Gerber and Co., CPAs and Financial Advisors

You've likely heard about the new tax credit for small organizations that provide healthcare coverage. Does your business or not-for-profit qualify? Is the credit worthwhile enough that companies that do not offer coverage will now start? The complex calculations to determine eligibility are explained in this article

The government recently issued interim rules for "grandfathered" health plans in existence before the healthcare legislation passed.

The recently enacted healthcare legislation includes a new tax credit for qualifying small employers. The credit can cover up to 35 percent of employee health insurance costs. It is available for tax years beginning in 2010, and can be claimed for eligible costs incurred before the healthcare legislation became law.

Does your company qualify for the credit? As with most tax topics, there's no simple answer. Here are the qualification rules.

Basics About The Credit

A qualifying small employer is one that:

Has no more than 25 full-time-equivalent (FTE) workers;

Pays an average FTE wage of no more than $50,000; and

Has a qualifying healthcare arrangement in place.

A qualifying healthcare arrangement is one that requires the employer to:

Pay at least 50 percent of the cost of each enrolled employee's coverage; and

Pay the same cost percentage for all enrolled employees. However, for tax years beginning in 2010, this uniform cost percentage requirement does not apply. Instead, a favorable transition rule allows you to pay an amount equal to at least 50 percent of the cost of single coverage for all enrolled employees (including those with more-expensive family or self-plus-one coverage). To be eligible for the credit in later years, however, you must pay the same cost percentage for all enrolled employees, including those with more expensive coverage.

In the typical situation in which the employer pays less than 100 percent of the cost of coverage (with employees picking up the balance), the credit can only be claimed for the percentage of the cost that is paid by the employer.

Healthcare premiums paid under a Section 125 cafeteria benefit plan salary-reduction arrangement do not count as an employer-paid cost.

The credit is allowed for all types of qualifying small employers, including C and S corporations, partnerships, LLCs, and sole proprietorships. However, certain workers who are also owners are classified as excluded workers, and costs to cover them are ineligible for the credit. Specifically, sole proprietors, partners, more-than-2 percent S corporation shareholder-employees, and more-than-5 percent C corporation shareholder-employees are excluded workers. Most employees who are members of these type of owners' families, including in-laws, are also classified as excluded workers, and costs to cover them are also ineligible for the credit.

Key Point. An employee who is married to a more-than-2 percent S corporation shareholder or a more-than-5 percent C corporation shareholder is an excluded worker. However, it is unclear if an employee who is married to a sole proprietor or a partner is an excluded worker. We are awaiting IRS guidance on that issue.

Calculating FTE Employees and Wages

As you will see, a complicated phase-out rule quickly reduces the credit if your business has over 10 FTE employees or an average full-time wage above $25,000. The credit is completely phased out once the number of FTE employees reaches 25 or the average wage reaches 50,000. Therefore, the FTE employee and wage calculations are really important in many cases. Here is the drill.

The number of FTE employees is calculated by dividing total paid employee hours for the year by 2,080. However, if a worker is paid for more than 2,080 hours, the excess hours are excluded from the calculation. Seasonal employees who work 120 days or less during the year (counting all days that any hours are worked) are also excluded from the calculation. The calculated number of FTE employees is then rounded down to the next whole number.

The average FTE wage for the year is calculated by dividing total employee wages by the number of FTE employees. Wages paid to seasonal employees who work 120 days or less (counting all days that any hours are worked) are excluded from the calculation. The calculated FTE wage amount is then rounded down to the next multiple of $1,000.

Because the credit cannot be claimed for costs to cover excluded workers (certain owners and their relatives, as explained earlier), their hours and wages aren't counted in determining the number of FTE employees or the average wage.

Key Point. As you can see, a business can have more than 25 workers and still be eligible for the credit if some of the workers are part-time employees, seasonal employees, or excluded workers.

Calculating the Tentative Credit

The maximum possible credit, which we will call the tentative credit, equals 35 percent of the lesser of:

The employer's real-world cost of providing employee health coverage under its qualifying arrangement; or

The imaginary cost to obtain "benchmark" coverage in the small-group market as determined on a state-by-state basis by the U.S. Department of Health and Human Services.

In the typical situation in which the employer pays less than 100 percent of the coverage cost, the tentative credit is calculated by multiplying the real-world cost or the imaginary benchmark cost (whichever is less) by the cost percentage paid by the employer.

TThe benchmark costs for tax years beginning in 2010 were published in IRS Revenue Ruling 2010-13. For higher-cost areas in some states, there may be additional 2010 benchmark costs later on.

Example: Alpha Corporation is a qualifying employer. The real cost of Alpha's eligible healthcare arrangement is $150,000, and the company pays 60 percent of the cost. Assume the imaginary benchmark cost in the state is $175,000. Alpha's tentative credit is $31,500 (60 percent times $150,000 times 35 percent).

Calculating the Allowable Credit after the Phase-Out Rule

An employer's allowable credit (the amount that can actually be claimed on the employer's federal income tax return) equals the tentative credit (based on 35 percent of the applicable healthcare cost figure) only when the employer has: :

10 or fewer FTE employees; and

An average FTE wage of $25,000 or less.

If the employer has more employees and/or a higher average wage, the allowable credit is quickly reduced under a complicated two-tiered phase-out rule that your tax adviser will calculate.

TWhen all is said and done, the credit will only provide meaningful benefits to truly small employers that pay modest wages. Unfortunately, such employers often don't provide company-paid health coverage.

Special Rules for Tax-Exempt Employers

For qualified small employers that are tax-exempt not-for-profit entities, the maximum credit percentage is 25 percent, and the phase-out rule explained above applies to them, too. In addition, the allowable credit amount for the year cannot exceed the sum of:

Federal income tax and 1.45 percent Medicare tax withheld from employee wages for that year; plus

The employer's 1.45 percent Medicare tax on wages for that year. Since there is no federal income tax liability to offset, the allowable credit amount for a tax-exempt employer is refunded to the employer in cash.

Other Considerations and Conclusion

The credit can be claimed for eligible healthcare costs incurred in tax years beginning in 2010 -- before the healthcare legislation was enacted.

An employer's federal tax deduction for employee health costs is reduced by the amount of the credit.

The credit is classified as a specified general business credit. As such, it can be used to offset both regular federal income tax and any alternative minimum tax. It cannot be used to offset federal employment tax liabilities. Unused credit amounts can be carried back for one year (but not to any pre-2010 year) and ahead for 20 years. Therefore, unused credits for tax years beginning in 2010 can only be carried forward.

Presumably, a fair number of small businesses that already provide health coverage will qualify for the credit. In this economy, it may not prompt many small businesses to suddenly start providing insurance. The fact that the credit rules are so complicated does not help matters. Consult with your tax adviser about questions in your situation.