Proposed Regs Provide Guidance on Insurance Exchange Requirement for Small Employers Taking Health Insurance Credit
(Parker's Federal Tax Bulletin: August 28, 2013)

Last week, the IRS issued proposed regulations on the tax credit under Code Sec. 45R for small employers providing health insurance to their employees. The credit, which is effective for tax years beginning in 2010, was part of the Patient Protection and Affordable Care Act (PPACA) . The regulations provide details on the requirement to purchase insurance through an exchange, and explain the uniform contribution rules.

For 2010-2013, the maximum credit is 35 percent of a taxable eligible small employer's premium payments taken into account for purposes of the credit. For a tax-exempt eligible small employer, the maximum credit is 25 percent of the employer's premium payments taken into account for purposes of the credit. For tax years beginning in 2014, these percentages change to 50 percent instead of 35 percent for taxable eligible small employers, and 35 instead of 25 percent for tax-exempt eligible small employers. In addition, beginning in 2014, the credit is available only to a qualified small employer that purchases health insurance coverage for its employees through a state exchange, and is available only for a maximum coverage period of two consecutive tax years beginning with the first year in which the employer or any predecessor first offers one or more qualified plans to its employees through an exchange.

In 2010, the IRS issued Notice 2010-44 and Notice 2010-82, both of which provided guidance on the employee health insurance tax credit. The new proposed regulations (REG-113792-13 (8/26/13)) generally incorporate the provisions of Notice 2010-44 and Notice 2010-82, as modified to reflect the differences in the rules applicable to years before 2014 and those applicable to years after 2013. Additionally, however, the regulations provide details on the requirement relating to the purchase of insurance coverage through an exchange, explain the requirement that an employer must generally pay a uniform percentage (not less than 50 percent) of the premium for each employee, and provide examples of how the uniform percentage rules work.

Practice Tip: An eligible small employer may use the credit to reduce estimated tax payments. An eligible small employer may also use the credit to offset the employer's alternative minimum tax (AMT) liability for the year, if any, subject to certain limitations. However, an eligible small employer may not reduce its deposits and payments of employment tax during the year in anticipation of the credit.

Eligibility for the Credit

As noted above, the health insurance credit is a percentage of an eligible small employer's premium payments. An eligible small employer is defined as an employer that has no more than 25 full-time employees (FTEs) for the tax year, whose employees have average annual wages of less than $50,000 per FTE (as adjusted for inflation for years after December 31, 2013), and that has a qualifying arrangement in effect that requires the employer to pay a uniform percentage (not less than 50 percent) of the premium cost of a qualified health plan (QHP) offered by the employer to its employees through a Small Business Health Options Program (SHOP) Exchange. A tax-exempt eligible small employer is an eligible small employer that is described in Code Sec. 501(c) and that is exempt from tax.

OBSERVATION: There is no requirement that, for an employer to be an eligible small employer, the employees perform services in a trade or business. Thus, an employer that otherwise meets the requirements for the credit does not fail to be an eligible small employer merely because the employees of the employer are not performing services in a trade or business. For example, a household employer that otherwise satisfies the requirements is an eligible small employer for purposes of the credit.

Under Code Sec. 45R(d), to be an eligible small employer with respect to any tax year, the employer must have in effect a contribution arrangement that qualifies under Code Sec. 45R(d)(4). A contribution arrangement qualifies if it requires an eligible small employer to make a nonelective contribution on behalf of each employee who enrolls in a qualified health plan (QHP) offered to employees by the employer through an Exchange in an amount equal to a uniform percentage (not less than 50 percent) of the premium cost of the QHP (referred to as the uniform percentage requirement). The proposed regulations provide that, for purposes of Code Sec. 45R, an Exchange refers to a Small Business Health Options Program (SHOP) Exchange, established pursuant to PPACA, Section 1311. A contribution arrangement that meets these requirements is referred to as a "qualifying arrangement."

An employer located outside the United States (including a U.S. Territory) may be an eligible small employer if the employer has income effectively connected with the conduct of a trade or business in the United States, otherwise meets the requirements of the regulations, and is able to offer a QHP to its employees through a SHOP Exchange.

Employees for Which Credit Can Be Taken

In general, all employees who perform services for the employer during the tax year are taken into account in determining FTEs and average annual wages, including those who are not performing services in the employer's trade or business.

