Beginning in taxable year 2010, the Affordable Care Act provides a tax credit to small businesses with no more than 25 full-time employees and average annual wages of less than $50,000 that provide health insurance to their employees. Employers that satisfy the requirements for the credit are referred to as “eligible small employers.” The credit phases out as firm size and average annual wages increase. The full amount of the credit is available to employers with ten or fewer full-time employees and average annual wages of less than $25,000. The credit is not payable in advance and is only available to offset the business’s actual tax liability. For tax-exempt small business, the credit is available as a reduction in payroll taxes. The credit is provided in two phases:
Phase I
Tax Years 2010 - 2013
A tax credit is available to eligible small businesses of up to 35% of an employer’s contribution as long as the employer contributes at least 50% of the total premium or 50% of a benchmark premium. Tax-exempt small businesses meeting the eligibility requirements can receive a tax credit of up to 25% of the employer’s contribution.
Phase II
Tax Years 2014 +
A tax credit is available to eligible small businesses of up to 50% of the employer’s contribution as long as the employer contributes at least 50% of the total premium or 50% of a benchmark premium. The credit is available up to two years. Tax-exempt small businesses meeting the eligibility requirements can receive a tax credit of up to 35% of the employer’s contribution.
Steps to determine whether an employer is eligible for a small business health care credit:
- 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 equivalents (FTEs).
- 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. Specifically, the premiums must be paid by an employer under a qualifying arrangement and must be paid for health insurance that meets the requirements of section 45R.
In general, employees who perform services for the employer during the taxable year are taken into account in determining the employer’s FTEs, average wages, and premiums paid, with certain individuals excluded and with employees of certain related employers included.
Exclusions from the definition of an employee are sole proprietors, partners in a partnership, shareholders owning more than two percent of an S corporation and any owners of more than 5% of other businesses. Family members of owners and partners are also not taken into account as employees. For purposes of section 45R, a family member is defined as a spouse, child (or descendant of a child), sibling or step-sibling; a parent (or ancestor of a parent), step-parent, niece or nephew, aunt or uncle, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law.
Any other member of the household of these owners and partners who qualifies as a dependent under section 152(d)(2)(H), is not taken into account as an employee for purposes of section 45R. If an individual is not considered an employee, then their wages, hours and premiums paid on their behalf are not counted in determining the amount of the section 45R credit. Seasonal workers are disregarded in determining FTEs and average annual wages unless the seasonal worker works for the employer more than 120 days during the taxable year. All employers treated as a single employer under section 414(b), (c), (m) or (o) are treated as a single employer for purposes of section 45R.
An employee’s hours of service for a year include:
- Each hour for which an employee is paid, or entitled to payment.
- The performance of duties for the employer during the employer’s taxable year.
- Each hour for which an employee is paid, or entitled to payment, by the employer on account of a period of time during which no duties are performed due to vacation, holiday, illness, incapacity (including disability), layoff, jury duty, military duty or leave of absence.
In calculating the total number of hours of service, the employer may use any of the following methods:
- Determine actual hours of service for which payment is made or due (payment is made or due for vacation, holiday, illness or incapacity).
- Use a days-worked equivalency where the employee is credited with eight hours of service for each day for which the employee would be required to be credited with at least one hour of service.
- Use a weeks-worked equivalency where the employee is credited with 40 hours of service for each week for which the employee would be required to be credited with at least one hour of service.
All examples are for the 2010-2013 taxable years. 1 – An employer’s payroll records indicate that Employee A worked 2,000 hours and was paid for an additional 80 hours on account of vacation, holiday and illness. The employer counts hours actually worked.
Under this method of counting hours, Employee A must be credited with 2,080 hours of service (2,000 hours worked and 80 hours for which payment was made or due).
2 – Employee B worked 49 weeks, took two weeks of vacation with pay, and took one week of leave without pay. The employer uses the weeks-worked equivalency.
Under this method of counting hours, Employee B must be credited with 2,040 hours of service (51 weeks multiplied by 40 hours per week).
FTE Determination Example
The number of an employer’s FTEs is determined by dividing the total hours of service credited during the year to employees taken into account (but not more than 2,080 hours for any employee) by 2,080. The result, if not a whole number, is then rounded to the next lowest whole number. In some circumstances, an employer with 25 or more employees may qualify for the credit if some of its employees work part-time. For example, an employer with 46 half-time employees (meaning they are paid wages for 1,040 hours) has 23 FTEs and, therefore, may qualify for the credit.
For example, if an employer pays five employees wages for 2,080 hours each, three employees wages for 1,040 hours each, and one employee wages for 2,300 hours; the employer does not use an equivalency method to determine hours of service for any of these employees.
