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JANUARY 14, 2011

Small Business Tax Credits



The Affordable Care Act offers incentives so that more of these companies will help provide their employees with health insurance.

What's the issue?

Small businesses frequently face steep premiums for health insurance coverage and, as a result, their workers are more likely to be uninsured than those who work for larger companies. Various provisions of the Affordable Care Act are intended to address the problem. The most targeted effort now in effect is a federal tax credit that will offset up to half of the premium costs for small businesses.

The federal government has notified 4 million companies that they may be eligible for the credit. The Congressional Budget Office estimates that the tax credits will reduce tax payments for small employers by $40 billion over the 10 years between 2010 and 2019. This brief describes the tax credit, issues related to its implementation, and some other provisions of the law that may help to expand coverage for workers employed by small businesses.

What's the background?

In the United States, most workers obtain health insurance through their employers, but companies are not required to offer coverage. Small businesses in particular are less likely to offer health insurance than are large firms (Exhibit 1). According to a recent report by the Commonwealth Fund, one-third of working adults were employed by companies having fewer than 50 employees in 2007 (the most recent year available). During that year, 36 percent of employees at these smaller firms were uninsured, compared to 15 percent of employees at larger firms.

Exhibit 1
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Part of the reason for the disparity is a significant difference in insurance costs per enrollee for small groups, compared to the larger groups of employees insured by bigger companies. On average, small firms pay up to 18 percent more in premiums than do large firms for the same health insurance coverage.

WHY COSTS DIFFER: The difference stems from several factors. First, insurers charge smaller companies higher administrative costs for health coverage, because small companies typically buy through insurance agents who are paid by the insurer, whereas larger companies often deal with insurers directly. In addition, many states permit "medical underwriting" for small companies--that is, adjusting the amount of the premium charged based on the medical history of the company's workers. This underwriting process adds to administrative costs.

Finally, where medical underwriting is used, premiums can vary significantly across otherwise-similar small firms, based on the health status of their workers, and may be unaffordable for companies with sicker workers. This is because the average rate of use of health care varies more widely across smaller groups than across larger groups. In contrast, insurers don't medically underwrite larger groups, since the risk that any one individual is or could become sick can be more evenly spread across all members of the larger pool.

Another reason that premiums for some smaller firms can be high is that, even where medical underwriting is prohibited, most states currently allow insurers to use specific individual characteristics--including age and gender--to predict future costs for each small group. Thus, employer groups with sicker, older, or more female employees are likely to face higher premiums. Despite the higher cost, coverage offered by small employers is often less comprehensive than that offered by larger employers. Only 48 percent of workers at small companies were considered adequately insured compared to 73 percent at companies with 50 or more employees, according to the Commonwealth Fund.

What's In The Law?

The Affordable Care Act will reform the health insurance market by limiting or eliminating many practices that create barriers to obtaining coverage. In particular, effective in 2014, both medical underwriting and gender rating will be prohibited, and premium variation based on age will be limited. The law will also make it easier for individuals and small firms to buy coverage through state-run insurance exchanges, and will give purchasers more information about their coverage options.

In addition, insurance market reforms mandated by the Affordable Care Act improve coverage for individuals and small groups. These include prohibitions on lifetime benefit caps and rescissions, a phased-in ban on annual limits, annual review of premium increases, and limits on the share of premiums spent on nonmedical costs. (See the Health Policy Brief published November 24, 2010, for more information.)

TAX CREDITS: The Affordable Care Act also includes a new federal income tax credit for health coverage targeted to small businesses with fewer than 25 employees, or those with enough part-time workers to constitute fewer than 25 “full-time equivalents.” Here is how it works:

Starting in 2010, employers with 10 or fewer full-time employees (or full-time equivalents) that have average wages of up to $25,000 are eligible for the maximum credit of 35 percent of the amount the company contributes toward insurance premiums (25 percent for tax-exempt employers).

The tax credit offsets a portion of the employer’s federal income tax liability for the year. Tax-exempt employers receive the credit as a refund, with the proviso that the refund cannot exceed the amount of federal income tax and Medicare payroll tax that the employer withholds from the employees’ wages, plus the Medicare tax paid by the employer.

The tax credit decreases as the number of employees approaches 25 and as average annual wages approach $50,000.

To qualify for the credit, an employer must pay at least half the premium for each employee. The percentage paid by the employer should generally be uniform for all employees, although special provisions will apply when a small employer offers its workers a choice of health plans. Since the law was enacted in March 2010, and employers may not have had time to adjust their policies, the Internal Revenue Service (IRS) in 2010 allowed employers who paid at least half the premium to qualify, even if the percentage of premium paid was not uniform across their entire work force.

From 2014 on, the maximum credit will increase to 50 percent (35 percent for tax-exempt employers). However, coverage will have to be purchased through one of the new state-based health insurance exchanges. The credit will only be available to any employer for two consecutive tax years after 2013. Exhibit 2 shows how the tax credit would reduce the employer’s health insurance contribution.

Exhibit 2
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There are a number of complexities involved in determining how many workers a small business has. The IRS will allow companies different options, as follows:

Small firms may count the actual number of hours per week that their employees work, or may estimate the number of full-time workers based on number of days or weeks worked.

