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Federal Tax Watch

Health insurance credit helps small employers

During the past couple of months, you may have received a postcard from the IRS alerting you to the existence of a new credit for businesses or tax-exempt organizations that provide health insurance to employees.

This credit was created by the Patient Protection and Affordable Care Act, which the president signed into law on March 23, 2010.

Under the new law, eligible small employers may claim a tax credit for payments made to provide health coverage for employees for tax years 2010-2015. For tax years 2010-2013, eligible businesses may claim a 35 percent nonrefundable tax credit, while eligible tax-exempt organizations may claim a 25 percent refundable tax credit.

For tax years after 2013, eligible businesses may claim an increased credit of 50 percent, while eligible tax-exempt organizations may claim an increased credit of 35 percent.

To be eligible for this credit:

  • Employers may not have more than 25 full-time equivalent employees for a taxable year.
  • The average annual compensation may not exceed $50,000.
  • The employer must pay for at least half the cost of participating employees' health coverage in a qualifying contribution arrangement.

"Full-time equivalent employees" is defined as the total number of hours for which employees were paid wages by the employer, divided by 2,080 hours. Thus, you count hours instead of heads.

The new law specifically excludes certain individuals as "employees" when calculating the credit. The following individuals are not considered employees:

  • Self-employed individuals
  • Shareholders who own 2 percent or more of an
    S corporation
  • For corporations, any stockholder who owns more than 5 percent of the outstanding stock of the corporation or wields more than 5 percent of the voting power
  • Individuals who have certain family relationships to the employer

Seasonal workers who do not work more than 120 days during the taxable year are not considered employees. However, leased employees may be considered employees for purposes of calculating this credit.

The hours and wages of people who do not qualify as employees should not be included in the calculation. The cost of health insurance premiums paid on behalf of people who do not qualify as employees may not be used to calculate the credit.

Average annual compensation is defined as total wages paid by the employer to employees during a given year divided by the number of full-time equivalent employees. In a nutshell, wages are broadly defined to be the cash value of all remuneration for employment, including noncash benefits.

Employers may take the entire credit if they have no more than 10 full-time equivalent employees and if average annual compensation is no more than $25,000. Unfortunately, the credit may be partially or entirely phased out as the number of full-time equivalent employees approaches 25 and as average annual compensation increases to $50,000.

The employer may calculate the credit based on only amounts paid pursuant to a qualifying contribution arrangement. A qualifying contribution arrangement
consists of the following:

  • A qualified health plan must comply with the definition found in §9832(b)(1). Consult your tax professional to determine whether your plan qualifies.
  • The employer must pay premiums according to a uniform percentage, which means paying the same percentage of each participating employee"s health insurance premium. This uniform percentage must be 50 percent or more.
  • The employer’s payments must be made as nonelective contributions - payments may not be made through a salary reduction arrangement under a cafeteria plan.
  • For tax years after 2013, the employer must offer coverage through an insurance exchange. For tax years 2010-2013, an employer may offer coverage through an insurance exchange, but this is not required.

Don't worry if the health insurance coverage your company offers doesn't meet all of the requirements for a qualifying contribution arrangement yet.

The IRS is expected to issue transition relief in the form of a grace period, which will ease some of the requirements for 2010. While exact details aren't yet known, the IRS has suggested that, for tax years beginning in 2010, it will not enforce the requirement that employers pay employee premiums according to a uniform percentage.

If employers pay employee premiums based only on the single-employee-only premium cost, the IRS has indicated that it may allow such payment to qualify for the credit in 2010.

Employers may not take both a deduction and a credit for the same amount of health insurance premiums paid. As such, employers must reduce any deduction for the costs of health coverage by the amount of the credit taken.

For example, if an eligible employer pays $100,000 of health insurance premiums on behalf of its employees and qualifies for the full 35 percent credit, then it may take a $35,000 credit and a $65,000 deduction. Remember that deductions generally reduce taxable income, while credits directly reduce the amount of tax due.

Several companies may find themselves unable to benefit from the credit due to the many requirements and swift phase-out of the credit. Nonetheless, it may be worth your time to determine whether your company can save considerable tax dollars while providing health insurance coverage for your employees.

We have not covered all aspects of the act. Please see your tax professional for additional details regarding this credit.

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