What Is a Dependent Care Assistance Program (DCAP)?
Dependent Care Assistance Programs (DCAPs) have long been a staple of employer benefit offerings. To better appreciate the advantages of the DCAP for working families today, we should explain that a DCAP is an employer-sponsored benefit, usually offered through a §125 cafeteria plan, that allows employees to exclude contribution amounts towards dependent care expenses from taxable income. These programs help families offset the rising cost of childcare, after-school programs, adult day care, and similar services.
DCAPs are distinct from health FSAs and HSAs: they are governed by IRC §129, have their own annual exclusion limit, and are subject to unique nondiscrimination testing requirements. We will talk about these distinctions and the newly proposed DCAP rules in just a moment.
Dependent Care FSA Limit 2026: The Increase to $7,500
First, let’s draw our attention to the 2026 DCAP contribution limits and the recent changes that have benefited many employees. For plan years that began on or after January 1, 2026, the annual exclusion for DCAP contributions increased from $5,000 to $7,500 (or from $2,500 to $3,750 for married individuals filing separately). This sizable increase, as a result of the One Big Beautiful Bill Act (OBBBA), was the first permanent increase since 1986. We should note that employers can certainly adopt this new higher limit, but they are not required to do so. If they opt to recognize the $7,500 limit, they must amend their plan documents accordingly.
There are significant reasons as to why the exclusion increase matters:
- Families can shelter more dependent care expenses from tax
- Employers can offer a more competitive benefit
- Higher contributions can increase nondiscrimination risk, especially for employers with higher-paid workforces
The last bullet leads us to another welcome DCAP update: comprehensive guidance on nondiscrimination testing under §129.
2026 Proposed Rules for DCAP Nondiscrimination Testing
The Department of the Treasury and Internal Revenue Service recently issued proposed regulations addressing nondiscrimination rules for Dependent Care Assistance Programs (DCAP). These proposed rules could resolve years of ambiguity and afford employers a better framework for compliance. Though the rules are still considered “proposed”, their preamble indicates they can be relied upon until final regulations are published. This is a significant development because there weren’t previously implemented regulations for how §129 requirements should operate.
The current §129 rules allow DCAPs to provide up to $7,500 each calendar year in tax-favored qualifying daycare assistance, while also prohibiting DCAPs from favoring Highly Compensated Employees (HCEs). To determine compliance, §129 requires a DCAP to satisfy four nondiscrimination tests:
- Contributions & Benefits Test
- Eligibility Test
- Owner Concentration Test
- 55% Average Benefits Test
The proposed rules seek to clarify how the tests are to be applied, with a particular emphasis on the eligibility and 55% average benefits tests.
Contributions & Benefits Test – Contributions and benefits to a DCAP may not discriminate in favor of HCEs. Offering all eligible employees the same salary-reduction terms will satisfy this test. The proposed rules both clarify and confirm this.
Eligibility Test – Eligibility to participate in a DCAP may not favor HCEs. If eligibility classifications are used (rather than offering the DCAP to everyone), they must be based on reasonable, bona fide business criteria such as job category, hourly vs. salaried status, or geographic location. The proposed rules further clarify that if eligibility is restricted to certain classes of employees, doing so must be nondiscriminatory under one of two methods:
- Facts and Circumstances Analysis — This is a subjective review of the plan’s nondiscriminatory status using a variety of facts and circumstances, such as the business rationale for restricted eligibility, the percentage of the workforce eligible, how eligibility compares across various salary ranges, etc.
- Ratio Percentage Test — This is a mathematical test of the plan’s nondiscriminatory status, performed by dividing the percentage of eligible Non-Highly Compensated Employees (NHCEs) by the percentage of eligible HCEs.
Owner Concentration Test – No more than 25% of DCAP amounts paid or incurred by the employer may go to owners or shareholders who hold more than 5% of the company. The proposed rules made no changes to this particular test.
55% Average Benefits Test – The average benefits provided to NHCEs must equal at least 55% of average benefits provided to HCEs. In the past, this test proved to be one of the hardest to pass, in part because it was often interpreted to include all eligible employees, instead of only those who actually received benefits. The proposed rule makes a key change here by clarifying that the calculation only needs to include employees who participate in the DCAP.
A DCAP must pass all four tests. Failing any of these tests does have consequences, but the proposed rules clarify that doing so doesn’t disqualify all DCAP benefits. Instead, the employer can report the excess/discriminatory portion that HCEs received on their W-2s by January 31st that follows the end of the plan year. The prior guidance on this was vague and confusing, and many thought that any corrections had to be made before the end of the plan year.
DCAP Testing and Plan Design Considerations for Employers
In light of the changes in these proposed regulations, there are several DCAP nondiscrimination testing and plan design considerations for employers that sponsor DCAPs including:
- Whether the clarification regarding the 55% average benefits test makes room to expand participation for HCEs;
- Meeting with their third-party administrator and payroll teams to determine when and how testing will be performed;
- How any HCE income inclusion will be reported if a test should fail;
- If any overall adjustments should be made to their DCAP’s plan design
Lumelight is in the process of adjusting our nondiscrimination testing methodology to account for these updates. If you would like more information, please reach out to info@lumelight.com.