FTE Calculation
The employer’s FTEs would be calculated as follows:
- Total hours of service not exceeding 2,080 per employee is the sum of:
- a) 10,400 hours of service for the five employees paid for 2,080 hours each (5 x 2,080)
- b) 3,120 hours of service for the three employees paid for 1,040 hours each (3 x 1,040), and
- c) 2,080 hours of service for the one employee paid for 2,300 hours (lesser of 2,300 and 2,080
- d) The sum of a, b and c equals 15,600 hours of service.
- FTEs equal 7 (15,600 divided by 2,080 = 7.5, rounded to the next lowest whole number).
For example, if the 2010 taxable year, an employer has 26 FTEs with average annual wages of $23,000 per FTE; only 20 of the employer’s employees are enrolled in the employer’s health insurance plan.
The hours of service and wages of all employees are taken into consideration in determining whether the employer is an eligible small employer for purposes of the credit. Because the employer does not have fewer than 25 FTEs for the taxable year, the employer is not an eligible small employer for purposes of the credit.
Average Annual Wages Calculation
The average annual wages paid by an employer for a taxable year is determined by dividing the total wages paid by the employer during the employer’s taxable year to employees 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).
Only wages that are paid for hours of service are taken into account.
For example, an employer pays $224,000 in wages and has 10 FTEs; the employer’s average annual wages is: $22,000 ($224,000 divided by 10 = $22,400, rounded down to the nearest $1,000).
Acceptable Health Insurance Coverage Example
Only premiums paid by the employer for health insurance coverage are counted in calculating the credit. For example, if an employer pays 80 percent of the premiums for employees’ coverage (with employees paying the other 20 percent), the 80 percent paid by the employer is taken into account in calculating the credit. Any premium paid pursuant to a salary reduction arrangement under a Section 125 Cafeteria Plan is not treated as paid by the employer. An employer’s premium payments are not taken into account for purposes of the credit unless they are paid for health insurance coverage under a qualifying arrangement. A qualifying arrangement is an arrangement where the employer pays at least 50% of the premiums for each employee enrolled in health insurance coverage offered by the employer (must be uniform percentage for all employees).
For example, if an eligible small employer pays 80 percent of the premiums for coverage provided to employees (and employees pay the other 20 percent), the premiums taken into account for purposes of the credit are the lesser of 80 percent of the total actual premiums paid or 80 percent of the premiums that would have been paid for the coverage if the average premium for the small group market in the state (or an area within the state) were substituted for the actual premium.
Example 1 – An eligible small employer offers a health insurance plan with single and family coverage. Employer has nine FTEs with average annual wages of $23,000 per FTE. Four employees are enrolled in single coverage and five are enrolled in family coverage. The employer pays 50 percent of the premiums for all employees enrolled in single coverage and 50 percent of the premiums for all employees enrolled in family coverage (and the employee is responsible for the remainder in each case). The premiums are $4,000 a year for single coverage and $10,000 a year for family coverage. The average premium for the small group market in employer’s state is $5,000 for single coverage and $12,000 for family coverage.
The employer’s premium payments for each FTE ($2,000 for single coverage and $5,000 for family coverage) do not exceed 50 percent of the average premium for the small group market in employer’s state ($2,500 for single coverage and $6,000 for family coverage). Thus, the amount of premiums paid by the employer for purposes of computing the credit equals $33,000 ((4 x $2,000) plus (5 x $5,000)).
Example 2 – Using the same facts as in Example 1, except that the premiums are $6,000 for single coverage and $14,000 for family coverage.
The employer’s premium payments for each employee ($3,000 for single coverage and $7,000 for family coverage) exceed 50 percent of the average premium for the small group market in the employer’s state ($2,500 for single coverage and $6,000 for family coverage). Thus, the amount of premiums paid by the employer for purposes of computing the credit equals $40,000 ((4 x $2,500) plus (5 x $6,000)).
Example 3 – An eligible small employer offers a major medical plan and a dental plan. The employer pays 50 percent of the premium cost for single coverage for all employees enrolled in the major medical plan and 50 percent of the premium cost for single coverage for all employees enrolled in the dental plan. The employer can take into consideration the premiums paid by the employer for both the major medical plan and the dental plan, but only up to 50 percent of the amount of the average premium for single coverage for the small group market in the employer’s state.
Example 4 – Same facts as in Example 3, except that the employer pays 40 percent of the premium cost for single coverage for all employees enrolled in the dental plan.
The employer can take into consideration only the premiums paid by the employer for the major medical plan, and only up to 50% of the amount of the average premium for single coverage for the small group market in the employer’s state. The employer cannot take into consideration premiums paid for the dental plan when employer pays less than 50% for the dental plan.
