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Implementing Health Reform: The Small Employer Tax Credit



May 18th, 2010

Editor’s Note:  Other posts by Timothy Jost provide analyses of regulations implementing provisions of the new health reform legislation governing standards for tax-exempt hospitals, the Web portal, reinsurance for early retirees, and young adult coverage

Implementation of health care reform continues at a rapid pace.  On Monday, May 17, the Internal Revenue Service issued Notice 2010-44, providing further guidance for the implementation of the small employer tax credit created by section 45R of the Internal Revenue Code, added by section 1421 of Patient Protection and Affordable Care Act (PPACA).  Section 45R offers a tax credit to small employers that provide health insurance to their employees. 

The IRS estimates that 4 million businesses may be eligible and for these businesses the tax credit represents a potentially very sizeable tax cut.  The provision is effective for tax years beginning after December 31, 2009, and the IRS has already sent a postcard to millions of small employers notifying them of their potential eligibility for the assistance.  The Notice clarifies a number of issues that had been left uncertain by the legislation.

The program offers small employers a tax credit to assist them in purchasing health insurance for their employees.  The credit currently covers 35% of the employer’s contribution for employee insurance premiums up to 35% of the average cost of an insurance plan in the small group market in the rating area.  For tax exempt organizations, the credit is 25%.  Once the new health insurance exchanges go online in 2014, the credit will be increased to 50% for businesses and 35% for exempt organizations, but the credit will only apply for insurance purchased through an exchange and will expire after an employer has received the credit for two years.  

The employer must pay directly (and not through a salary-reduction agreement) at least 50% of the premium for employee coverage and must pay a uniform percentage of the premium cost for all workers.  A business can set off the credit against income tax owed (including the AMT), and can carry the credit forward for 20 years or backwards for one year (after 2010).  Tax exempt organizations can set off the credit against withholding and Medicare taxes that they owe for their employees.

A Narrowly Targeted Provision

Like the other provisions of PPACA that are being implemented prior to 2014, the small employer tax credit does not offer a comprehensive approach to the problem of the uninsured, but rather a narrowly targeted solution to a specific problem.  The tax credit is only available to employers with fewer than 25 FTE (full-time equivalent) employees whose average wage does not exceed $50,000 per employee.  Indeed, the full credit is only available to employers with 10 or fewer FTEs with an average annual wage of $25,000 or less and phases out above those levels.  It is not available to the self-employed and only covers employees, not owners or their families. 

Although small employers in general are less likely to offer health insurance than larger employers, lack of employee coverage is a particularly acute problem for the employers targeted by the tax credit.  Whereas 95% of employers with 50 to 100 employees offered health insurance in 2009, only 46% of those with 3 to 9 employees and 72% of those with 10 to 24 employees do.  Moreover, this is where the most erosion in coverage has been in recent years.  The percentage of employers with 3 to 9 workers who offer health insurance has dropped 10% over the past decade, while the percentage of employers with more than 25 employees who offer insurance hardly changed at all between 1999 and 2009.  The provision should be particularly useful to small churches and nonprofits and to moderate- to low-wage small businesses like restaurants, landscapers, and cleaning services. 

The National Federation of Independent Businesses, a small business lobbying group which last week joined the state attorney general litigation challenging the constitutionality of the reform legislation, criticized the program for covering only the smallest of small businesses and for not providing enough assistance to be viable.  The NFIB claims that only 1.8 million businesses will be eligible for the subsidies and that many of these will not be able to afford health insurance.  On the other hand, the Main Street Alliance, another small business group, has welcomed the tax credit program as providing a real benefit to small businesses.  The Congressional Budget Office projects that about $40 billion in tax credits will be provided to small employers over the next ten years, with program expenditures hitting a maximum of $6 billion in 2013 and then stabilizing at the $3 to $4 billion annual level going forward.

How The Credit Will Work: The Details

The May 17 Notice supplements other information available on the IRS website concerning the small employer credit, including a frequently asked questions page.  As has been true with other regulatory issuances released to date, it construes the requirements of the statute liberally to maximize participation.

The Notice sets out a multi-step process for determining eligibility for the credit.  The first step is to determine the number of employees to be taken into account in calculating the number of FTEs and average annual wages.  Owners, their family members, and dependents are not counted, nor are seasonal workers who do not work more than 120 days per year.  Employees of controlled or affiliated service groups are aggregated for determining eligibility.

Next the number of hours of service for employees is totaled.  This includes not only the hours workers are paid for performance of duties, but also paid vacation, illness, holiday or other leave time.  The employer may calculate the total number of hours of service for determining the number of FTEs by either determining the actual number of hours for which payment has been made or by using days-worked or weeks-worked equivalents, claiming credit for 8 hours for any day or 40 hours for any week in which an employee would be credited for at least one hour of work.

The total number of paid hours is next totaled, and divided by 2080 and rounded to the next lowest whole number  to determine the number of FTEs for eligibility purposes.  The average annual wages paid to employees (and not to owners or their families) are totaled and divided by the number of FTEs (and rounded down to the nearest $1000) to determine the average wage.

Next, the premiums paid by the employer for employees (not owners or their families or dependents) are totaled to determine the amount of the credit.  Premiums paid for coverage for seasonal workers can be included.  Not only are premiums for hospital or medical insurance counted, but also premiums paid by the employer for dental, vision, long-term care, Medicare supplement, and other specific forms of limited-coverage insurance.  The uniform percentage of premium and 50 percent payment requirements must be separately met for each form of insurance for which a credit is sought.   The amount of employer contributions taken into account in determining the credit cannot exceed the payment the employer would have made had the average premium for small group coverage in the rating area been substituted for the actual premium paid, but this cap applies overall and not separately to each form of insurance offered.   Current average premium rates can be found here

To calculate the actual credit, premiums actually paid by the employer are first multiplied by the  credit percentage (currently 35% for taxable businesses, 25% for tax exempt entities) to determine the maximum credit.   For tax exempt organizations, the credit is capped at the sum of the taxes withheld by the employer plus the employee and employer share of the Medicare tax, since the credit will be set off against these amounts. 

Next, the maximum credit is reduced by the sum of:

  • the amount of the credit times a fraction the numerator of which is the number of FTEs minus 10 and the denominator is 15, plus
  • the amount of the credit times a fraction the numerator of which is the employer’s average wage minus $25,000 and the denominator is $25,000.

The credit disappears if the employer has more than 25 employees or pays an average wage of more than $50,000, but since the effect of the two factors is cumulative, the credit can disappear before either number reaches the maximum.  State tax credits or subsidies are not subtracted from the credit as long as the credit does not exceed the amount the employer actually pays.  About 20 states have tax credit or subsidy programs, and employers in these states stand to gain a substantial benefit.

The tax credit is already in effect and employers may immediately begin reducing their estimated tax payments by the amount of their expected credit.  For 2010, the transition year, the uniformity of contribution requirement is waived as long as the employer pays at least 50% of the premium for single coverage for each employee (even if an employee has family coverage).  The White House hopes that the tax credit will persuade a segment of the population that has been particularly wary of health care reform that the legislation may in fact be in their best interests.

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