A Look at the New Health Insurance Credit

You may already be getting questions from clients about the new health insurance credit.  In addition to the Internet and other news coverage it has gotten, the IRS has mailed postcards about this credit to millions of small employers.  Although the benefits of this new credit are very limited, employers who do qualify for it will want to take full advantage of it.  Here are a few details.

 What is it?

The Tax Credit for Employee Health Insurance Expenses of Small Employers is part of the Patient Protection and Affordable Care Act which was signed into law in March of 2010.  The Act makes a credit available to small employers who pay at least 50% of the cost of qualifying health care coverage for their employees.

 Who is affected?

The credit affects small businesses that meet these criteria:

• Pay at least 50% of their employees’ qualifying health care coverage costs
• Employ fewer than 25 full-time equivalent employees
• Pay an average annual wage, per employee, of less than $50,000

Tax-exempt organizations may also qualify, even if they have no taxable income. A tax-exempt organization can claim a refund of the credit up to the amount of the income and Medicare taxes it was required to withhold from its employee’s wages, plus the employer’s Medicare contribution. 

How do I know if my clients are eligible?

To determine if your clients qualify for the credit, you must ensure that they employ fewer than 25 qualified FTE employees and pay an average annual wage of less than $50,000.

FTE Employees: To calculate the number of qualified FTE employees, divide the total number of hours worked by all eligible employees during the year (including vacation and sick time) by 2,080. Note that the number of FTE employees may differ from the number of actual employees. For example, if Moe worked 1,000 hours, Larry worked 500 hours, and Curly worked 580 hours, the three will have worked a total of 2,080 hours—equaling one “FTE employee.”

Average Annual Wage: To determine the average annual wage, divide the total wages paid for the year by the number of qualified FTE employees, and round down to the nearest $1,000. When making this calculation, do not include hours worked by, or wages paid to, the following types of workers:

• Seasonal workers who worked for the employer for 120 days or less
• Domestic employees

• Owners (including partners, sole proprietors, more than 2% owners of S corporations, and more than 5% owners of regular corporations)  and their family members

 Doing the math

Once you’ve determined that your client is eligible, you need to figure how much of the credit your client can take. Employers with 10 or fewer FTE employees, and who pay an average annual wage of $25,000 or less, can take the full amount of the credit. The credit is phased out for larger employers.

To determine the amount for those who aren’t eligible for the full credit, begin by determining what the full credit would be: 35% (25% for non-profit organizations) of the amount paid by the employer for health coverage. (For example, the full credit for a business that paid $10,000 for employee health insurance would be $3,500, or 35% of $10,000.) Next, subtract any reduction for having more than 10 employees, or for having an average wage of more than $25,000.

More than 10 Employees: To compute the reduction for having more than 10 employees, take the number of employees in excess of 10, divide it by 15, and multiply the result by the full credit amount. For example, if an employer that paid $10,000 for employee health insurance has 12 employees, you would divide 2 by 15, multiply the result by $3,500, and reduce the credit by the resulting amount:

Full Credit: $10,000 X 0.35 = $3,500

Reduction for having more than 10 employees: 2/15 X $3500 = $467

Actual Credit Allowed: $3,500 – $467 = $3,033

Average Wages of More than $25,000: To compute the reduction for having average annual wages of more than $25,000, figure the amount by which the average annual wage exceeds $25,000, divide it by 25,000, and multiply the result by the full credit amount. For example, if the employer that paid $10,000 for employee health insurance pays an average wage of $30,000, you would divide $5,000 by 25,000, multiply the result by $3,500, and reduce the credit by the resulting amount:

Full Credit: $10,000 X 0.35 = $3,500

Reduction for average wage exceeding $25,000: 5,000/25,000 X $3,500 = $700

Actual Credit allowed: $3,500 – $700 = $2,800

Note that an employer can be subject to both reductions. If the employer that paid $10,000 for employee health insurance had twelve employees and paid an average annual wage of $30,000, the allowed credit would be $2,333:

Full Credit: $10,000 X 0.35 = $3,500

Reduction for having more than 10 employees: 2/15 X $3500 = $467

Reduction for average wage exceeding $25,000: 5,000/25,000 X $3,500 = $700

Actual Credit Allowed: $3,500 – $467 – $700 = $2,333

Additional information

The amount of employee health insurance expense that can be used may be limited based on amounts determined by the Department of Health and Human Services. See Revenue Ruling 2010-13 for more information.

Starting in 2014, the maximum credit amount is scheduled to increase to 50% for businesses and 35% for non-profit organizations, but it will be available only to employers who purchase insurance through a state exchange.

More information is available in Internal Revenue Bulletin 2010-22 and at www.irs.gov.