Credits Against Tax
Beginning in 2010, the Patient Protection and Affordable Care Act, P.L. 111-148, provides a credit to small employers who contribute to the purchase of health insurance for their employees. The amount of the small business health insurance tax credit (Sec. 45R) is typically a percentage of the employer’s premium contribution subject to phaseouts related to number of employees and average employee compensation. This item explains and illustrates the computations.
To be eligible for the credit, employers must contribute a uniform percentage of at least 50% of the premium cost of qualified employee health plans (Sec. 45R(d)(4)), and that contribution cannot be the result of a salary reduction agreement (Sec. 45R(e)(3)). For the years 2010–2013, the amount of the credit is generally 35% (25% for tax-exempt entities) (Sec. 45R(g)(2)(A)) of the lesser of the nonelective contributions made by the employer on behalf of employees or a benchmark premium amount (Sec. 45R(b)). The benchmark premium is the average premium for the small group market in the rating area in which the employee enrolls for coverage (either the state or an area within the state).
The credit for taxable entities is part of the general business credit (Sec. 45R(a)) and thus is nonrefundable, but it may be carried back one year and carried forward 20 years to offset income tax liability. Because the health insurance credit is new for 2010, however, any unused amount will not be eligible for carryback to 2009 (Sec. 39(d)). The credit for tax-exempt entities is refundable to the extent of payroll taxes paid. The payroll taxes that may be offset by the health insurance credit include the employees’ income tax withheld and both the employees’ and employer’s share of Medicare taxes (Sec.45R(f)).
The credit amount is subject to two phaseouts. One is for employers with more than 10 full-time equivalent (FTE) employees, and the other is for employers who pay employees an average annual wage that exceeds $25,000.
The credit is phased out as the number of FTE employees rises from 10 to 25 (Sec. 45R(c)(1)). As a result, no credit is given to employers who have 25 or more full-time equivalent employees. The phaseout computation is similar to many other phaseout computations in the Code. The initial credit is reduced by:
Initial credit × [(number of FTE employees – 10) ÷ 15]
The number of FTE employees is found by totaling the number of employee hours of service for which the employer paid taxable wages during the year, dividing that amount by 2,080, and rounding down to a whole number. Where an employee has worked more than 2,080 hours during the year, only 2,080 hours are included in the computation for that employee (Sec. 45R(d)(2)). The IRS will issue guidance on the computation of hours of service for employees who are compensated on a basis other than the number of hours worked (Sec. 45R(d)(2)(C)).
The hours worked by seasonal employees are not taken into account in determining the number of full-time equivalent employees unless a seasonal employee works for the employer for more than 120 days during the tax year (Sec. 45R(d)(5)). Also not included in the computation of FTE employees are the business owners, the families of the business owners, or dependent members of the business owner’s households. Business owners include proprietors, partners, shareholders owning more than 2% of an S corporation, and any other party owning more than 5% of the business. Family members are those relatives listed in Secs. 152(d)(2)(A) through (G) and individuals who are dependents of a business owner as defined in Sec. 152(d)(2)(H) (Sec. 45R(e)(1)).
The credit is also phased out as the average annual wage paid to the employees rises from $25,000 to $50,000 (Sec 45R(d)(3)). The wages included in the computation are those that are subject to FICA taxes (without regard to the annual limit). No credit is provided to employers who pay an average annual wage of $50,000 or more. The computation of the phaseout provides that the initial credit is reduced by:
Initial credit × [(average annual wage – $25,000) ÷ $25,000]
The $25,000 amounts are adjusted for inflation after 2013. The average annual wage is the aggregate amount of wages paid by the employer to full-time employees during the tax year, divided by the FTE employees determined for the year, and rounded down to a multiple of $1,000 (Sec. 45R(d)(3)). The average annual wage computation excludes the pay of those seasonal workers and owners (and their families) who are also excluded from the FTE employee computation.
