the initial standard
- Reasonable design: The program must be reasonably designed to promote health or prevent disease
- Employee notice: The availability of a reasonable alternative standard must be disclosed in all plan materials describing the terms of the wellness program. However, if plan materials merely mention that such a program is available without describing its terms, this disclosure is not required.
FAQ Guidance
The FAQs refer to the Departments’ 2013 final rules on workplace wellness programs and focus on two requirements that have been at issue in the tobacco surcharge litigation: availability of the full reward and the employee notice.
Availability of the Full Reward
The FAQs address the question of whether an individual who satisfies a reasonable alternative standard partway through the plan year must be provided with the reward retroactive to the beginning of the plan year or, alternatively, from the time they satisfy the reasonable alternative standard required for the reward. In answering this question, the Departments acknowledge that the preamble to the 2013 final rules includes statements indicating that retroactive payments are required. However, the regulatory text of the 2013 final rules does not clearly require retroactive payments of the reward. The new FAQ guidance states that, until further guidance or rules are issued, the Departments will not take enforcement action against wellness programs that provide a reward corresponding to the period after the reasonable alternative standard is satisfied (but not retroactively to the beginning of the plan year) and otherwise satisfy applicable nondiscrimination requirements.
The FAQs also note that, for health-contingent wellness programs, all the facts and circumstances must also be considered in determining whether a reasonable alternative standard has been provided. Under the Departments’ enforcement discretion, the wellness program must still provide sufficient time for individuals to complete the alternative standard and receive a reward.
Employee Notice
A health-contingent wellness program must disclose the availability of a reasonable alternative standard to qualify for the reward (and, if applicable, the possibility of waiver of the otherwise applicable standard) in all plan materials describing the program. The FAQs reiterate that this notice must be included in all plan materials describing the terms of the wellness program and, for outcome-based wellness programs, in any disclosure that an individual did not satisfy an initial outcome-based standard. The notice must contain contact information for obtaining a reasonable alternative standard and a statement that recommendations of an individual’s personal physician will be accommodated.
The FAQs also reiterate that if plan materials merely mention that such a program is available, without describing its terms, this disclosure is not required. For example, a Summary of Benefits and Coverage that notes that cost sharing may vary based on participation in an outcome-based wellness program, without describing the standards of the program, would not trigger this disclosure.
Employer Takeaway
While the FAQs provide guidance on the Departments’ position for their own enforcement actions, they do not directly impact any private litigation regarding wellness programs, including the tobacco surcharge lawsuits. Therefore, future guidance from the agencies and/or higher courts would be welcomed. For additional information on compliance in wellness programs, see our on-demand CE-credit webinar from August.
Employer Medicaid Fees: An Emerging State Trend
As we mentioned on LinkedIn last month, to help fund rising Medicaid costs, a growing number of states are looking to employers to help absorb a larger share of the financial burden. States such as Colorado, Oregon and Washington have introduced legislation that would assess fees on large employers with employees enrolled in Medicaid, though none of these bills have been signed into law. California has enacted a measure directing state officials to study similar options, and Connecticut’s governor has proposed a comparable employer assessment, though it has not yet been introduced as formal legislation.
New Jersey became the first state to enact such a fee, and its experience may shape other states’ approach.
Key Requirements: New Jersey
Effective July 1, 2026, New Jersey’s Assembly Bill (AB) 5324 requires large employers to pay a fee when their workers receive health benefits coverage through the state’s Medicaid program. Under AB 5324, the fee is scaled with the number of employees (and dependents) that are enrolled in Medicaid:
- The fee for employers with 50-249 employees on Medicaid is $325 per enrolled individual
- The fee for employers with 250-499 employees on Medicaid is $525 per enrolled individual
- The fee for employers with 500 or more employees on Medicaid is $725 per enrolled individual.
Independent contractors, employees, and dependents with developmental, intellectual or permanent physical disabilities are excluded. Starting in July 2027, part-time, per diem, seasonal and temporary workers are also exempt.
Employer Takeaway
The New Jersey Division of Revenue and Enterprise Services will notify covered employers by March 1 of each year whether they owe a payment, with all payments due by April 15. However, a coalition of business groups has already sued to block enforcement of the law, and any ruling could reshape or eliminate employer obligations before the first fees are due. Employers should monitor the pending litigation, as its resolution may inform how similar measures are evaluated in other jurisdictions.