Part-time workers are included in the calculation, but not company owners or their family members.

HEALTH INSURANCE EXCHANGES: By 2014, states are required to establish Small Business Health Options Program (SHOP) exchanges that will help companies with fewer than 100 employees to purchase health insurance. States may choose to combine the SHOP exchanges with a separately required exchange for individuals. Prior to 2016, states may also choose to limit the SHOP exchanges to employers with fewer than 50 workers.

If individuals and families are not offered employer-sponsored coverage from the firms they work for, they may buy subsidized coverage through the individual exchanges. Subsidies will be available to those whose income is between 133 percent and 400 percent of the federal poverty level, which in 2010 is $22,050 for a family of four. Since larger companies and firms with higher average salaries are more likely to already offer their employees health insurance, a significant portion of those benefiting from the subsidies are likely to be employees at small businesses.

What's the debate?

The small employer tax credit, along with many other aspects of the Affordable Care Act, has been a subject of some debate. Supporters of the program argue that it is targeted to companies that are the least likely to offer coverage and that have seen the greatest decline in coverage since 2000. Supporters contend that the credit will help keep companies from dropping coverage or reducing benefits and could allow firms to make salary improvements that they would not otherwise make.

Critics, on the other hand, say that the tax credit program is too complicated and too limited in scope and will primarily help companies that are already offering coverage. They argue that the credit could actually provide a disincentive to hire new workers for companies on the edge of qualifying for the program since going from 24 to 25 employees or more means the employer will no longer qualify for the credit. Although the program is often cited as a benefit to small business, critics contend that it will do little to address rising health care costs, a prime concern of small business owners.

The effects of the tax credit are uncertain. Estimates performed for the Commonwealth Fund by researchers at the Massachusetts Institute of Technology are that 16.6 million employees work at small businesses that are eligible for the credit. However, because the value of the tax credits is relatively modest, they may only incentivize firms that employ about 3.4 million of those workers--or about 1 in 5 workers in eligible firms--to take up the credit between 2010 and 2013. The researchers did not estimate what could happen from 2014 on, when the value of the credit rises to 50 percent of a firm's contributions toward insurance premiums.

To some degree, the direct impact of the health reform law on small businesses will be difficult to isolate from other changes to health coverage and premiums. For example, recently, the percentage of very small firms that offer health coverage to their workers has jumped from 46 percent in 2009 to 59 percent in 2010. Some supporters of the Affordable Care Act suggest that the increase is attributable to the new small business tax credits. Other observers explain the increase by hypothesizing that companies in this category that did not offer benefits were more likely to fail and, having done so, were no longer included in the data.

What's next?

Eligible companies will begin claiming the credit for 2010 premiums when they file tax returns due in the spring of 2011. As they assume control of the House of Representatives in 2011, Republicans have pledged to seek changes to or repeal the health care law. Legislative activity in the House may target provisions disliked by the business community, although the small business tax credit is not likely to be among them.

Resources

Andrews, Michelle, “Health Care Tax Credit Comes with Benefits, Strings for Small Businesses,” Kaiser Health News, June 1, 2010.

Claxton, Gary, Bianca DiJulio, Heidi Whitmore, Jeremy D. Pickreign, Megan McHugh, Awo Osei-Anto, et al, “Health Benefits In 2010: Premiums Rise Modestly, Workers Pay More Toward Coverage,” Health Affairs 29, no. 10 (2010): 1942-50.

Collins, Sara R., Karen Davis, Jennifer L. Nicholson, and Kristof Stremikis, “Realizing Health Reform’s Potential: Small Businesses and the Affordable Care Act of 2010,” The Commonwealth Fund, September 2, 2010.

Congressional Budget Office, Letter to Sen. Evan Bayh, November 30, 2009.

Families USA and Small Business Majority, “A Helping Hand for Small Business: Health Insurance Tax Credits,” July 2010.

Holahan, John, “The 2007-09 Recession and Health Insurance Coverage,” Health Affairs 30, no. 1 (2011): 145-52.

Internal Revenue Service, “Small Business Health Care Tax Credit: Frequently Asked Questions,” December 3, 2010.

Kaiser Family Foundation, “Health Benefit Offer Rates and Employee Earnings,” Snapshots: Health Care Costs, November 16, 2010.

National Federation of Independent Business, “Will the Small Business Tax Credit Help Small Business Owners Provide Insurance?” April 22, 2010.

About Health Policy Briefs

Written by:
Amanda Cassidy
Principal

Meitheal Health Policy
(Cassidy previously worked for the
Centers for Medicare and Medicaid
Services, in the Office of Legislation
and the Center for Medicare
Management.)

Editorial review by
Ed Neuschler
Senior Program Officer
Institute for Health Policy Solutions

Mark Hall
Professor
School of Law
Wake Forest University

Ted Agres
Senior Editor for Special Content
Health Affairs

Susan Dentzer
Editor-in-Chief
Health Affairs

Health Policy Briefs are produced under a partnership of Health Affairs and the Robert Wood Johnson Foundation.

Cite as:
"Health Policy Brief: Small Business Tax Credits," Health Affairs, January 14, 2011.

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