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Small Employer Health Insurance Tax Credit

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The new health insurance reform package (the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010) includes an immediate tax break for qualified small businesses: the Code Sec. 45R small employer health insurance tax credit. Qualified small employers, including nonprofit employers, may reduce the cost of providing health insurance to their employees this year. However, the credit is complex and there are important limitations, especially when calculating the number of employees and other provisions.

Do not let the complexity of the credit discourage you from exploring its benefits. The small business health insurance tax credit is targeted to employers that have no more than 25 full-time equivalent (FTE) employees paying wages averaging less than $50,000 for each employee per year. According to the U.S. Department of Health and Human Services (HHS), a qualified small business can choose to start offering health insurance coverage to employees in 2010 and be eligible for the credit. HHS has also indicated that the credit is retroactive to January 1, 2010. Employers with 10 or fewer full-time employees (FTEs) paying average annual wages of not more than $25,000 may be eligible for a maximum credit of 35 percent for tax years beginning in 2010 through 2013.

The maximum credit for tax-exempt employers is 25 percent for tax years beginning in 2010 through 2013. For tax years beginning in 2014 through 2015, the maximum credit climbs to 50 percent of qualified premium costs paid by for-profit employers (35 percent for tax-exempt employers). However, an employer may claim the credit after 2013 only if it offers one or more qualified health plans through a state insurance exchange. The health care reform package requires states to create insurance exchanges by January 1, 2014. The credit is subject to phase-out rules. The credit is reduced by 6.667 percent for each FTE in excess of 10 employees. The credit is also reduced by four percent for each $1,000 that average annual compensation paid to the employees exceeds $25,000. This means that the credit completely phases out if an employer has 25 or more FTEs and pays $50,000 or more in average annual wages. Let's look at an example of how the credit works in 2010.

A small manufacturer employs nine individuals with average annual wages of $23,000 for each employee in 2010. The manufacturer pays $72,000 in health care premiums for its employees. Assuming that the manufacturer meets all the other requirements, its credit for 2010 is $25,200 (35 percent x $72,000). To determine eligibility for the credit, employers have to calculate their number of FTEs. The number of an employer's FTEs is determined by dividing the total hours of service (but not more than 2,080 hours for any employee) by 2,080. The result, if not a whole number, is rounded to the next lowest whole number. Lawmakers selected 2,080 hours because 2,080 hours comprise the number of hours in a 52-week year, assuming a 40-hour work week. Any hours beyond 2,080, such as overtime hours, are not taken into account when calculating FTEs. Employers also need to calculate average annual wages. The amount of average annual wages is determined by first dividing the total wages paid by the employer to employees during the employer's tax year by the number of the employer's FTEs for the year. The result is then rounded down to the nearest $1,000 (if not otherwise a multiple of $1,000).

Employers also must determine the number of hours of service performed by employees. The IRS has provided three methods that employers may use to calculate the total number of hours of service that must be taken into account for an employee for the year. The three methods are: (1) Actual hours of service; (2) Days-worked equivalency; or (3) Weeks-worked equivalency. The days-worked equivalency is based on an eight-hour work day and the week-worked equivalency is based on a 40-hour work week. Example: Peter worked 48 weeks, took three weeks of vacation and one week of unpaid leave. Peter’s employer uses the weeks-worked equivalency method to calculate the total number of hours of service. Using this method, Peter would be credited with 2,040 hours of service (51 weeks x 40 hours per week). Congress imposed some important limitations on the credit.

Employers must exclude certain individuals from the calculation of FTEs and average annual wages. Certain family members of these individuals are also excluded from the calculation of FTEs and average annual wages. Additionally, the credit applies only to premiums paid by the employer under a qualifying plan. An employer's contribution is also linked to the average cost of health insurance in its state or part of a state. Because the credit is effective for 2010 but was not enacted until March 23, 2010, some employers currently offering coverage may not meet all of the requirements for a qualifying arrangement. The IRS has provided transition relief. The credit also impacts an employer's deduction for the cost of health insurance premiums paid on behalf of employees. The amount of premiums that an employer may deduct is reduced by the amount of the small employer health care tax credit. Additionally, the IRS has advised that the credit will generally not be reduced by a state health insurance credit that the employer may claim. The credit is a general business credit and qualified for-profit employers will claim it on their annual income tax return. The IRS has indicated it will issue guidance on how tax-exempt employers will claim the credit.