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May 20, 2010

HRB 4 - The Small Business Health Care Tax Credit

May 20, 2010 -- Small businesses and tax-exempt employers that provide health care coverage to their employees under a qualified health care arrangement may now qualify for a special tax credit starting this year.  Included in the recent health care reform legislation passed in March, the credit is designed to encourage small businesses that employ low and moderate income workers to offer and maintain health insurance coverage for their employees.  To qualify for the credit, the employer must have a plan that requires the employer to contribute at least half the cost of participating employees’ health insurance premiums.   On May 17, 2010, the Internal Revenue Service issued Notice 2010-44, providing additional clarification and guidance for employers regarding the Small Business Tax Credit. 

 

The maximum amount of the credit is 35% of the premiums paid (25% in the case of tax-exempt employers), which is available to employers with 10 or fewer full time equivalent employees with average annual average wages of $25,000 or less.  The credit phases out gradually for companies with up to 25 employees and average wages between $25,000 and $50,000.   

Eligibility Criteria

In order to qualify, a business must: (a)  have no more than 25 full-time equivalent employees (“FTEs”) for the tax year, (b) pay average annual wages of less than $50,000 per employee, and (c) provide qualifying coverage.  Qualified tax-exempt organizations1 that meet the foregoing requirements can also qualify for the credit.

1.  Full-Time Equivalent Employees

The number of FTEs is determined by dividing (1) the total hours for which an employee is paid during the year (but not more than 2,080 hours per employee) by (2) 2,080. The result, if not a whole number, is then rounded to the next lowest whole number.  The number 2,080 is the number of hours in a 52 week work year, assuming 40 hours per week; effectively, overtime hours are not taken into account for determining the number of FTEs.  Since the limitation on the number of employees is based on FTEs, an employer with 25 or more employees could qualify for the credit if some of its employees work part-time. 

To illustrate, assume that an employer has five employees who work at least 2,080 hours each, three employees who work 1,040 hours each, and one employee who works 2,300 hours. The employer has seven FTEs, calculated as follows:

  1. Total hours: 15,600 which is the sum of:
    • 10,400 hours for 5 employees paid for 2,080 hours each (5 x 2,080)
    • 3,120 hours for 3 employees paid for 1,040 hours each (3 x 1,040)
    • 2,080 hours for 1 employee paid for 2,300 hours
  2. FTEs: 7 (15,600 divided by 2,080 = 7.5, rounded to the next lowest whole number)

Aggregation Rules:  Certain aggregation rules apply to treat multiple companies as one employer for purposes of the credit.  Members of a controlled group (e.g., businesses with overlapping ownership, including attribution of ownership from related persons and entities) or an affiliated service group (e.g., related businesses where one performs services for the other) are treated as a single employer for purposes of the credit. In that case, all employees in the group and all wages paid to them are counted in determining whether a member in the controlled or affiliated service group is a qualified employer.

The Secretary of Health and Human Services and the Secretary of Labor are charged with issuing regulations to determine the hours of service of an employee, including how the new law applies to employees who are not compensated on an hourly basis.  For example, regulations will be issued to give guidance on whether vacation and sick leave will be considered hours of service for purposes of the credit calculation.

Excluded Individuals:  A sole proprietor, a partner in a partnership, a shareholder owning more than two percent of an S corporation, and any owner of more than five percent of other businesses are not considered employees for purposes of the credit.  Also excluded are their family members2 or a member of the business owner’s or partner’s household.  Seasonal employees working for the employer for not more than 120 days during the tax year are likewise excluded.  The wages or hours of excluded individuals are not counted in determining either the number of FTEs or the amount of average annual wages, and premiums paid on their behalf are not counted in determining the amount of the credit.

2.  Average Annual Wages

The amount of average annual wages is equal to the aggregate amount of wages paid by the employer to employees during the tax year, divided by the number of FTEs during the tax year.  The result is then rounded down to the nearest $1,000. For this purpose, only wages as defined for FICA purposes (without regard to the wage base limitation) are counted.  As a result, for example, the amounts contributed to a flexible spending account would not be included. 

3.  Qualifying Coverage

The employer must have a contribution arrangement in place requiring the employer to pay premiums for each employee enrolled in the health care coverage offered by the employer in an amount equal to a uniform percentage, but not less than 50%, of the premium.  Any premium paid pursuant to a salary reduction arrangement under a section 125 cafeteria plan is not treated as paid by the employer and is not counted for the 50% requirement.

Moreover, the expenditures used to calculate the credit are capped by the average premium that the employer would have paid for the same arrangement in the state’s small group market.  For the 2010 taxable year, the average premium for the state’s small group market is set forth in Revenue Ruling 2010-13,3 and the Department of Health and Human Services may provide additional average premium rates for the small group market for areas within some states (sub-state rates). These additional sub-state rates will be published by the IRS and will not be lower than the applicable rate for each state that is set forth in Revenue Ruling 2010-13. 

Computing the Credit

For tax years beginning in 2010 through 2013, the maximum credit is 35% of the employer’s eligible premium expenses.  After 2013, the credit is increased to 50% of eligible premium expenses, but only if the insurance is offered through an Exchange (discussed below).  The applicable credit percentage for tax-exempt 501(c) organizations is 25% for 2010 through 2013, and 35% thereafter.  Tax-exempt organizations can apply the credit against certain withheld payroll taxes.  If an employer qualifies for the credit, it must reduce its deduction for premiums paid by the amount of the credit claimed.