Example 1: In 2012 Z, an S corporation employer, has 18 employees with hours worked and annual compensation as reported in the exhibit. All the employees are full time except for Q and R, who work no more than 120 days in the summer. Employee A is a 2% shareholder. For the remaining 15 employees, the employer pays a total of $100,000 in health insurance premiums—an amount that is less than the benchmark premium and at least 50% of the total premium cost for each employee. The initial credit is 35% of the premiums paid, or $35,000. The number of FTE employees is found by summing the total number of hours worked by full-time employees (other than the owner), subject to a maximum of 2,080 hours per employee, dividing by 2,080 hours, and rounding down to a whole number: 28,100 ÷ 2,080 = 13.51 = 13 FTEs. The phaseout for excess FTE employees is $35,000 × [(13 – 10) ÷ 15] = $7,000. The average annual wage is found by totaling the pay of the qualifying full-time employees, dividing that amount by the number of FTE employees, and rounding down to a multiple of $1,000: $509,960 ÷ 13 = $39,228 = $39,000. The phaseout for wages in excess of $25,000 is $35,000 × [($39,000 – $25,000) ÷ $25,000] = $19,600. The resulting small business health insurance tax credit is $35,000 – $7,000 – $19,600 = $8,400.
When calculating the amount of health insurance premiums paid by the employer, the premiums paid for coverage of business owners and their families is excluded; however, the premiums paid for coverage of seasonal employees is included. In addition, to the extent that the state contributes to pay the cost of health insurance (such as through Medicaid), the contributions (either as direct payments to insurers or reimbursements of employer’s cost) are considered employer contributions for purposes of computing the credit. Payments by the state to the insurer are considered employer contributions, and payments to the employer do not offset actual employer contributions. The only limitation is that the amount of the actual credit may not exceed the net premiums paid by the employer (Notice 2010-44).
Example 2: Employer Y has six employees. In 2010, total health insurance premiums for the year amount to $100,000, of which the employees pay $40,000, Y pays $15,000, and the state pays $45,000. The amount paid by the state is treated as paid by Y. The resulting health insurance tax credit is $60,000 × 35% = $21,000. However, the credit is limited to the $15,000 net premium actually paid by Y.
Sec. 45R(d)(4) requires that employers pay a uniform percentage of health care premium cost that is not less than 50%. Since the provision was signed into law in March 2010, Treasury has issued some transition relief for meeting the uniform percentage requirement. For tax years that begin in 2010, employers who pay at least 50% of the premium cost for each employee enrolled in health insurance coverage will satisfy the requirement, even if the same percentage is not paid for each employee. In addition, for each employee the employer must pay only 50% of the premium required for employee-only coverage. Thus, if an employee receives expanded (e.g., family) coverage, the employer must pay only an amount that is equal to 50% of the premium that would be required if the employee carried only single coverage (Notice 2010-44).
There will be several changes after 2013. One is that the credit will be available only to employers who purchase health insurance through a state exchange. Until then, employers will be able to purchase health insurance from any state-licensed insurance company (Sec. 45R(g)(3)). In addition, after 2013 the 35% credit for taxable entities becomes 50%, and the 25% credit for tax-exempt entities becomes 35%. The credit will be available for a maximum of two consecutive years, beginning with the first year the employer offers a qualified plan through an exchange after 2013 (Sec. 45R(e)(2)). As a result, those employers who can take advantage of the credit starting in 2010 will be eligible for the credit for a total of six years (2010–2013 and 2014–2015).
For the next few years the small business health insurance credit will provide some assistance to small businesses trying to provide their employees with health insurance. Unfortunately, the assistance is not quite as good as advertised. Like the treatment for many other credits, any deduction allowed for employee health insurance cost must be reduced by the amount of the credit (Notice 2010-44). As a result, for the years 2010–2013 the effective tax credit for a taxpayer in the 25% tax bracket is not 35% but 26.25%. For a taxpayer in the 35% bracket, the effective credit is 22.75%. Nonetheless, any assistance with the high cost of health insurance is likely to be appreciated.
Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or email@example.com.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.