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Small Business Employee Benefits and HR Blog

Small Employer Health Care Tax Credit -- How Does it Work?

The Health Care Reform Bill signed into law on March 23, 2010 created a new tax credit for eligible small companies who provide health care to their employees. 

So, "How Does the Small Employer Health Care Tax Credit Work?" Unfortunately, answering this question in layman's terms (i.e. non tax terms) has not been easy...Small Business Tax Credit

This week, the Treasury released some new information explaining how the "Small Business Health Care Credit" works.  

This credit is broken into two phases:

    • Phase I -- tax years 2010 - 2013

    • Phase II -- tax years 2014 and later

During Phase I, the credit is worth up to 35% of a company's health insurance costs (25% for non-profits).

During Phase II, the credit is worth up to 50% of a company's health insurance costs (35% for non-profits).

Let's break this question into the following five mini questions and walk through an example using ABC Manufacturing:

  1. Does the company meet the size requirements to be eligible for the credit?
  2. Does the company meet the average wage requirements to be eligible for the credit?
  3. What type of coverage does the company need to offer to get the credit?
  4. How much is the tax credit?
  5. How does the company claim the credit?

1. Does the company meet the size requirements to be eligible for the credit?

To be eligible for the credit, the company must employ less than 25 full-time equivalent employees (FTEs) during the tax year.  

To calculate the number of FTEs, the company should do the following, the company should first determine the number of full-time employees* (i.e. those working 40 or more hours per week).

Next, the company must determine the full-time equivalent of its part-time employees* (i.e. those working less than 40 hours per week) by:

    1) adding up all hours for which wages were paid to part-time employees* and 

    2) divide that number by 2,080 

The number of FTEs is equal to the company's full-time employees* plus full-time equivalent part-time employees* rounded to the lowest whole number.

 
Example. For the 2010 tax year, ABC Manufacturing pays 5 employees* wages for 40 hours per week (2,080 hours per year) each and 5 employees* wages for 20 hours per week (1,040 hours per year) each.
    • The number of full-time employees* is 5
    • The number of full-time equivalent part-time employees* is 2 (5*1,040/2,080 rounded to the lowest whole number)
ABC Manufacturing has 7 FTEs (5+2) and is eligible for the credit.  


2. Does the company meet the average wage requirements to be eligible for the credit?

If the company meets the size requirements, they must also pay average annual wages below $50,000.  To calculate average annual wages, the company should:

    1) add up the total wages paid by the company to employees* during the tax year and

    2) divide that number by the number of FTEs

Example. For the 2010 tax year, ABC Manufacturing pays $196,000 in wages.

ABC Manufacturing pays average annual wages of $28,000 ($196,000/7) and is eligible for the credit.


 3. What type of coverage does the company need to offer to get the credit?

If the company meets the size and annual wage requirements, then the employer must pay at least 50% of an employee's qualified health insurance through a qualified contribution arrangement to receive the credit.

A qualified contribution arrangement is any employer contribution to an employee's health insurance except for contributions through employee salary reduction.

During Phase I (tax years 2010 - 2013), qualified health insurance is defined as any health insurance policy that meets the IRS definition of health insurance coverage.

During Phase II (tax years 2014 -), qualified health insurance is defined as any health insurance policy offered by the employer through an Exchange that meets the IRS definition of health insurance coverage.

Example. For the 2010 tax year, ABC Manufacturing pays 60% of group health insurance premium for its employees*.

ABC Manufacturing meets the coverage requirements for 2010 and may receive a tax credit.


4. How much is the tax credit?

For Phase I, the largest credit a company can receive is 35% (25% for tax-exempt companies) of the state's "average premium" set by HHS (the HHS is expected to release these numbers by the end of this month).

If the company's contribution is less than the "average premium", then the company's maximum credit is equal to 35% of the company's contributions.  Otherwise, it is equal to 35% of the "average premium" described above.

Once the company's maximum credit is determined, the amount of the credit is reduced based on the company's FTEs and average annual wages:

    • If the company has more than 10 FTEs, the credit is reduced by an amount equal to the company's maximum credit multiplied by ((#FTEs - 10) / 15).
    • If the company pays more than $25,000 in average annual wages, the credit is reduce by the company's maximum credit multiplied by ((average annual wages - $25,000) /$25,000)

 

Example. For the 2010 tax year, ABC Manufacturing pays $72,000 in health care premiums for its employees*. 

Assuming the "average premium" set by HHS is greater than $72,000, then the amount of the credit will be calculated as follows:
    • The maximum credit is $25,200 (35% x $72,000) 
    • There is no credit reduction for FTEs because ABC Manufacturing has less than 10 FTEs
    • The credit reduction for average annual wages is $3,024 ($25,200 x $3,000/$25,000)

Therefore, ABC Manufacturing receives a health care tax credit equal to $22,176 ($25,200 - $3,024)


For Phase II, the only difference is that the largest credit is increased to 50% of the "average premium" (35% for non-profits).

5. How does the company claim the credit?

For tax-paying companies, the credit is claimed on the company's annual income tax return as a general business credit.  If the company does not owe any income taxes in the current tax year, it cannot claim the credit.  However, the credit can generally be carried back 1 year or carried forward up to 20 years.  Also, the company’s tax deduction for health insurance costs will be reduced by the amount of the credit.

For tax-exempt companies, the IRS will provide further information on how to claim the credit as a refundable credit.

Example. For the 2010 tax year, ABC Manufacturing owes the IRS $10,000 in income taxes.

ABC Manufacturing would receive a $10,000 health care tax credit in 2010 and the remaining amount of the credit ($12,176) would be carried forward to the next year  

“This credit provides a real boost to eligible small businesses by helping them afford health coverage for their employees... We urge small businesses and tax-exempt employers to look closely at this important tax break — which is already effective — to see if they qualify.”

-IRS Commissioner Doug Shulman. 

Click here for some more company examples provided by the IRS.

What do you think?  Does this really help U.S. small businesses?

*For purposes of this credit, the following types of workers are not included as "employees":

    • Seasonal workers not included in determining FTEs and average annual wages unless the seasonal worker works for the employer on more than 120 days during the tax year

    • 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 and 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. 

    • A family member of any of the business owners or partners member of such a business owner’s or partner’s household, is also not considered an employee for purposes of the credit.

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