Credit for Small Employer Health Insurance Premiums

Small employers that pay at least half of the premiums for single health insurance coverage for their employees are eligible to claim a tax credit. It is specifically targeted to help small businesses and tax-exempt organizations that primarily employ moderate- and lower-income workers.

The small business health care tax credit is designed to encourage both small businesses and small tax-exempt organizations to offer health insurance coverage to their employees for the first time or to maintain coverage they already have. In 2010 through 2013, the maximum credit is 35 percent of the employer's eligible premium expenses.

Claiming this credit can result in a substantial tax savings. For example, if you paid $72,000 in health care premiums for your employees and you meet all the requirements for the full amount of the credit, you could claim a credit for $25,200 (35% x $72,000).

Health insurance premiums paid for an employee are deductible business expenses. However, a tax credit is almost always better than a deduction because a credit cuts your tax bill dollar-for-dollar, while the value of a deduction is tied to your marginal tax bracket. In order to maximize your tax savings, you should claim as large a tax credit as possible, and then deduct the remaining premiums.

There are two tests that you have to meet to qualify for this credit: you must be a "qualified employer" and you must pay the premiums under a "qualifying arrangement."

Qualified Employer

To be a qualified employer, you must have fewer than 25 full-time employees (FTE), regardless of whether or not they are enrolled in your health plan, and their average annual wages must be least then $50,000 per full-time employee.

Full-time employees. To find out how many FTEs you have, add the total number of hours of service for which you paid wages to employees during the year and, then, divide this number by 2080. If the result is a fraction, it gets rounded to the nearest whole number. To determine the number of the employees, you consider the hours of service of all employees: both full and part-time. You can determine the number of hours your employees worked by any of the following methods:

• using records showing their actual hours of service and of paid leave;
• using a "days-worked equivalency" which credits an 8 hours of service for each day in which the employee actually worked one hour; or
• using "weeks-worked equivalency" which credits an employee with 40 hours of service for each week if he or she actually worked for one hour in the week.
• Example. For the 2012 tax year, you paid five employees wages for 2,080 hours each, three employees wages for 1,040 hours each, and one employee wages for 2,300 hours. You are using the hours actually worked method to determine FTEs. First you total the hours of all employees, not exceeding 2,080 per employee. This means that you only count 2,080 of the 2,300 hours worked by one employee. The total number of hours is 15,600 hours ((6 x 2,080)+(3 x 1,040).) This total is divided by 2,080, which equals 7.5. A fraction is rounded to the nearest whole number, in this case, 7.

There are some caveats. You can't count more than 2080 hours for an employee. Also, you aren't required to count more than 160 hours of service for any single continuous period of paid leave. 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, although premiums paid on their behalf may be counted in determining the amount of credit.

In addition, you may not be able to count yourself or your family members for any purpose related to the Health Care Tax Credit. If you are 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, you are not considered an employee 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.

Similarly, the family member or member of the household of the business owners or partners is not considered an employee for purposes of the credit. Thus, neither their wages nor their hours are counted in determining 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. 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.

Warning Even if you qualify, the amount of your credit may be reduced if you have more than 10 full-time employees and/or the employees' average annual wages exceed $25,000. (See Limits on the Amount of Credit, below.)

Average wages. You determine the amount of average annual wages by dividing:

1. the total wages you paid during the year to employees whose hours are included in the FTE computation by
2. the number of your FTEs for the year. The result is then rounded down to the nearest $1,000 (if not otherwise a multiple of $1,000).

Wages for this purpose means wages as defined for FICA purposes (without regard to the wage base limitation.)

Qualifying Arrangement

In order to be eligible for the credit, premiums must be paid under a "qualifying arrangement." This means that:

• The premiums must be paid to an insurance company or HMO for health-care coverage.
• You must pay a uniform percentage of not less than 50 percent of the premium cost of the coverage for each employee enrolled in the plan. (You must actually pay the premiums directly; amounts paid under a cafeteria plan salary reduction arrangement don't count as paid by the employer.)

You can claim the credit for more than one type of plan (e.g., major medical and dental) but each plan must meet the qualifying arrangement test separately from the others--you can't aggregate the plan types to meet the "qualifying arrangement" requirements.

