One of the main objectives of President Obama’s health care reform law (the “Affordable Care Act”) is universal coverage. The Act contains several provisions to achieve this goal. One of them is a new tax credit that will help small businesses and small tax-exempt organizations afford the cost of providing health insurance for their employees. The credit is up to 25 percent of the cost of health insurance premiums paid by a qualifying employer for its employees.
Many church leaders are confused by this provision. After all, how will a tax credit (a reduction in taxes) benefit churches that pay no taxes? In fact, the credit does benefit tax-exempt entities because the law makes it “refundable,” meaning that it is payable in cash. It is important for church leaders to become familiar with this credit, since it will help many churches afford the cost of health care coverage for their employees.
Church leaders also need to understand that the deadline for claiming the credit for 2010 is May 15, 2011.
The new credit is specifically targeted for those employers with low- and moderate- income workers, and it is designed to encourage small employers to offer health insurance coverage for the first time or maintain coverage they already have. In general, the credit is available to small employers that pay at least half the cost of single coverage for their employees.
This article will explain the credit, and its application to churches.
1. eligible employers
In order for a church to qualify for the credit, it must meet the following three requirements:
- it must have fewer than 25 “full-time equivalent” employees (FTEs) for the tax year;
- the average annual wages of its employees for the year is less than $50,000 per FTE; and
- it pays premiums for health insurance coverage under a “qualifying arrangement.”
As noted later in this article, the credit is phased out for churches having more than 10 FTEs (but fewer than 25 FTEs) for the tax year, or average annual wages of more than $25,000 (but less than $50,000).
The terms FTE, average annual wages, and qualifying arrangement are defined below.
2. figuring FTEs and average annual wages
The number of a church’s FTEs is determined by dividing the total hours of service for which a church pays wages to employees during the year (but not more than 2,080 hours for any employee) by 2,080.
An employee’s hours of service for a year include each hour for which an employee is paid for the performance of duties for the church during the year and each hour of paid leave. To calculate the total number of hours of service which must be taken into account for an employee for the year, a church may use any of the following methods:
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- determine actual hours of service from records of hours worked and hours for which payment is made or due, including hours for paid leave;
- use a days-worked equivalency whereby the employee is credited with 8 hours of service for each day for which the employee would be required to be credited with at least 1 hour of service under Method 1; or
- use a weeks-worked equivalency whereby the employee is credited with 40 hours of service for each week for which the employee would be required to be credited with at least 1 hour of service under Method 1.
The amount of average annual wages is determined by first dividing the total wages paid by the church during the year by the number of its FTEs for the year. The result is then rounded down to the nearest $1,000. Only wages that are paid for hours of service are taken into account. Wages for this purpose means wages subject to Social Security and Medicare tax withholding.
3. calculating the credit
Only premiums paid by a church under a “qualifying arrangement” are counted in calculating the credit. Under a qualifying arrangement, the church pays premiums for each employee enrolled in health care coverage in an amount equal to a uniform percentage (not less than 50 percent) of the premium cost of the coverage. However, a qualifying arrangement also includes an arrangement under which the employer pays at least 50 percent of the premium cost for single (employee-only) coverage for each employee enrolled in any health insurance coverage offered by the employer.
For tax years beginning in 2010 through 2013, only premiums paid to a health insurance provider for health care coverage are counted for purposes of the credit. A health insurance provider is either an insurance company or another entity licensed under state law to provide health insurance coverage. The IRS has clarified that the term health insurance provider also includes “an arrangement under which an otherwise qualifying small church employer pays premiums for employees who receive medical care coverage under a church welfare benefit plan.” As a result, premiums paid to many denominational health plans will be counted for purposes of the credit.
Premiums for health care coverage that covers a wide variety of conditions, such as a major medical plan, are counted, and premiums for certain coverage that is more limited in scope, such as limited scope dental or vision coverage, are also counted. However, if an employer offers more than one type of coverage, such as a major medical plan and a separate limited scope dental or vision plan, the employer must separately satisfy the requirements for a qualifying arrangement with respect to each type of coverage the employer offers (meaning the employer cannot aggregate these different plans for purposes of meeting the qualifying arrangement requirement).
