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The Ins & Outs of the Health Insurance Tax Credit

Selecting the right health insurance is consistently cited as one of the most difficult decisions for a business to make. Small businesses, in particular, often feel like health insurance plans aren’t built to support their needs. And sadly, with the coronavirus pandemic still influencing workers’ health care decisions, companies with sub-par plans are losing out in the labor market.

Fortunately, there are a few health insurance tax incentives available to small businesses that can make health insurance more affordable.

Small Business Health Care Tax Credit

Small businesses may be eligible for a health insurance tax credit worth up to 50% of premiums.

The small business health care tax credit is only available to businesses that purchase health coverage through the Small Business Health Options Program (SHOP). But if you qualify, this credit can temporarily reduce the cost of your insurance plan, making it easier for you to establish a quality plan for your employees.

The credit returns up to 50% of premiums you pay (or up to 35% of premiums for tax-exempt employers) for two consecutive years. Here’s how you can qualify:

• You offer SHOP coverage to all full-time employees. Employees reach full-time status if they work 2,080 hours per year, which averages to 40 hours a week.
• You have fewer than 25 full-time equivalent employees (FTEs). You’ll receive the largest credit if you have fewer than 10 FTEs. Calculating FTEs can get a bit confusing, but here are a few things to keep in mind:
  • Any number of employees can work a combined number of hours to reach the 2,080 full-time threshold. For example, if you have three part-time employees who each work 700 hours per year, they together count as one FTE.
  • Sole proprietors, partners, S corporation shareholders owning 2%+ of the business and C corporation shareholders owning 5%+ of the business (and family members of these owners) do not count as employees for purposes of the credit.
  • Generally, seasonal workers don’t count as FTEs, but part-time employees and leased employees do.
• You pay at least 50% of all employees’ health care premiums. The percentage you cover must be at least 50% for all employees. You cannot pay for 80% of the premiums for one class of employees and 20% for another class to get to that 50% threshold.
• Your average employee salary is $57,400 or less (in 2022). You’ll receive the largest credit if your average annual wages are $28,700 or less (in 2022).

How Is the Health Insurance Tax Credit Calculated?

The small business health care tax credit calculation is fairly straightforward:

[Premiums Paid by Employer]   X   50%*   =   [Credit]

*35% for nonprofit organizations

To claim the full credit in 2022, your small business must have 10 or fewer FTEs with an average salary of $28,700 or less. As FTEs rise and/or as average salaries rise, the credit phases out. The credit will be phased out completely if FTEs are greater than 25 or if average annual wages exceed $57,400.

The credit — which you should calculate and report on Form 8941 — is nonrefundable for for-profit entities, but businesses can carry unused credits forward to offset income in future tax years.

Health Insurance Tax Deduction

Businesses that are ineligible for the small business health care tax credit (or businesses that have already claimed the credit for two years) aren’t out of luck; they can still deduct the cost of health insurance on their tax returns. Typically, as long as the expenses are ordinary and necessary for your business, you can deduct all your health care costs.

In addition to the insurance premiums you pay on behalf of your employees, the following health care costs are deductible:

• Administrative costs of sponsoring a health plan
• Contributions you make to your employees’ HSAs or FSAs
• The cost of health reimbursement arrangements (HRAs)
• The cost of medical reimbursement programs that help employees purchase health insurance coverage elsewhere

There is one major caveat, though: you can’t deduct the full cost of health insurance premiums if you are also claiming the small business health care tax credit.

The IRS doesn’t want you “double dipping” by taking both a deduction and a credit for the same expenses. Instead, you should reduce your deduction by the amount of your health insurance tax credit. This lets you deduct the remaining health care costs you incurred.

When selecting either the deduction or the credit, you should almost always choose the credit. The credit returns 50% of the costs back to you while a deduction merely reduces your tax base. If you are in the highest marginal tax bracket, your deduction will save you only 37%. If you’re still not sure, talk to a tax advisor. If your advisor uses a quality tax planning software, they can show you exactly how the credit will impact your taxable income, and together you can decide whether the deduction or credit is best.

Tax Planning for Small Business Health Care

Health care decisions are never easy to make, and even though taxes are only one piece of the puzzle, talking with a tax advisor can help you see your options more clearly. Reach out to a tax planner today if you want to learn more about the small business health care tax credit.