Claiming the small employer health insurance tax credit

The small employer health insurance tax credit under Sec. 45R was enacted by the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, to help small businesses and small Sec. 501(c) tax-exempt organizations afford the cost of providing health insurance coverage for their employees. However, many potentially eligible employers that have gone through the relatively complex credit calculation have been dismayed to find that they were eligible only for a small credit or none at all. Because the maximum potential credit increased for 2014, employers that take the time to make the calculation may find that they are eligible for a substantially larger credit than in prior years.

The credit is specifically targeted toward employers with low- and moderate-income workers. All employers treated as a single employer under Sec. 414(b), (c), (m), or (o) (e.g., in controlled groups or entities under common control) must be aggregated and treated as a single employer for credit purposes.

To be eligible, an employer must:

• Pay premiums for employee health insurance under a qualifying arrangement;
• Have fewer than 25 full-time-equivalent employees (FTEs) for the tax year; and
• Pay average annual wages of less than $50,000 per FTE (inflation-adjusted to $50,800 for tax years beginning in 2014).

A qualifying arrangement, further described below, generally is one in which the employer pays at least 50% of the premium cost for single (employee-only) coverage.

Phase I. For tax years 2010 through 2013, the maximum credit was 35% of the employer’s contribution toward the employees’ health insurance premiums (25% for nonprofits).

Phase II. For tax years 2014 and later, the maximum credit is 50% of the employer’s contribution toward the employees’ health insurance premiums (35% for nonprofits). The credit is available for a maximum of two years. In addition, employers must obtain the insurance through the Small Business Health Options Program (SHOP), a feature of the health benefit exchanges, or “marketplaces,” that states and the federal government have established under PPACA.

An employer’s eligible premium contribution is limited to the average cost of health insurance for the small group market in the employer’s state or an area of the state (see Prop. Regs. Sec. 1.45R-3(b)). The average premium for the small group market is determined by the Department of Health and Human Services (HHS). After HHS sets the rate for a state (or within a state), it is published on the IRS website (irs.gov) and included in the instructions for Form 8941, Credit for Small Employer Health Insurance Premiums.

The credit phases out as average annual wages increase between $25,000 and $50,000 ($25,400 and $50,800 for 2014) and/or average FTEs increase between 10 and 25.

The credit is claimed using Form 8941. It is part of the general business credit, unused portions of which can be carried back one year and forward 20 years. The credit can be applied to both regular taxes and the alternative minimum tax.

The employer must reduce its health insurance premium expense deduction under Sec. 162 by the amount of the credit.

For tax-exempt small employers, the credit is also calculated on Form 8941 and is attached to Form 990-T, Exempt Organization Business Income Tax Return. The credit is refundable and limited to the payroll taxes (federal income taxes withheld, Medicare taxes withheld, and employer Medicare taxes paid) for the tax year.

PRACTICAL TIPS FOR CALCULATING THE CREDIT

Calculating the credit can be extremely complex and cumbersome, and often it does not seem cost-effective. However, as financial advisers, CPAs need to attempt to calculate the credit whenever possible. They can often rule out an employer’s eligibility with a quick calculation of average wages or FTEs before requesting the amount of insurance premiums paid. Most small businesses have payroll data readily available on wages and hours worked. Once a standard template is set up for calculating the credit, the employer (or tax preparer) can enter wage and insurance data directly onto the template. This should make the calculation easier to complete when preparing the tax return for the second year the business is eligible for the credit.

IRS RESOURCES 

The IRS maintains an Affordable Care Act Tax Provisions website (available at tinyurl.com/p44xjf5) to educate individuals and businesses on how the health care law may affect them. The site’s homepage includes three sections explaining the tax benefits and responsibilities for individuals and families, employers, and other organizations, with links and information for each group. The site also provides information about other Affordable Care Act tax provisions in effect in 2014 and beyond.