Key Point. Employer contributions to health reimbursement arrangements (HRAs), health flexible spending arrangements (FSAs), and health savings accounts (HSAs) are not taken into account for purposes of the small business health care tax credit.
If a church pays only a portion of the premiums for the coverage provided to employees under the arrangement, with employees paying the rest, the amount of premiums counted in calculating the credit is only the portion paid by the church. For purposes of the credit, including the requirement to make a uniform contribution of not less than 50 percent of the premium, any premium paid pursuant to a salary reduction arrangement under a section 125 cafeteria plan is not treated as paid by the church. For example, if a church pays 80 percent of the premiums for employees’ coverage, with employees paying the other 20 percent pursuant to a salary reduction arrangement under a cafeteria plan, only the 80 percent premium amount paid by the church counts in calculating the credit.
In addition, the amount of a church’s premium payments that counts for purposes of the credit is capped by the premium payments it would have made under the same arrangement if the average premium for the small group market in the state in which the church offers coverage were substituted for the actual premium. The average premium is determined by the Department of Health and Human Services (HHS). See the instructions to IRS form 8941 for a listing of average premiums by state.
4. maximum credit amount
For tax years beginning in 2010 through 2013, the maximum refundable credit for a church or other tax-exempt qualified employer is 25 percent of the employer’s health insurance premium expenses that count towards the credit. However, for churches and other tax-exempt organizations, the refundable credit is limited to the amount of their “payroll taxes” for the year. For this purpose, payroll taxes of an employer mean:
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- the amount of income taxes “required to be withheld” from employees’ wages under section 3401(a) of the tax code;
- Medicare taxes the employer was required to withhold from employees’ wages; and
- Medicare taxes the employer was required to pay for the year.
Key Point. Section 3401(a) of the tax code states that churches are not required to withhold income taxes from the wages of ministers with respect to services performed in the exercise of ministry. Ministers use the quarterly estimated tax procedure to pay their in- come taxes and self-employment taxes. However, ministers may elect to have these taxes withheld by their employing church under a “voluntary withholding” arrangement. Do the income taxes withheld by a church under such an arrangement constitute “amounts required to be withheld”? If so, they will increase the amount of the refundable credit. Unfortunately, the answer is not clear. Logically, a voluntary withholding arrangement would not alter the fact that section 3401(a) does not “require” that income taxes be withheld from ministers’ wages, and if this interpretation is correct, then a church would not include income taxes voluntarily withheld from ministers’ wages in computing the maximum refundable credit amount. Church leaders should consult with a tax professional for guidance on this question, and study future issues of this newsletter for further clarifications as they become available.
One more point. If it turns out that the IRS will treat voluntarily withheld income taxes of ministers as income taxes “required to be withheld” (thereby decreasing the refundable credit amount), then churches that have entered into voluntary withholding arrangements with one or more ministers should re-evaluate these arrangements in light of their negative impact on the amount of the refundable credit.
5. reducing the credit
The maximum credit goes to smaller employers—those with 10 or fewer full- time equivalent (FTE) employees—paying annual average wages of $25,000 or less. The credit is completely phased out for employers that have 25 or more FTEs or that pay average wages of $50,000 or more per year. Because the eligibility rules are based in part on the number of FTEs, not the number of employees, employers that use part-time workers may qualify even if they employ more than 25 individuals.
How is the credit reduced if the number of FTEs exceeds 10 or the average annual wages exceed $25,000? If the number of FTEs exceeds 10 or if the average annual wages exceeds $25,000, the amount of the credit is reduced as follows:
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- 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 the average annual wages exceeds $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 exceeds $25,000 and the denominator of which is $25,000.
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In both cases, the result of the calculation is subtracted from the otherwise applicable credit to determine the credit to which the employer is entitled. For an employer with both more than 10 FTEs and average annual wages exceeding $25,000, the reduction in the credit amount is equal to the sum of the amount of the two reductions. 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.