An employer that pays an amount equal to at least 50% of the premium for single (employee-only) coverage for each employee enrolled in coverage offered to employees by the employer will be deemed to satisfy the uniformity requirement for a qualifying arrangement, even if the employer does not pay the same percentage of the premium for each such employee. The requirement that an employer pay at least 50% of the premium for an employee applies to the premium for single coverage for the employee. An employer will be deemed to satisfy the uniformity requirement for a qualifying arrangement if it pays at least 50% of the premium for single coverage for each employee receiving single coverage; and if the employer offers coverage that is more expensive than single coverage (such as family or self-plus-one coverage), if it pays an amount for each employee receiving the more expensive coverage that is no less than 50% of the premium for single coverage for that employee (even if it is less than 50% of the premium for the more expensive coverage the employee is actually receiving).
State Tax Credits
Some states offer tax credits or subsidies to certain small employers that provide health insurance to their employees. State tax credits and subsidies are treated as amounts paid by the employer for purposes of determining whether the employer has satisfied the “qualifying arrangement” requirement to pay an amount equal to a uniform percentage (not less than 50%) of the premium cost. However, the amount of the credit cannot exceed the amount the employer actually paid in premiums. When calculating the employer’s actual premium payments, the amount of any state tax credit or subsidy is not included.
Credit Phase Out
The credit phases out gradually (but not below zero) for eligible small employers if the number of FTEs exceeds 10 or if the average annual wages exceeds $25,000. If the number of FTEs exceeds 10, the reduction is determined by multiplying the otherwise applicable credit amount by a fraction; the numerator of which is the number of FTEs in excess of 10 and the denominator of which is 15.
If average annual wages exceed $25,000, the reduction is determined by multiplying the otherwise applicable credit amount by a fraction; the numerator of which is the amount by which average annual wages exceed $25,000 and the denominator of which is $25,000. In both cases, the result of the calculation is subtracted from the otherwise applicable credit to determine the credit to which the employer is entitled.
For an employer with both more than ten FTEs and average annual wages exceeding $25,000, the total reduction is the sum of the two reductions.
How to calculate the credit:
- Calculate the maximum amount of the credit.
- Reduce the maximum credit in step 1 in accordance with the phase out rule, if necessary.
- For employers receiving a state credit or subsidy for health insurance, determine the employer’s actual premium payment.
Example 1 – Calculating the maximum credit for a taxable eligible small employer. A taxable eligible small employer has 9 FTEs with average annual wages of $23,000 per FTE. The employer pays $72,000 in health insurance premiums for those employees (which does not exceed the average premium for the small group market in the employer’s state) and otherwise meets the requirements for the credit.
The credit equals $25,200 (35% x $72,000).
Example 2 – Calculating the maximum credit for a tax-exempt eligible small employer. A tax-exempt eligible small employer has ten FTEs with average annual wages of $21,000 per FTE. The employer pays $80,000 in health insurance premiums for its employees (which does not exceed the average premium for the small group market in the employer’s state) and otherwise meets the requirements for the credit. The total amount of the employer’s income tax and Medicare tax withholding plus the employer’s share of the Medicare tax equals $30,000 in 2010. The credit is calculated as follows:
Initial amount of credit determined before any reduction: (25% x $80,000) = $20,000. Employer’s withholding and Medicare taxes: $30,000
Example 3 - Calculating the credit phase-out if the number of FTEs exceeds 10 or average annual wages exceed $25,000.
A taxable eligible small employer has 12 FTEs and average annual wages of $30,000. The employer pays $96,000 in health insurance premiums for its employees (which does not exceed the average premium for the small group market in the employer’s state) and otherwise meets the requirements for the credit. The credit is calculated as follows:
- Initial amount of credit determined before any reduction: (35% x $96,000) = $33,600
- Credit reduction for FTEs in excess of 10: (33,600 x 2/15) = $4,480
- Credit reduction for average annual wages in excess of $25,000: ($33,600 x $5,000/ $25,000) = $6,720
- Total credit reduction: ($4,480 + $6,720) = $11,200
- Total tax credit equals $22,400 ($33,600 - $11,200).
Claiming the Credit
The credit is claimed on an eligible small employer’s annual income tax return and offsets an employer’s actual tax liability for the year. Eligible small employers should attach the Form 8941, Credit for Small Employer Health Insurance Premiums, to their tax return. Tax exempt organizations must attach the Form to their 990-T. The credit is a general business credit and any unused credit amount can be carried back one year and carried forward 20 years. For a tax-exempt eligible small employer, the credit will be a reduction in payroll taxes.
The credit can also be used to offset an employer’s alternative minimum tax (AMT) liability for the year but is subject to certain limitations based on the amount of an employer’s regular tax liability. No deduction is allowed for the employer under section 162 for that portion of the health insurance premiums which is equal to the amount of the section 45R credit.
For taxable years beginning in 2014
The maximum amount of the tax credit is 50% of the employer’s contribution (35% for tax-exempt employers). The credit is only available to small businesses purchasing health insurance through an exchange and is also only available for two years (not counting any years prior to 2014 when the small business may have received the credit).
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