IRS Gives Explanation and Guidance on New Credit for Small Business Health Insurance

The IRS has provided additional guidance in Notice 2010-44 and a general explanation of the application of the new tax credit under §45R for health insurance expenses of small employers. In the notice, the IRS outlines employer eligible for the credit, the calculation of the credit, and how the credit is claimed on the return, along with its interaction with estimated taxes and the alternative minimum tax. The notice goes on to provide transition rules for 2010 that the IRS had originally committed to provide in the explanation of the credit that was posted to the IRS website.

The IRS outlines the following steps that are necessary to determine if an employer is eligible to claim the credit:

1. Determine the employees who are taken into account for purposes of the credit.
2. Determine the number of hours of service performed by those employees.
3. Calculate the number of the employer’s FTEs.
4. Determine the average annual wages paid per FTE.
5. Determine the premiums paid by the employer that are taken into account for purposes of the credit.

Employees taken into account do not include sole proprietors, partners in a partnership, more than 2% shareholders of an S corporation and more than 5% owners of any other business (which would include a C corporation). As well, family members or dependents of those individuals are not taken into account. Seasonal workers are excluded from the computation of full time equivalents (FTEs) unless the seasonal worker works for the employer more than 120 days during the taxable year, but the premiums paid for them may still be counted in computing the credit.

Hours of service include each hour for which an employee is paid, or entitled to payment, for duties performed for the employer during the year and each hour for which the employer is paid, or entitled to payment, for time in which no duties are performed due to vacation, holiday, illness, incapacity, jury duty, military duty or leave of absence. However, no more than 160 hours is counted under the “no service” category for any single continuous period for which service is not performed.

The IRS offers three methods that an employer may use to compute the hours of service. The hours can be based on 1) the record of actual hours that meet the above criteria, 2) a “days-worked equivalency method” counting 8 hours of service for each day for which an employee would be credited for one hour under the first criteria or 3) a “weeks-worked” equivalency method counting 40 hours for each week for which an employee would be credited with one or more hours.

The number of FTEs is computed by dividing the hours computed in step 2 by 2,080, with result rounded down to the next lowest whole number if the calculation does not result in a whole number. Average wages are computed by taking the total wages paid to employees who are counted in the FTE calculation and dividing them by the number of FTEs. This number is rounded down to next lower multiple of $1,000 if it does not result in an even multiple of 1,000.

The amount of premiums paid are those paid under a qualifying arrangement for the employee’s health care by the employer. If the employee pays a share of the premiums, the employee’s payment is not counted. Neither are payments made (clarification-by employee salary deferral) under a §125 cafeteria plan deemed paid by the employer for purposes of the credit. Prior to 2014, the coverage can include a broad range of health insurance options, but does not include specific types of coverage listed in §9832(c)(1).

The premiums paid for all coverage for an employee are limited to no more than the amount that would have been paid under the average premium for the small group market in the State (or area within the State) in which the employer offers overage. That average rate will be published by the IRS for each year to which it applies, with the 2010 amounts found in Revenue Ruling 2010-21.

The notice then goes on to describe how to calculate the actual credit, laying out a three step process:

1. Calculate the maximum amount of the credit;
2. Reduce the maximum credit in step 1 in accordance with the phaseout rule, if necessary; and
3. For employers receiving a State credit or subsidy for health insurance, determine the employer’s actual premium payment.

From 2010 to 2013 the maximum credit is 35% of eligible premium payments for a taxable entity, and 25% of such premiums for a tax-exempt entity. For tax exempt entities the credit is capped at the total amount of income tax withheld from employees pay plus the employer and employee portion of Medicare taxes (but not social security taxes).

The reductions for FTEs in excess of 10 and average wages in excess of $25,000 apply separately, and thus the notice points out that an employer with less than 25 employees and average wages of less than $50,000 may nevertheless find it qualifies for no credit. In each case, the reduction is based on a ratio of the excess over the beginning of the phase out level, which results in a percentage to reduce the credit by. If the total of those percentages exceed 100%, no credit will be allowed.

The IRS gives the following example in its notice:

Example 12 – Calculating the credit phase-out if the number of FTEs exceeds 10 or average annual wages exceed $25,000. (i) For the 2010 taxable year, 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.
(ii) The credit is calculated as follows:
(1) Initial amount of credit determined before any reduction: (35% x $96,000) = $33,600
(2) Credit reduction for FTEs in excess of 10: ($33,600 x 2/15) = $4,480
(3) Credit reduction for average annual wages in excess of $25,000: ($33,600 x $5,000/$25,000) = $6,720
(4) Total credit reduction: ($4,480 + $6,720) = $11,200 (5) Total 2010 tax credit equals $22,400 ($33,600 – $11,200).

The notice also describes the special limitations that apply if a state government pays a subsidy or grants a tax credit to employers who offer coverage. Such amounts are treated as payments made by the employer for the purpose of the credit, but in no case may the credit allowed exceed the net amount of premiums actually paid by the employer after removing the subsidy or offsetting the payments by the state credit.

The credit is claimed on the employer’s income tax return as a general business credit (the IRS indicated it will announce later how nonprofits will be able to claim the credit). Generally the credit can be carried back one year and forward 20. However, since the law provides the credit cannot be carried back to a year prior to enactment, 2010 credits will not be able to be carried back.

For 2010 only a special transition rule granting relief from the uniform percentage rule will apply. In 2010, so long as the employer pays at least 50% of the premium for employee-only coverage for all employees covered it will be deemed to satisfy the uniformity requirement for 2010.

The credit is one of the topics I will be covering in the full day Fringe Benefits course I will present on August 30 at the Arizona Society offices in Phoenix.  You can sign up for the course on the ASCPA website.

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