Example. A church has 2 ministers and 5 lay employees. All 7 workers are treated as employees for income tax purposes by the church. The ministers’ combined wages are $85,000, and the lay employees’ combined wages are $130,000. The church pays $75,000 in health care costs for its 7 employees. For 2010, it is eligible for a partial small business health care credit. The 2 ministers are taken into account in determining the church’s FTEs for purposes of the health care tax credit. But, compensation paid to ministers for duties performed in the exercise of their ministry is not subject to FICA taxes and therefore are not taken into account for purposes of computing average annual wages. Therefore, the church’s average annual wages is $130,000/7 or $18,571. Since this is less than $25,000, the church is entitled to a full refundable credit, computed by multiplying 25 percent times health care expenditures of $75,000 ($18,750). Note that if the ministers’ wages were included in computing average annual wages, the church would not be eligible for any credit since its annual average wages would be more than $25,000.
Example. A church has 29 full-time equivalent employees, consisting of 6 ministers and 23 lay employees. The ministers’ wages are not considered in computing the church’s average annual wages for purposes of the small employer health care tax credit since they are not subject to Social Security and Medicare withholding (ministers are self-employed for Social Security with respect to compensation received for ministerial services). But, ministers are counted in computing FTEs, and so the church’s total workforce consists of 29 FTEs. Since this exceeds 25, the church is not eligible for the credit. This illustrates the purpose of the credit—to assist small employers in providing health coverage for their employees.
6. how to claim the credit
Small businesses can claim the credit for 2010 through 2013 and for any two years after that. For tax years 2010 to 2013, the maximum credit is 25 percent of premiums paid by eligible tax-exempt organizations. Beginning in 2014, the maximum tax credit will increase to 35 percent of premiums paid by eligible tax-exempt organizations.
Key Point. The deadline for claiming the credit for 2010 is May 15, 2011.
Tax-exempt organizations use Form 8941 to figure their refundable credit, and then claim the credit on Line 44f of Form 990-T. Though primarily filed by those organizations liable for the tax on unrelated business income, Form 990-T will also be used by any eligible tax-exempt organization to claim the credit, regardless of whether they are subject to this tax. Form 990-T has been revised for the 2011 filing season to enable eligible tax-exempt organizations to claim the health care tax credit.
Note that qualifying tax-exempt employers (including churches) having no taxable income to be offset with a tax credit will claim a “refundable” tax credit, meaning that the amount of the credit that would otherwise have offset taxable income is refunded to them.
Caution. In January 2011 a federal district court judge in Florida declared the entire Affordable Healthcare Act unconstitutional. The judge ruled that the requirement that American citizens obtain health insurance, with criminal penalties for noncompliance, exceeded the constitutional authority of Congress. And, given the centrality of this provision to the Act’s purposes, the judge ruled that the entire Act was unconstitutional. That ruling is on appeal. Ultimately, the United States Supreme Court may determine the law’s validity. For now, it is important to recognize that there is some doubt as to the continuing availability of the health insurance tax credit.
What about ministers?
Note the following two points regarding the treatment of ministers for purposes of the health insurance tax credit:
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- If a minister is an employee under the so-called “common law employee test,” he or she is taken into account in determining an employer’s FTEs for purposes of the health care tax credit. Also, premiums paid by the church for the health insurance coverage of a minister who is an employee can be taken into account in computing the credit, subject to limitations on the credit. If the minister is self-employed for income tax reporting purposes, then he or she is not taken into account in determining an employer’s FTEs or premiums paid.
- Compensation paid to ministers who are employees for duties performed in the exercise of their ministry is not subject to FICA taxes and is not wages subject to income tax withholding. As a result, their wages are not be taken into account for purposes of computing average annual wages.
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The fact that ministers are taken into account in determining a church’s FTE count, but their wages are not considered in computing the average annual wages paid by a church, makes it more likely that some churches will benefit from the credit since the generally higher wages paid to ministers are removed from consideration.
See chapter 2 in Richard Hammar’s 2011 Church & Clergy Tax Guide for a full explanation of the common law employee test. This is one of the tests used by the IRS and the courts in determining a minister’s reporting status for federal income tax reporting purposes.
This article first appeared in Church Finance Today, May 2011.