Limits on the Amount of Credit

Even if you are a qualifying employer and you pay premiums under a qualifying arrangement, the amount of the credit you can claim may be limited by three factors:

• the "average premium for the small market group" in your state;
• the number of employees and their average annual wages; and
• the amount of your taxable income.

Average premium cap. The amount of premium payments that can be counted toward the credit is limited to the smaller of the "average premium for the small group market in the state (or area of the state)" for comparable insurance coverage, or the amount you actually paid. The average premium for the small group market in a state (or an area within the state) is determined by the Department of Health and Human Services (HHS). The annual premium cap for each state is included in the Instructions for Form 8941 In recognition of the fact that certain areas within a state may have much higher premium rates than other areas, HHS may provide additional average premium rates for high-premium areas within a state.

This is a cap on the total amount--for purposes of this test, you can aggregate all your costs under all your qualifying plans.

For the 2012 tax year, you operate a business in Illinois and offer a health insurance plan with single and family coverage. You have nine full-time employees and their average annual wage is $23,000 per FTE. This means that you are considered a qualifying employer and you may be eligible for a credit for premiums paid if you meet the other tests. Four of your employees are enrolled in single coverage and five are enrolled in family coverage. You pay 50% of the premiums for each employee, regardless of whether their coverage is single or family. The premiums are $4,000 a year for single coverage (of which you pay $2,000) and $10,000 a year for family coverage (of which you pay $5,000). Therefore, you meet the percentage and equality of payments tests. To determine the amount of premiums that qualify for the credit, you need to compare the amount that you paid to the small group market in your state. Assume that the average premium for the small group market for 2012 in Illinois is $5,565 for single coverage and $13,176 for family coverage. Because you are paying 50% of the premium, the cap is based on 50% of the state market premiums: $2,782.50 for single coverage and $6,588 for family coverage. In this case, the premium amount you paid is less than the state limit, so you can include the entire amount to compute the credit.

Reduction based on number of employees and average salary. Once you have determined the total amount of eligible premium costs, you may have to reduce that amount if you have more than 10 employees and/or the average wage is more than $25,000.

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.

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. Note that 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

For the 2012 tax year, you have 12 FTEs and average annual wages of $30,000. You paid $96,000 in health care premiums for those employees, which does not exceed the average premium for the small group market in your state, and otherwise meets the requirements for the credit. The credit is calculated as follows: Initial amount of credit determined before any reduction: (35% x $96,000) = $33,600 Credit reduction for FTEs in excess of 10: ($33,600 x 2/15) = $4,480 Credit reduction for average annual wages in excess of $25,000: ($33,600 x $5,000/$25,000) = $6,720 Total credit reduction: ($4,480 + $6,720) = $11,200 Total 2012 tax credit: ($33,600 - $11,200) = $22,400.

Taxable income limitation. The amount of credit can only offset your actual income tax liability or AMT liability for the year, unless you are a tax-exempt employer (see Special Rules for Tax Exempt Employers, below.) However, any unused credit amount can generally be carried back one year and carried forward 20 years.

Claiming the Credit

If you qualify for the credit, and you are not a tax-exempt employer, you claim the credit using Form 8941, which must be attached to your income tax return.

In the Business Tools is Form 8941, Credit for Small Employer Health Insurance Premiums. It is in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.

Special Rules for Tax-Exempt Employers

Only 501(c) tax exempt organizations are eligible to claim the Health Care Tax Credit. 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, as determined above. 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 for the year.

For the 2012 tax year, a qualified tax-exempt employer has 10 FTEs with average annual wages of $21,000 per FTE. The employer pays $80,000 in health care premiums for those 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. The total amount of the employer's income tax and Medicare tax withholding plus the employer's share of the Medicare tax equals $30,000 in 2012. The credit is calculated as follows: Initial amount of credit determined before any reduction: (25% x $80,000) = $20,000 Employer's withholding and Medicare taxes: $30,000 Total 2012 tax credit is $20,000 (the lesser of $20,000 and $30,000).

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). The tax-exempt claims the refundable credit by filing a Form 990-T with an attached Form 8941.