Understanding the Small-Business Health Care Tax Credit

Running a business is expensive, especially when you start adding in employee health care costs. The good news is that some of these costs can actually wind up lowering your overall business tax bill.

The government offers an incentive to help small-business owners manage the costs of contributing to an employee health insurance plan: the small-business health care tax credit.

The small-business health care tax credit has some restrictions and confusing calculations, but this guide will walk you through everything you need to know.

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The small-business health care tax credit is a credit available to small businesses to help offset the cost of health care premiums they pay for their employees. To qualify, small businesses must offer a qualified health plan to their employees through the Small-Business Health Options Program Marketplace (SHOP), pay at least 50% of the cost, and have fewer than 25 full-time equivalent employees with an average salary less than $55,000. To claim this credit, you will file Form 8941 with your business tax return.

But this isn’t a tax credit that you can claim year after year — you can claim this tax credit for two years in a row and that’s it.

Before you can claim the small-business health care tax credit, there are a few strict requirements you need to meet:

Fewer than 25 full-time equivalent employees

For this tax credit, a small business is defined as one with fewer than 25 full-time equivalent employees (FTE). The IRS considers one FTE to be someone who works at least 2,080 hours per year.

Figuring out how many full-time equivalent employees you have is easy if you only have full-time employees. Things get complicated if you have part-time employees. Multiple part-time employees can be combined and counted as a full-time employee. For example, two employees working half-time would count as one full-time employee.

The IRS gives examples of exactly how to calculate your FTEs if you have part-time employees in your workforce. We'll provide more information on how to calculate a full-time equivalent employee in the next section.

Average salary of less than $55,000

To qualify for the small-business health care tax credit, the average annual wages that you pay for the year must be less than $55,000 per full-time equivalent employee.

To calculate the average wage, you’ll take the total wages paid to full-time equivalent employees and divide by the number of employees. For example, if you paid total wages of $320,000 and you have eight full-time equivalent employees, the average wage paid to employees is $40,000.

Qualifying health care premiums

You also need to pay for a portion of your employees’ health care plans to receive this credit. You’ll need to offer a qualified health care plan to employees from the Small-Business Health Options Program Marketplace (SHOP) and pay a uniform percentage of the cost of at least 50%.

If you offer family health care plans, you don’t need to pay 50% of the family plan to qualify — you just need to pay at least 50% of the employee-only premium costs.

When you have a workforce of part-time employees, figuring out how many full-time equivalent employees you have makes things a little complicated.

If you have part-time employees, the first step is to calculate how many hours each part-time employee works. There are three ways you can do this:

1. Actual hours worked: Track the actual amount of hours an employee works, including holiday, vacation and sick time.

2. Days worked: Count each day an employee works as eight hours of service. For example, if an employee works for 150 days per year, that’s 1,200 hours (150 days x 8 hours per day).

3. Weeks worked: This method assumes a work week is 40 hours per week and the calculation works the same way as the days-worked equivalency method. If an employee works 45 weeks per year and took seven weeks off without pay, that would be counted as 1,800 hours worked in a year.

Once you know how many hours each part-time employee works, you’ll use this to calculate how many FTEs you have. For example, using the actual hours worked, you have four employees working 30 hours per week, 52 weeks per year. To calculate how many full-time equivalent employees that is, you’d calculate:

4 employees x 30 hours per week x 52 weeks per year = 6,240 hours

6,240 / 2080 = 3 full-time equivalent employees

Your four part-time employees count as three full-time equivalent employees for this tax credit.

Owners and family members don’t qualify

There is a notable exception to counting full-time equivalent employees. Owners and their family members don’t count as FTEs. This includes:

• An owner of a sole proprietorship.

• A partner in a partnership.

• An S-corporation shareholder who owns more than 2%.

• An owner who owns more than 5% of the business.

Family members of the owner who don’t qualify as full-time equivalent employees include spouses, children, grandchildren, siblings or step-siblings, parents, step-parents, nieces and nephews, aunts and uncles, son or daughters-in-law and mother or fathers-in-law. Plus any spouses of these family members also wouldn’t be included in the full-time equivalent employee calculation. Pretty much anyone who might be related to an owner can’t be included.

You also can’t include premiums paid for the owner or family member’s health insurance toward the credit. But don’t worry, the premiums paid can still be tax-deductible.

There’s a lot of work that goes into calculating this health care small-business tax credit. How much is it actually worth? For some small businesses, it can mean significant savings.

The credit will be most valuable for small businesses that have fewer than 10 full-time equivalent employees with an average salary of less than $27,000 or less — this would qualify for the maximum tax credit of 50% of the premiums paid. That percentage will begin to phase out based on the number of FTEs and the average salaries paid.

For small tax-exempt employers, the maximum credit is 35% of premiums paid.

Credit limitations

To qualify for the maximum credit, you’ll need to have less than 10 full-time equivalent employees who are paid an average of $27,000 or less. The credit is phased out until you reach 25 employees or an average salary of greater than $55,000. After that threshold, you won’t be eligible for the tax credit.

Your tax credit is also limited by the average premiums in the employer’s small group market, published by the Department of Health and Human Services. For example, even if you pay more in premiums, your deduction will be limited by the average premiums.

For example, say the premium for an employee-only health care plan is $6,000 per year and you pay 50%, or $3,000. The average premium in your small group market is $5,000. You’ll be limited to a credit of 50% of the average premium in your small group market, or $2,500.

When to claim

If you don’t owe anything in taxes, you can still take advantage of this tax credit. The credit isn’t limited by how much you owe in taxes for the year. If you don’t have any taxable income for the year, the credit can be carried forward or backward.

Claiming a credit and deduction

If you want to also take a health care-related tax deduction, know that you can take both a deduction and a credit for health insurance premiums paid. However, the deduction will be reduced by the credit taken.

The small-business health care tax credit can be claimed using Form 8941. The form is then attached to your business tax return and will reduce any tax that is owed. Remember, the credit can only be claimed for two consecutive tax years. If you’re unsure whether you qualify or how to claim this credit, consult your CPA or other tax professional to help you through the process.

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