Employers Get IRS Guidance on Health Insurance Tax Credit

By Robert Steere, Toolkit Staff Writer

Many small employers were excited to discover that the health care overhaul recently enacted by Congress included a substantial tax credit beginning immediately for amounts paid for group health insurance for employees. But many of those same employers were looking for instruction on just how to calculate and claim the credit. The Internal Revenue Service (IRS) has responded with the issuance of official guidance in IRS Notice 2010-44 intended to make it easier for small businesses to determine whether they are eligible for the new small employer health insurance tax credit and to calculate the amount of the tax credit they can claim.

"The guidance builds on frequently asked questions (FAQs) on the IRS website," explained Michael Mundaca, Department of Treasury's assistant secretary for tax policy, shortly after the guidance was released. Among other things, the guidance clarifies how employers must calculate the credit, the types of coverage eligible for the credit and the interaction of the federal tax credit with state tax credits.

"The intention (of the IRS guidance) is to make the credit as clear as possible to small businesses," declared Karen Mills, administrator of the Small Business Administration. The small employer health insurance tax credit is designed to encourage small employers that primarily employ moderate- and lower-income workers to offer health insurance coverage for the first time or maintain coverage they already have.

The maximum credit. The new law allows qualified small employers to claim a tax credit based on a percentage of the cost of group health insurance premiums paid for by the employer on behalf of its employees. The maximum credit for 2010 for regular business employers is 35 percent of insurance premiums paid. For tax-exempt employers, the maximum credit is 25 percent of insurance premiums paid. The maximum credit remains the same for each year through 2013. Beginning in 2014, the maximum credit for regular business employers rises from 35 to 50 percent of insurance premiums paid; for tax-exempt employers it rises from 25 to 35 percent of insurance premiums paid. The credit can be claimed for only two tax years starting in 2014.

The phase-out of the credit. The maximum tax credit is available only to employers with 10 or fewer full-time equivalent (FTE) employees who are paid average annual wages per FTE employee of not more than $25,000. The tax credit is phased out by 6.667 percent for each FTE employee in excess of 10, and phased out by 4 percent for each $1,000 of average annual wages per FTE employee exceeding $25,000. Thus, it is only the smallest employers that can benefit fully from the tax credit.

Those with more than 25 FTE employees are automatically excluded from claiming the credit. Those who pay average annual wages in excess of $50,000 per FTE are also automatically excluded from claiming the credit. But because the two phase-outs (number of employees and amount of average annual wages) operate in tandem, an employer may be disqualified from taking the credit with fewer than 25 FTE employees and average annual wages of less than $50,000.

Qualifying small businesses. The credit is available to small employers that pay at least half the cost of single coverage for their employees annually. Because of the credit's phase-out provisions, an employer must have fewer than 25 FTEs employees and must pay average annual wages per employee less than $50,000 to have any chance of qualifying for the credit. According to the White House, approximately 4 million small employers could qualify for the credit if they provide insurance coverage. "Not all of the 4 million provide health care to their employees," said Mundaca. He declined to make a prediction when asked how many small employers are likely to take advantage of the tax credit.

Steps to determine eligibility for the tax credit. The IRS guidance explains the steps for an employer to take in determining eligibility for the tax credit. It provides detailed guidelines, illustrated by more than a dozen examples, to help small employers determine whether they qualify for the credit and estimate the amount of the credit. These are the steps to be taken in determining eligibility and estimating the credit amount:

• Determine the employees who are taken into account for purposes of the credit.
• Determine the number of hours of service performed by those employees.
• Calculate the number of the employer's full-time equivalent (FTE) employees.
• Determine the average annual wages paid per FTE.
• Determine the premiums paid by the employer that are taken into account for purposes of the credit.

To calculate hours of service, employers may use one of three methods: actual hours; days-worked equivalency; or weeks-worked equivalency. "With respect to figuring the number of hours for the credit, we tried to provide maximum flexibility," said Mundaca.

Employees taken into account. In general, employees who perform services for an employer during the taxable year are taken into account in determining the employer's FTE employees, average annual wages, and premiums paid. However, certain individuals are excluded from the calculation and some employees of certain related employers may be included. Employees excluded from the calculation include sole proprietors, partners of a partnership, shareholders owning more than 2 percent of an S corporation, and any owners of more than 5 percent of other business entities. Family members of those excluded above are also not taken into account as employees.

Seasonal workers are also disregarded in determining FTE employees and average annual wages, except for seasonal workers who work for the employer on more than 120 days during the taxable year. However, health insurance premiums paid on their behalf may be included in calculating the amount of the tax credit.

Full-time equivalent employees. The number of an employer's FTE employees is determined by dividing (1) the total hours of service (but not more than 2,080 hours for any individual employee) credited during the year to those employees who are taken into account by (2) 2,080. The result, if not a whole number, is then rounded to the next lowest whole number. In some circumstances, an employer with more than 25 employees may qualify for the credit if some of its employees work part-time. Remember, 40 half-time employees (meaning they are paid wages for 1,040 hours) equals 20 FTE employees, which still may qualify for the tax credit.

Average annual wages. The average annual wages paid by an employer for a taxable year is determined by dividing (1) the total wages paid by the employer during the taxable year to the employees taken into account by (2) the number of the employer's FTE employees for the year. The result is then rounded down to the nearest $1,000 (if not otherwise a multiple of $1,000). Thus, if an employer pays $200,000 in wages to 9 FTE employees, then the average annual wages per FTE amounts to $22,000 ($22,222 rounded down to the nearest $1,000)

Coverage qualifying for the tax credit. For 2010 through 2013, qualified health insurance coverage means benefits consisting of medical care (provided directly, through insurance or reimbursement, or otherwise) under any hospital or medical service policy or certificate, hospital or medical service plan contract, or health maintenance organization contract offered by a health insurance issuer. Employers can claim the credit not only for general medical coverage, but also for coverage of dental and vision benefits, long-term care, nursing home care, home health care, community-based care, and many other coverages.

Related state tax credits can be taken, too. The IRS noted that approximately 20 states offer health insurance tax credits to small employers. Qualified employers can claim the new federal tax credit even if they receive state tax credits for their insurance premiums.

Claiming the credit. Eligible small businesses can claim the credit as part of the general business credit starting with the 2010 income tax return they file in 2011. For tax-exempt organizations, the IRS will provide further information on how to claim the credit.

Transition relief for 2010 is formalized. Because the tax credit is effective for 2010 but was not enacted until March 23, some small businesses providing health insurance in 2010 may not meet all the specific requirements for a qualifying health insurance offer. To ensure that these businesses benefit from the credit, special transition relief for tax year 2010 is being granted. The transition rules simplify the requirements for what constitutes a qualifying health insurance offer while maintaining the core requirement that an employer make a significant contribution to the employee's coverage.

More information about the credit, including a step-by-step guide, answers to frequently asked questions, and clarification of transition relief is available on the Affordable Care Act page on the IRS website.