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April 12, 2010
Healthcare Reform Update: Small Employer Tax Credit

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The new health reform law gives a tax credit to certain small employers that provide health care coverage to their employees, effective with tax years beginning in 2010. The IRS has issued information on the credit as it applies for 2010-2013, including information on transition relief for 2010. An enhanced version of the credit takes effect in 2014.

Eligible small employers. Small employers that provide health care coverage to their employees and that meet certain requirements (qualified employers) generally are eligible for a federal income tax credit for health insurance premiums they pay for certain employees. In order to be a qualified employer:

  • An employer must have fewer than 25 full-time equivalent employees (FTEs”) for the tax year,
  • The average annual wages of its employees for the year must be less than $50,000 per FTE, and
  • The employer must pay the premiums under a “qualifying arrangement.”
IRS has stated that tax exempt organizations are entitled to the credit, but must calculate the credit under special rules.

Calculation of the credit. Only premiums paid by the employer under an arrangement meeting certain requirements (a “qualifying arrangement”) are counted in calculating the credit. Under a qualifying arrangement, the employer pays premiums for each employee enrolled in health care coverage offered by the employer in an amount equal to a uniform percentage (not less than 50 percent) of the total premium cost of the coverage. If an employer pays only a portion of the premiums, only the portion paid by the employer is counted in calculating the credit. For purposes of the credit (including the 50-percent requirement), any premium paid pursuant to a salary reduction arrangement under a Sec. 125 cafeteria plan is not treated as paid by the employer. IRS has clarified that premiums paid by the employer in 2010, but before the new health reform legislation was enacted on March 23, 2010 may be counted in calculating the credit.

The amount of an employer’s premium payments that counts when calculating the credit may not exceed the average premium for the small group market in the particular state (or an area within the state) in which the employer offers coverage for the same arrangement. The average premium for the small group market in a state (or an area within the State) will be determined by the Department of Health and Human Services (HHS). IRS has published this information in Rev. Rul. 2010-13 which is posted on the IRS Web site. HHS has stated that for the 2010 taxable year, it may provide additional average premium rates for the small group market in certain areas within States. However, in no case will any such additional sub-State rates be lower than the applicable rate for each State that is set forth in Rev. Rul. 2010-13.

Maximum credit amount. For tax years beginning in 2010 through 2013, the maximum credit is 35 percent of the employer's premium expenses that count towards the credit.

Maximum credit for a tax-exempt qualified employer. For tax years beginning in 2010 through 2013, the maximum credit for a tax-exempt qualified employer is 25 percent of the employer's premium expenses that count towards the credit. However, the amount of the credit cannot exceed the total amount of income and Medicare (i.e., Hospital Insurance) tax the employer is required to withhold from employees' wages for the year and the employer share of Medicare tax on employees' wages.

Credit reductions. If the number of FTEs exceeds 10 or if average annual wages exceed $25,000, the amount of the credit is reduced. 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 10 FTEs and average annual wages exceeding $25,000, the reduction is the sum of the amount of the two reductions. This sum may reduce the credit to zero for some employers with fewer than 25 FTEs and average annual wages of less than $50,000.

Determining the number of FTEs. The number of an employer's FTEs is determined by dividing (1) the total hours for which the employer pays wages to employees during the year (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. Because the limitation on the number of employees is based on FTEs, an employer with 25 or more employees could qualify for the credit if some of its employees work part-time.

Determining the amount of 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. For this purpose, wages means wages as defined for FICA purposes (without regard to the wage base limitation).

Disregarded workers. Seasonal workers are disregarded 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. Thus, the wages or hours of these business owners and partners 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. For this purpose, a family member is defined 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 a son-in-law, daughter- in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law.

Controlled groups. Members of a controlled group (e.g., businesses with the same owners) or an affiliated service group (e.g., related businesses of which one performs services for the other) are treated as a single employer for purposes of the credit. Thus, for example, all employees of the controlled group or affiliated service group, and all wages paid to employees by the controlled group or affiliated service group, are counted in determining whether any member of the controlled group or affiliated service group is a qualified employer.

Claiming the credit. The credit is claimed on the employer's annual income tax return. IRS says it will provide further information on how tax exempt organizations are to claim the credit. As a general business credit, an unused credit amount can generally be carried back 1 year and carried forward 20 years. Because an unused credit amount cannot be carried back to a year before the effective date of the credit, an unused credit amount for 2010 can only be carried forward. IRS says that the credit can be reflected in determining estimated tax payments for the year to which the credit applies in accordance with regular estimated tax rules. For a tax-exempt employer, the credit is a refundable credit, so that even if the employer has no taxable income, the employer may receive a refund so long as it does not exceed the income tax withholding and Medicare tax liability,

Effect on employer's deduction for health insurance premiums. In determining the employer's deduction for health insurance premiums, the amount of premiums that can be deducted is reduced by the amount of the credit.

Transition relief for tax years beginning in 2010. IRS expects that transition relief will be provided for tax years beginning in 2010 to make it easier for taxpayers to meet the requirements for a qualifying arrangement. IRS says that guidance will provide that, for tax years beginning in 2010, an employer that pays at least 50 percent of the premium for each enrolled employee will not fail to maintain a qualifying arrangement merely because the employer does not pay a uniform percentage of the premium for each employee. Accordingly, if the employer otherwise satisfies the requirements for the credit, it will qualify for the credit even though the percentage of the premium it pays is not uniform for all such employees.

The requirement that the employer pay at least 50 percent of the premium for an employee applies to the premium for single (employee-only) coverage. Therefore, if the employee is receiving single coverage, the employer satisfies the 50 percent requirement if it pays at least 50 percent of the premium for that coverage. If the employee is receiving coverage that is more expensive than single coverage, the employer satisfies the 50 percent requirement if the employer pays an amount of the premium that is at least 50 percent of the premium for single coverage even if it is less than 50 percent of the premium for the coverage the employee is actually receiving.

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