However, certain individuals are not considered employees when calculating the credit, and hours and wages of these individuals are not counted when determining an employer's eligibility for the credit. The following individuals are not employees or are otherwise excluded for this purpose: independent contractors (including sole proprietors); partners in a partnership; shareholders owning more than 2 percent of an S corporation; owners of more than 5 percent of other businesses; family members of these owners and partners, including 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 a sister-in-law. A spouse is also considered a family member for this purpose, as is a member of the household who is not a family member but qualifies as a dependent on the individual income tax return of an excluded individual.

Seasonal employees who work for 120 or fewer days during the tax year are not considered employees when determining FTEs and average annual wages, but premiums paid on behalf of seasonal workers may be counted in determining the amount of the credit. Seasonal workers include retail workers employed exclusively during holiday seasons and workers employed exclusively during the summer.

Special rules apply to ministers because of the nature of their employment. If under the common law a minister is not an employee, the minister is not taken into account in determining an employer's FTEs. If under the common law a minister is an employee, the minister is taken into account in determining an employer's FTEs. However, because a minister performing services in the exercise of his or her ministry is treated as not engaged in employment for FICA purposes, compensation paid to a minister is not considered wages and so is not included for purposes of computing an employer's average annual wages for purposes of the health insurance premium credit.

It is important to determine the number of hours an employee works to establish whether or not the employee is an FTE for which the employer is eligible to take the credit. The proposed regulations provide that an employee's hours of service for a year include hours for which the employee is paid, or entitled to payment, for the performance of duties for the employer during the employer's tax year. Hours of service also include hours for which the employee is paid for vacation, holiday, illness, incapacity (including disability), layoff, jury duty, military duty, or leave of absence.

OBSERVATION: Hours of service do not include the hours of seasonal employees who work for 120 or fewer days during the tax year, nor do they include hours worked for a year in excess of 2,080 for a single employee.

These proposed regulations describe three methods for calculating the total number of hours of service for a single employee for the tax year:

(1) actual hours worked;

(2) days-worked equivalency; and

(3) weeks-worked equivalency.

Practice Tip: Employers do not have to use the same method for all employees and may apply different methods for different classifications of employees if the classifications are reasonable and consistently applied. For example, an employer may use the actual hours worked method for all hourly employees and the weeks-worked equivalency method for all salaried employees.

The proposed regulations define wages, for purposes of the credit, as wages defined under Code Sec. 3121(a) for FICA purposes, determined without considering the social security wage base limitation. To calculate average annual FTE wages, an employer must figure the total wages paid during the tax year to all employees, divide the total wages paid by the number of FTEs, and if the result is not a multiple of $1,000, round the result to the next lowest multiple of $1,000. For example, $30,699 is rounded down to $30,000.

Calculating the Credit

For tax years beginning during or after 2014, the maximum credit for an eligible small employer other than a tax-exempt eligible small employer is 50 percent of the eligible small employer's premium payments made on behalf of its employees under a qualifying arrangement for QHPs offered through a SHOP Exchange. For a tax-exempt eligible small employer for those years, the maximum credit is 35 percent. The employer's tax credit is subject to the following adjustments and limitations:

(1) the average premium limitation;

(2) the credit phaseout;

(3) the state subsidy and tax credit limitation;

(4) the payroll tax limitation for tax-exempt employers; and

(5) the two-consecutive-tax year credit period limitation.

For purposes of calculating the credit for tax years beginning after 2013, the employer's premium payments are limited by the average premium in the small group market in the rating area in which the employee enrolls for coverage through a SHOP Exchange. The credit will be reduced by the excess of the credit calculated using the employer's premium payments over the credit calculated using the average premium.

Example: ABC Corporation pays 50 percent of the $7,000 premium for family coverage for its employees ($3,500), but the average premium for family coverage in the small group market in the rating area in which the employees enroll is $6,000. For purposes of calculating the credit, ABC's premium payments are limited to $3,000 (50 percent of $6,000).

The credit phases out for eligible small employers if the number of FTEs exceeds 10, or if the average annual wages for FTEs exceed $25,000 (as adjusted for inflation for tax years beginning after December 31, 2013). For an employer with both more than 10 FTEs and average annual FTE wages exceeding $25,000, the credit is reduced based on the sum of the two reductions.

OBSERVATION: This may reduce the credit to zero for some employers with fewer than 25 FTEs and average annual FTE wages of less than double the $25,000 dollar amount (as adjusted for inflation).