The IRS site links to a Small Business Health Care Tax Credit Estimator developed by the Taxpayer Advocate Service (available at tinyurl.com/oz9te8z) to help small businesses determine whether they are eligible for the credit and how much they might receive. Currently, the estimator is extremely limited and is unable to take into account all of the various complexities and limitations involved in the average calculation.

The IRS issued proposed regulations (REG-113792-13) on Aug. 26, 2013, that provide guidance on the credit. The regulations are proposed to be effective the date they are published as final in the Federal Register and apply to tax years beginning after 2013. If future guidance is more restrictive, it will not be applied retroactively.

SPECIFIC REQUIREMENTS FOR CLAIMING THE CREDIT

Following are some additional details on various aspects of qualifying for and calculating the credit.

Qualifying arrangement. A qualifying arrangement generally requires the employer to pay at least 50% of the premium cost for single (employee-only) coverage for each employee enrolled in any health insurance coverage provided by the employer, even if the employer did not pay the same percentage of the premium for each employee. The health insurance provider must be either an insurance company or another entity licensed under state law to provide health insurance coverage.

Individuals considered employees. All employees other than specifically excluded employees are taken into account in determining FTEs, average annual wages, and premiums paid. The number of FTEs is calculated by dividing the total hours of service for all employees during the employer’s tax year by 2,080 maximum hours. No employee may be treated as working more than 2,080 hours. To calculate the total number of hours of service, an employer can use the actual-hours-worked method, a days-worked equivalency method, or a weeks-worked equivalency method. The number calculated, if not already a whole number, is rounded down to the next lower whole number (or if less than one, up to one), which may or may not be advantageous to the employer, depending on the circumstances.

Specifically excluded employees. A sole proprietor, a partner in a partnership, a shareholder who owns 2% of an S corporation, a person who owns more than 5% of any other business, and family members or dependents of any of the above are excluded from the calculation of the credit.

Leased employees. Leased employees generally are included in the calculation unless their health insurance premiums are paid by the leasing organization.

Seasonal employees. Seasonal employees who work 120 or fewer days during the tax year are excluded from the FTE calculation, but any premiums paid on their behalf are included in determining the credit amount.

Household and nonbusiness employees. Household and other nonbusiness employees may be included in the calculation. A sole proprietor must include both business and nonbusiness employees to determine FTEs, average annual wages, and premiums paid.

Ministers. A minister is taken into account in determining the number of FTEs and premiums paid only if he or she is an employee under the common law test for determining worker status. However, the minister’s gross wages are excluded from the total wages paid, resulting in a lower average annual wage base.

Average annual wages. Wages, for purposes of the credit, mean wages subject to Social Security and Medicare tax determined without regard to the wage base limit. Therefore, gross wages per Form W-2, Wage and Tax Statement, are reduced by any pretax employee deductions, including the employee share of health insurance premiums paid. This results in a lower wage base for the calculation. The average annual wages paid by an employer for a tax year is determined by dividing total applicable wages paid by the total number of FTEs. This number is rounded down to the next lowest multiple of $1,000 (if not already a multiple), which is always advantageous to the employer because it results in a lower average annual wage base.

SAMPLE CALCULATIONS BASED ON HOURS WORKED

As previously indicated, the credit phases out as total FTEs rise between 10 and 25 and average wages increase from $25,000 (inflation-adjusted to $25,400 for tax years beginning in 2014) to $50,000 ($50,800 in 2014). In addition, the credit may be further limited by the average state premium amount, as discussed above. The number of months covered under the plan and the employer percentage of premiums paid also must be factored into the calculation.

Example 1: Total phaseout due to excess average wages. In 2013, XYZ Co., located in State X, pays total wages of $261,000 (excluding shareholders) to seven employees. The total number of hours worked is 12,320. This results in 5.92 FTEs. However, since that number must be rounded down to the next lower whole number, the average FTEs for this calculation is five. Therefore, the average wages paid is $52,000 (rounded down from $52,200). Since this amount is greater than the maximum wage threshold of $50,000, the credit is totally phased out.

