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Tuesday, October 5, 2010

IRS Guidance: New Small Employer Tax Credit for Health Insurance Expenses

The Patient Protection and Affordable Care Act (PPACA), signed into law in March, offers a valuable new tax credit to eligible small businesses and nonprofits that provide health coverage to their employees. But the rules are complex, and many business owners and nonprofit organizations have been unsure whether they can benefit or how much they can save.

To help small employers determine whether they're eligible for the credit and estimate the amount of any credit, the IRS recently issued Notice 2010-44. It provides guidance on Section 45R of the Internal Revenue Code (IRC), Tax Credit for Employee Health Insurance Expenses of Small Employers, which was added by the PPACA and applies to tax years beginning after Dec. 31, 2009, but before Jan. 1, 2014.

Eligibility for the Credit

The new federal income tax credit is generally available to eligible small employers - including nonprofit organizations - that provide health care coverage to their employees and that meet certain requirements. To be an eligible small employer:

  • The employer must have fewer than 25 full-time equivalent employees (FTEs) for the tax year,
  • The average annual wages the employer pays its FTEs in that tax year must be under $50,000 per FTE, and
  • The employer must pay the premiums under a "qualifying arrangement."

In a qualifying arrangement, the employer pays premiums for each employee enrolled in the health care plan in an amount equal to a uniform percentage of at least 50% of the premium cost.

Determining the Number of FTEs

To determine the number of FTEs, the total hours of service for which the employer pays wages during the year (but not more than 2,080 hours for any individual employee) are divided by 2,080. Because the limitation on the number of workers is based on FTEs, an employer with 25 or more employees may be eligible for the credit if some of the employees work part-time.

Seasonal workers, however, generally are disregarded when calculating FTEs (and average annual wages) - unless the seasonal worker works for the employer on more than 120 days during the tax year.

Business owners who provide services to the business also usually aren't considered FTEs. Specifically, a sole proprietor, a partner in a partnership, a shareholder owning more than 2% of an S corporation and any owner of more than 5% of other businesses aren't considered employees for purposes of the credit. Their hours aren't counted toward the calculation of the number of FTEs, and premiums paid to insure them aren't counted toward the calculation of the credit.

This exclusion also applies to family members of the owner who work for the business. Notice 2010-44 defines family members as a child (or descendant of a child), a sibling or step-sibling, a parent (or ancestor of a parent), a step-parent, a niece or nephew, an aunt or uncle, or in-laws.

Determining the Average Annual Wages

To determine the amount of average annual wages, the total wages the employer paid during the tax year for hours of service are divided by the number of FTEs for the year. Because owners and their family members generally aren't considered in the FTE calculation, their wages generally aren't considered in the calculation of average annual wages.

Calculating the Credit

When computing the credit, an employer can only count premiums paid under a qualifying arrangement. If the employer pays less than 100% of the premium cost, only the portion it pays is counted in calculating the credit. Premiums paid as part of a salary reduction arrangement under a cafeteria plan aren't considered to be paid by the employer.

The guidance further explains that the amount of the premium payments considered is capped by the premium payments the employer would have made under the same arrangement if the average premium for the applicable small group coverage market were substituted for the actual premium paid. The average small group premium for a market is determined by the U.S. Department of Health and Human Services.

The amount of the credit itself is also capped. For tax years beginning in 2010 through 2013, the maximum credit for small businesses is 35% of their premium expenses that count toward the credit.

The maximum credit for nonprofit organizations during that same period is 25% of the premium expenses that count toward the credit - but the credit also may not exceed the total amount of income and Medicare tax the employer must withhold from wages for the year and the employer share of Medicare tax on employees' wages.

The guidance presents the example of an eligible for-profit employer with nine FTEs with average annual wages of $23,000 per FTE. The employer pays $72,000 in health care premiums - which doesn't exceed the average premium for the applicable small group market - and otherwise satisfies the requirements for the credit. The employer can claim a credit of $25,200 (35% of $72,000).

Now suppose the employer is a nonprofit, and the total amount of its income tax and Medicare tax withholding plus its share of the Medicare tax equals $30,000 for 2010. The tax credit for 2010 would be $18,000 (25% × $72,000).

Applying the Credit Phaseout

The amount of the credit is reduced if the employer has more than 10 FTEs or if the average annual wages exceed $25,000. Where the number of FTEs is greater than 10, the reduction is calculated by multiplying the otherwise applicable credit amount by a fraction with a numerator of the number of FTEs in excess of 10 and a denominator of 15.

If the average annual wages are greater than $25,000, the otherwise applicable credit amount is multiplied by a fraction with a numerator of the amount by which the average annual wages exceed $25,000 and a denominator of $25,000.

Employers that exceed both the number of employees and the average annual wage amount must reduce their credits by the sum of the two reductions.

Another example in the guidance considers an eligible employer, with 12 FTEs and average annual wages of $30,000, that pays $96,000 in health care premiums in 2010. That figure doesn't exceed the average small group market premium, and the employer otherwise is eligible for the credit. Its credit is calculated as follows:

  • The base credit amount is $33,600 (35% × $96,000).
  • The credit reduction for excess FTEs is $4,480 ($33,600 × 2/15).
  • The credit reduction for excess average annual wages is $6,720 ($33,600 × $5,000/$25,000).
  • The total credit reduction is $11,200 ($4,480 + $6,720).
  • The total 2010 tax credit is $22,400 ($33,360 - $11,200).

Claiming the Credit

Eligible for-profit employers can claim the credit on their annual income tax return. They can't, however, claim the credit if they don't have any taxable income for the year - though an unused credit amount generally can be carried back one year and forward 20 years. (For 2010, an unused credit amount can only be carried forward.)

The IRS is expected to soon provide further information on how nonprofit employers can claim the credit. The credit for nonprofits is a refundable credit, so such organizations can claim it even in the absence of taxable income, assuming the credit doesn't exceed the income tax withholding and Medicare tax liability.

Can you Benefit?

The calculations required to determine the credit amount can prove complicated, particularly computing the hours of service. Additional rules apply, such as the requirement to account for any state tax credits or premium subsidies. And some employers may qualify for transitional relief for 2010.

A qualified tax professional can advise you on how to proceed. If you think your business or organization might benefit from this credit, we'd be pleased to assist with the necessary calculations to determine your eligibility and, if applicable, the amount of your credit.


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