Some states offer tax credits to a small employer that provides health insurance to its employees. Some of these credits are refundable credits and others are nonrefundable credits. In addition, some states offer premium subsidy programs for certain small employers under which the state makes a payment equal to a portion of the employees' health insurance premiums. Generally, the state pays this premium subsidy either directly to the employer or to the employer's insurance company (or another entity licensed under state law to engage in the business of insurance). If the employer is entitled to a state tax credit or premium subsidy that is paid directly to the employer, the amount of employer premiums paid is not reduced for purposes of calculating the health insurance premium credit, but the amount of the credit cannot exceed the net premiums paid, which are the employer premiums paid minus the amount of any state tax credits or premium subsidies received.

If a state makes premium payments directly to the insurance company, the state is treated as making these payments on behalf of the employer for purposes of determining whether the employer has satisfied the "qualifying arrangement" requirement to pay an amount equal to a uniform percentage (not less than 50 percent) of the premium cost of coverage. Also, these premium payments by the state are treated as an employer contribution for purposes of calculating the credit, but the amount of the credit cannot exceed the premiums actually paid by the employer.

OBSERVATION: If a state-administered program, such as Medicaid, makes payments on behalf of individuals and their families who meet certain eligibility requirements, these payments do not reduce the amount of employer premiums paid for purposes of calculating the credit.

For a tax-exempt eligible small employer, the amount of the credit cannot exceed the amount of the payroll taxes of the employer during the calendar year in which the tax year begins.

The proposed regulations provide that the first year for which an eligible small employer files Form 8941, Credit for Small Employer Health Insurance Premiums, claiming the credit, or files Form 990-T, Exempt Organization Business Income Tax Return, with an attached Form 8941, is the first year of the two-consecutive-tax year credit period. Even if the employer is only eligible to claim the credit for part of the first year, the filing of Form 8941 begins the first year of the two-consecutive-tax-year credit period.

Beginning in 2014, the credit is available only for a maximum coverage period of two consecutive tax years beginning with the first year in which the employer or any predecessor first offers one or more qualified plans to its employees through an exchange. Special transition rules apply in determining the application of the two-consecutive-tax year credit period for tax years beginning in 2014 where the eligible small employer offers coverage on a plan year that begins on a date other than the first day of its tax year. In such a case, if an eligible small employer has a health plan year beginning after January 1, 2014, but before January 1, 2015 (2014 health plan year) that begins after the start of its first tax year beginning after January 1, 2014 (2014 tax year), and the employer offers one or more QHPs to its employees through a SHOP Exchange as of the first day of its 2014 health plan year, then the eligible small employer is treated as offering coverage through a SHOP Exchange for its entire 2014 tax year for purposes of Code Sec. 45R if the health care coverage provided from the first day of the 2014 tax year through the day immediately preceding the first day of the 2014 health plan year would have qualified for a credit under Code Sec. 45R using the rules applicable to tax years beginning before January 1, 2014. If the eligible small employer claims the credit in the 2014 tax year, the 2014 tax year begins the first year of the credit period.

Example: ABC Corporation is an eligible small employer (and is not a tax-exempt organization) and has a 2014 tax year that begins January 1, 2014, and ends on December 31, 2014, and a 2014 health plan year that begins July 1, 2014 and ends June 30, 2015. ABC offers a QHP through a SHOP Exchange the coverage under which begins July 1, 2014. ABC provides coverage from January 1, 2014, through June 30, 2014, that would have qualified for a credit using the rules applicable to tax years beginning before January 1, 2014. ABC may claim the credit at the 50 percent rate for the entire 2014 tax year. Accordingly, in calculating the credit, ABC may count premiums paid for coverage from January 1, 2014 through June 30, 2014, as well as premiums paid from July 1, 2014, through December 31, 2014. If ABC claims the credit for the 2014 tax year, that tax year is the first year of the credit period.

Applying the Uniform Percentage Requirement

To be eligible for the credit, an eligible small employer must generally pay a uniform percentage (not less than 50 percent) of the premium for each employee enrolled in a QHP offered to its employees through a SHOP Exchange. Prop. Reg. Sec. 1.45R-4 sets forth the rules for applying this requirement in separate situations depending on (1) whether the premium established for the QHP is based on list billing or is based on composite billing; (2) whether the QHP offers only self-only coverage, or other coverage (such as family coverage) for which a higher premium is charged; and (3) whether the employer offers one QHP or more than one QHP. The uniform percentage rule applies only to the employees offered coverage and does not impose a coverage requirement.

