Who is the source? Principal or SPED supervisor? I would ask a SPED supervisor. Then tell the principal what they said and see what they think.

Does the student have read aloud as an accommodation in the IEP? If so, you can read the story aloud to the student and assess that way. I do it all the time with my kids who can’t read and no one balks, thankfully. I use this strategy a lot when we work on identifying the main idea of a grade level text.

This is going to totally depend on the rules in your school/district. Do your students have modifications written on their IEPs stating that they will be assessed only with text at their instructional level, rather than their current grade level? If so, you might have a case.

Here, we are not allowed to put modifications on IEPs for students unless they have intellectual disabilities. Students with LDs are not allowed modifications. Informally, we may assess at their instructional level to get information on instructional next steps, but their official report card is based on grade level standards only and cannot contain information about how they do with specific skills on lower level text.

I have 4th grade students reading on a k or 1st grade level. I want to assess if they know Character and setting of a story. I feel I should give them a story at their reading level k to 2 to assess this. However I am being told to assess with grade level reading material 4th grade. If I assess with a 4th grade passage all will fail even if they know what Character and setting are because they can not independently read the passage.
What is the correct procedure?