Example 2: Partial phaseout due to excess average wages. In 2013, XYZ Co., located in State X, pays total wages of $261,000 to seven employees (excluding shareholders). The total number of hours worked is 12,620 (300 more than in Example 1). This results in 6.07 FTEs, which when rounded down becomes six, as opposed to five in Example 1. The average wages paid is $43,000 (rounded down from $43,500), which is below the maximum wage threshold. The company pays $34,000 in health insurance premiums for four employees, two with family coverage and two with single coverage. Twenty-five percent, or $8,500, of the premiums is paid by employee contributions and 75%, or $25,500, is paid by the company. Assume the state average premium limit (75% of the State X average premium amount for the employees) is $24,448 for the four employees, so the maximum credit is $8,557 ($24,448 × 35%). This maximum credit is partially phased out based on the ratio of the excess wages (i.e., the amount by which average wages exceed $25,000) divided by $25,000. This means that the maximum credit is reduced by 72% ([$43,000 − $25,000] ÷ $25,000). XYZ Co. has a total credit of $2,396 ($8,557 × 28%). XYZ Co. must reduce the deduction for health insurance paid by the credit amount.

Example 3: Increased credit amount in 2014. Assume the same facts as in Example 2, except that XYZ Co. calculates its credit for the 2014 tax year using the inflation-adjusted wage floor of $25,400 and the maximum credit percentage of 50%. The maximum credit is $12,224 ($24,448 × 50%). This maximum credit is partially phased out based on the ratio of excess average wages over $25,400 divided by $25,400. This means that the maximum credit is reduced by 69% ([$43,000 − $25,400] ÷ $25,400), or $8,435. XYZ Co. has a total credit of $3,789 ($12,224 − $8,435), an increase of $1,393 over the 2013 amount.

Example 4: Tax-exempt organization partial phaseout due to excess average wages. In 2013, ABC Church, located in State X, pays total wages of $261,000 to seven employees (excluding the minister, who is an employee under common law). Although the minister’s wages are excluded from the calculation, his hours and premiums paid is included. In this case, the total hours worked is 14,700, average FTEs is seven, and average wages paid are $37,000. The church pays $38,000 in health insurance premiums, $34,000 for the four employees and $4,000 for the minister. Twenty-five percent, or $8,500, of the employees’ premiums is paid by employee contributions. The church pays 75%, or $25,500, of the employees’ premiums and 100% of the minister’s premiums, resulting in total employer premiums paid of $29,500. However, the total state average premium limit for the minister and the four other employees is $29,435 (75% of the State X average premium amount for the employees and 100% of the State X average premium amount for the minister). The maximum credit is $7,359 ($29,435 × 25%), based on the credit rate for tax-exempt organizations in 2013. The maximum credit is reduced by 48% ([$37,000 – 25,000] ÷ $25,000), or $3,532. This means that ABC Church will have a total credit of $3,827 ($7,359 – $3,532). The church must file Form 990-T to claim the refundable credit.

Example 5: Increased tax-exempt credit in 2014. In 2014, the maximum credit amount for ABC Church is increased to 35% and the wage base to $25,400. Using the other facts in Example 4 results in a maximum credit amount of $10,302 ($29,435 × 35%). The maximum credit is reduced by 46% ([$37,000 − $25,400] ÷ $25,400), or $4,739. This means that ABC Church will have a total credit of $5,563 ($10,302 – $4,739), an increase of $1,736 over the 2013 credit amount.

REALIZING A BENEFIT

There is no doubt that calculating the credit can be complicated and cumbersome, and it appears that the majority of claims may be limited to partial credits. However, resources are available to assist in the calculation, and the benefit to eligible small employers who already provide health insurance to their employees makes it worth the time it takes to make the calculation.