The term "composite billing" is defined to mean a system of billing under which a health insurer charges a uniform premium for each of the employer's employees or charges a single aggregate premium for the group of covered employees that the employer may then divide by the number of covered employees to determine the uniform premium. In contrast, the term "list billing" is defined as a billing system under which a health insurer lists a separate premium for each employee based on the age of the employee or other factors.

For an eligible small employer offering self-only coverage and using composite billing, the employer satisfies the applicable requirements if it pays the same amount toward the premium for each employee receiving self-only coverage under the QHP, and that amount is equal to at least 50 percent of the premium for self-only coverage.

For an eligible small employer offering one QHP providing at least one tier of coverage with a higher premium than self-only coverage and using composite billing, the employer satisfies the applicable requirements if it either:

(1) pays an amount for each employee enrolled in that more expensive tier of coverage that is the same for all employees and that is no less than the amount that the employer would have contributed toward self-only coverage for that employee, or

(2) meets the requirements of an employer offering self-only coverage and using composite billing (see above) for each tier of coverage that if offers.

For an eligible small employer offering one QHP providing only self-only coverage and using list billing, the employer satisfies the applicable requirements if either:

(1) the employer pays toward the premium an amount equal to a uniform percentage (not less than 50 percent) of the premium charged for each employee, or

(2) the employer converts the individual premiums for self-only coverage into an employer-computed composite rate for self-only coverage, and, if an employee contribution is required, each employee who receives coverage under the QHP pays a uniform amount toward the self-only premium that is no more than 50 percent of the employer computed composite rate for self-only coverage.

If an employer offers more than one QHP through a SHOP Exchange, the uniform percentage requirement may be satisfied in one of two ways. The first is on a plan-by-plan basis, meaning that the employer's premium payments for each plan must individually satisfy the uniform percentage requirements stated above. The amounts or percentages of premiums paid toward each QHP do not have to be the same, but they must each satisfy the uniform percentage requirement if each QHP is tested separately. The other permissible method to satisfy the uniform percentage requirement is through the reference plan method. Under the reference plan method, the employer designates one of its QHPs as a reference plan. Then the employer either determines a level of employer contributions for each employee such that, if all eligible employees enrolled in the reference plan, the contributions would satisfy the uniform percentage requirement as applied to that reference plan, or the employer allows each employee to apply the minimum amount of employer contribution determined necessary to meet the uniform percentage requirement toward the reference plan or toward coverage under any other available QHP.

Example 1: An eligible small employer, ABC Corporation, offers a QHP on a SHOP Exchange, Plan A, which uses composite billing. The premiums for Plan A are $5,000 per year for self-only coverage, and $10,000 for family coverage. Employees can elect self-only or family coverage under Plan A. ABC pays $3,000 (60 percent of the premium) toward self-only coverage under Plan A and $6,000 (60 percent of the premium) toward family coverage under Plan A. ABC's contributions of 60 percent of the premium for each tier of coverage satisfy the uniform percentage requirement.

Example 2: The facts are the same as in Example 1, except that ABC pays $3,000 (60 percent of the premium) for each employee electing self-only coverage under Plan A and pays $3,000 (30 percent of the premium) for each employee electing family coverage under Plan A. ABC's contributions of 60 percent of the premium toward self-only coverage and the same dollar amount toward the premium for family coverage satisfy the uniform percentage requirement, even though the percentage is not the same.

Example 3: ABC Corporation offers two QHPs, Plan A and Plan B, both of which use composite billing. The premiums for Plan A are $5,000 per year for self-only coverage and $10,000 for family coverage. The premiums for Plan B are $7,000 per year for self-only coverage and $13,000 for family coverage. Employees can elect self-only or family coverage under either Plan A or Plan B. ABC pays $3,000 (60 percent of the premium) for each employee electing self-only coverage under Plan A, $3,000 (30 percent of the premium) for each employee electing family coverage under Plan A, $3,500 (50 percent of the premium) for each employee electing self-only coverage under Plan B, and $3,500 (27 percent of the premium) for each employee electing family coverage under Plan B. ABC's contributions of 60 percent (or $3,000) of the premiums for self-only coverage and the same dollar amounts toward the premium for family coverage under Plan A, and of 50 percent (or $3,500) of the premium for self-only of coverage and the same dollar amount toward the premium for family coverage under Plan B, satisfy the uniform percentage requirement on a QHP-by-QHP basis; therefore, ABC's contributions to both plans satisfy the uniform percentage requirement.

Parker Tax Publishing Staff Writers

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