Credit Phaseout

The full amount of the credit will be available to employers with 10 or fewer employees with average annual wages of $25,000 or less.  If the number of FTEs exceeds 10, or if average annual wages exceed $25,000, the amount of the credit is reduced (but not below zero) by the sum of the following amounts:

Employees:  Applicable credit amount  (times) No. of FTEs minus 10
                                                                                                    15

Wages:        Applicable credit amount  (times) Average Annual Wages minus $25,000
                                                                                                $25,000

The sum of the two amounts is subtracted from the otherwise applicable credit to determine the credit to which the employer is entitled.  The formula results in a reduction of the credit by 6.667% for each FTE in excess of 10, and 4% for each $1,000 of wages in excess of $25,000. The following table shows how the credit percentage phases out as the number of FTEs increases from 10 to 25 and as average compensation increases from $25,000 to $50,000 in the case of for-profit firms in 2010-2013. 

 

 

  Average Wage    
  FTEs    
  ≤ $25,000    
  $30,000    
  $35,000    
  $40,000    
  $45,000    
  $50,000    
  Up to 10    
  35%    
  28%    
  21%    
  14%    
  7%    
  0%    
  11    
  33%    
  26%    
  19%    
  12%    
  5%    
  0%    
  12    
  30%    
  23%    
  16%    
  9%    
  2%    
  0%    
  13  
  28%    
  21%    
  14%    
  7%    
  0%    
  0%    
  14    
  26%    
  19%    
  12%    
  5%    
  0%    
  0%    
  15    
  23%    
  16%    
  9%    
  2%    
  0%    
  0%    
  16    
  21%    
  14%    
  7%    
  0%    
  0%    
  0%    
  17    
  19%    
  12%    
  5%    
  0%    
  0%    
  0%    
  18    
  16%    
  9%    
  2%    
  0%    
  0%    
  0%    
  19    
  14%    
  7%    
  0%    

0%

  0%    
  0%    
  20    
  12%    
  5%    
  0%    

0%

  0%    
  0%    
  21    
  9%    
  2%    
  0%    

0%

  0%    
  0%    
  22    
  7%    
  0%    

0%

0%

  0%    
  0%    
  23    
  5%    
  0%    

0%

  0%    
  0%    
  0%    
  24    
  2%    
  0%    

0%

  0%    
  0%    
  0%    
  25    
  0%    
  0%    

0%

  0%    
  0%    
  0%  

Claiming the Credit

The credit is claimed on the employer’s annual income tax return. It is part of the general business credit and may only be claimed if the taxpayer has taxable income.  The credit applies to offset both regular income tax liability and alternative minimum tax liability, and any unused credit can generally be carried back one year and carried forward 20 years.  Because an unused credit cannot be carried back to a year before the effective date of the credit, any unused credit for 2010 can only be carried forward.  The credit can be reflected in determining estimated tax payments for the year to which the credit applies in accordance with regular estimated tax rules.  Furthermore, for-profit entities can only use the credit against income tax and not employment taxes, so the employer may not reduce withheld income tax, social security tax, or Medicare tax in anticipation of the credit.

Special Rules for Tax-Exempt Employers:  The IRS will provide further guidelines on how tax-exempt employers can claim the credit.  Generally, however, the credit is a refundable credit for tax-exempt employers, so that even if the employer has no taxable income, the employer may receive a refund so long as it does not exceed the income tax withholding and Medicare tax the employer is required to withhold from employees’ wages for the year and the employer share of Medicare tax on employees’ wages. 

Transition Provisions Beginning in 2010

The IRS and Treasury will be issuing guidance on how the following transition relief applies with respect to the requirements for a qualifying arrangement:

  1. An employer with a nonelective contribution arrangement, whereby it pays at least 50% of the premium for each employee enrolled in coverage, will still be eligible for the credit, although the employer does not pay a uniform percentage of the premium. 
  2. The requirement that the employer pay at least 50% of the premium for an employee applies to the premium for single (employee-only) coverage for the employee.  Even if an employee’s actual coverage is more expensive than single coverage (such as family or self-plus-one coverage), the employer satisfies the 50% requirement if it pays at least 50% of the premium cost for single coverage for that employee.

 

Tax Years Beginning in 2014

For tax years after 2013, an employer must offer coverage through an insurance Exchange in order to claim the credit, and may only claim the credit for two additional consecutive tax years.  Each state is required to establish by January 1, 2014 an American Health Benefit Exchange and Small Business Health Options Program (SHOP Exchange) to provide qualified individuals and small business employers access to qualified health plans.  The IRS has been granted authority to issue regulations to prevent the use of successor entities to avoid the two-year limitation on the credit period for the tax years beginning after 2013, and to prevent the use of multiple entities to avoid the credit phaseout rules based on the number of employees and average wages.

Conclusion

The Small Business Tax Credit can provide a great benefit to qualifying employers offering health coverage to their employees.  As discussed above, however, determining whether your company qualifies, and if so, the value of your actual benefits, will be no easy task.  If you think your business may qualify, contact your CBIZ tax, benefits and insurance, or payroll tax professional soon to get a better idea of exactly how the credit will help you.

 

Average Premium for the Small Group Market in each State for 2010

State

Employee-only Coverage

Family Coverage

Alaska

6,204

13,723

Alabama

4,441

11,275

Arkansas

4,329

9,677

Arizona

4,495

10,239

California

4,628

10,957

Colorado

4,972

11,437

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