In addition to the increase in the maximum credit to 50% in 2014, the average wage phaseout threshold increases to $25,400 due to inflation. The credit very well may be a considerable amount for a small employer who is eligible for the full credit, and it may be just enough to encourage employers to offer health insurance to employees.

GAO Studies Low Credit Use, Suggests Improvements

The U.S. Government Accountability Office (GAO) in 2012 reported to Congress on the impact of the small employer health insurance tax credit for the 2010 tax year. The GAO attempted to determine (1) the extent to which the credit was claimed and factors limiting claims, (2) how the IRS was ensuring that the credit was correctly claimed, and (3) what further data were needed to evaluate the credit’s effects (Small Employer Health Tax Credit: Factors Contributing to Low Use and Complexity, Rep’t No. GAO-12-549 (5/14/12)).

The GAO reported that far fewer small employers claimed the credit than were estimated to have been eligible. Depending on the estimate, only 4% to 12% of small businesses eligible for the credit claimed it in 2010. Most claims were limited to a partial credit amount by average wage and FTE limitations and state premium averages. In addition, the report, citing another study, indicated that only 17% of businesses that might have been eligible for the maximum credit offered health insurance to employees.

Small business representatives and tax preparer groups indicated that the credit was not large enough to encourage employers to begin offering health insurance, and, due to complex rules, the time needed to calculate the credit often deterred claims.

The GAO recommended that the IRS improve instructions to examiners reviewing credit claims and analyze the results to identify and address errors. It also recommended that the IRS give greater attention to confirming eligibility for the credit taken by small employers with non-U.S. addresses. The IRS agreed with these recommendations, and although additional instructions have been provided to examiners regarding some of the recommendations, not all have yet been implemented.

EXECUTIVE SUMMARY

The small employer health insurance tax credit entails often complex calculations but can be beneficial for qualifying employers, especially since the maximum credit has increased for 2014 to 50% of employer contributions toward premiums (from 35% earlier). Tax-exempt small employers may qualify for a refundable credit (increased for 2014 to 35% from 25% in prior years).

A qualifying small employer must pay premiums for employee health insurance under a qualifying arrangement (generally one in which the employer pays at least half the cost of single coverage), have fewer than 25 full-time-equivalent employees (FTEs) for the tax year, and pay average annual wages of less than $50,000 (increased for 2014 to $50,800) per FTE.

The credit is subject to phaseout between 10 and 25 FTEs and average annual wages of between $25,000 and $50,000 ($25,400 and $50,800 in 2014). An employer may claim the credit for a maximum of two tax years after 2013.

CPAs can advise business clients with preliminary calculations of eligibility and potential credit amounts, helping establish a standard template for the credit’s threshold requirements of hours of employee service, FTEs, average wages, and state average premium amounts.

Vicki S. Bernardi (vickib@hobe.com) is a tax manager with Hobe & Lucas CPAs Inc. in Independence, Ohio.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

AICPA RESOURCES

JofA article

“Small Businesses Struggle to Navigate Provisions of the Health Care Law,” Jan. 2013, page 38

CPE self-study

• 2013 Corporate Tax Returns Videocourse (#112644, DVD/manual)
• Health Care Reform Act 2013: Critical Tax and Insurance Ramifications (#745813, text; and #155812, online access)

Conference

Employee Benefit Plans Conference, May 13–15, Las Vegas

Webcasts

“Health Care Reform Act: Critical Tax and Insurance Ramifications for You, Your Business, and Your Clients,” audio webcasts (#VCL4HCRA016, Feb. 21; and #VCL4HCRA017, March 21)

For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077.

The Tax Adviser and Tax Section

The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies, and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/tax. The current issue of The Tax Adviser is available at thetaxadviser.com.

OTHER RESOURCES

Websites

• IRS, Affordable Care Act Tax Provisions
• Taxpayer Advocate Service, Small Business Health Care Tax Credit Estimator