As a small business owner, keeping overhead low is usually the goal, and health insurance is often one of the highest costs on that list. But offering good coverage to your employees shouldn't feel like it's working against you. Wouldn't it be nice to get a tax break for doing right by them? Through the Small Business Health Care Tax Credit, eligible businesses can do exactly that.

The Small Business Health Care Tax Credit is a non-refundable tax credit for for-profit businesses (refundable for tax-exempt organizations) that provides a financial incentive for eligible employers who offer health insurance coverage to their employees. This means that the credit can reduce a for-profit’s tax liability to zero, but no excess is refundable, unlike a tax-exempt organization, which can receive the credit as a direct refund.

Designed to help offset the cost of providing employee health coverage, this tax credit applies to for-profit businesses and tax-exempt organizations that meet specific requirements. The tax credit can be claimed up to twice.

To qualify for the credit, an employer must meet specific criteria. To qualify for partial credit, the business must have no more than 25 full-time equivalent (“FTE”) employees and must pay average annual wages below a ceiling that the IRS adjusts for inflation each year, with the 2026 ceiling being $68,200. Only employers with 10 or fewer FTE’s and average annual wages of $34,100 can qualify for the full credit, which can be up to 50% of premiums paid.

In addition to meeting the size and wage requirements, the employer must offer a qualified health plan through a Small Business Health Options Program (“SHOP”) Marketplace or qualify for a limited exception to this requirement. At least 50% of the cost of employee-only health care coverage must be paid by the employer. Accessing SHOP plans can be challenging, depending on the state, as some states operate their own SHOP programs while others rely on the federal marketplace.

The credit provides a maximum of 50% of premiums paid for small business employers and 35% for small tax-exempt employers and is available for two consecutive taxable years. One limitation is easy to overlook. The credit is computed on the lesser of the premiums actually paid or the average premium for the small group market in the applicable rating area, so a generous plan does not automatically yield a larger credit. This could mean that a qualifying employer with 10 FTE’s that paid $25,000 in premiums could qualify for a credit of $12,500, whereas a similarly situated small tax-exempt employer could receive a credit of $8,750.

The credit also phases out on a sliding scale based on two factors, the number of FTE employees and the average wages paid. The reduction does not begin at 25 FTEs. It begins once the employer exceeds 10 FTEs and separately once average annual wages exceed half the ceiling described above.

The two-year credit period is not a window that closes on its own. It begins with the first taxable year in which the employer files an income tax return with Form 8941 attached, so an employer that has never claimed the credit still has both years ahead of it.

Another example is that if a small business pays $50,000 per year in employee health insurance premiums, it could receive the maximum 50% credit, resulting in $25,000 in annual savings and $50,000 over two years. A small tax-exempt employer paying the same amount could receive the maximum 35% credit, for $17,500 per year and $35,000 over two years. These examples assume the business qualified for the full credit under the sliding scale, which reduces the credit once the employer passes 10 FTEs or exceeds the average wage trigger described above. Even if a business does not reach the maximum, it can still receive a meaningful partial credit, helping offset health insurance costs significantly.

Claiming the Credit

Even businesses that do not owe tax during the year can benefit. As part of the general business credit, an unused credit can generally be carried back one year and forward up to 20 years. Additionally, since the amount of premium payments is usually more than the credit, the portion of the premiums not covered by the credit can be claimed as a business expense deduction, because the deduction is denied only to the extent of the credit claimed. This allows eligible employers to benefit from both a credit and a deduction. A credit directly reduces the amount of tax owed, providing a dollar-for-dollar decrease in liability, while a deduction lowers the amount of taxable income, indirectly reducing tax owed.

Tax-exempt employers may also be eligible for a refundable credit, provided it does not exceed the total of the income tax withheld from employee wages plus both the employee and employer shares of Medicare tax. Refunds are subject to sequestration, which reduces the refundable portion by a rate reset each federal fiscal year, 5.7% in recent years.

The credit can be claimed retroactively, and an amended return may be filed if it was not previously claimed. However, it is important to note that there are limitations on refund claims. Generally, a claim must be filed within three years from the time the return was filed or within two years from when the tax was paid, whichever is later. If no return was filed, the claim must be made within two years from the time the tax was paid.

When calculating full-time equivalent employees for the purpose of the credit, all employees who perform services for the employer during the tax year are considered, except for certain individuals. These excluded individuals include the owner of a sole proprietorship, a partner in a partnership, a shareholder owning more than 2% of an S corporation, an owner holding more than 5% of the business, and certain family members of those individuals. One FTE is based on 2,080 hours per year. Any hours exceeding that amount are excluded from the calculation. Seasonal employees who work 120 or fewer days during the year are not included in the count of FTEs or in the calculation of average annual wages, though premiums paid on their behalf may still be used in determining the total credit amount.

For example, a small business employs 10 workers during the year. One of them owns more than 5% of the business and is therefore excluded from the FTE count. The remaining 9 employees each worked 2,000 hours, totaling 18,000 hours. Dividing 18,000 by 2,080 hours (the standard for one FTE) results in approximately 8.65 FTEs. Additionally, the business hired two seasonal workers who each worked 100 days; they are not included in the FTE count, but the premiums paid for their coverage can still be used when calculating the total credit.

To determine average annual wages, total wages paid during the year are divided by the number of FTEs. By continuing the example above, assume the same business paid a total of $260,000 in wages to the 9 eligible employees during the year. To determine the average annual wage, the total wages of $260,000 are divided by the 8.65 FTE employees, resulting in approximately $30,058, which is then rounded down to the nearest $1,000, giving an average annual wage of $30,000. This figure is used to assess eligibility and to calculate the amount of the Small Business Health Care Tax Credit.

Employers must use Form 8941, Credit for Small Employer Health Insurance Premiums, to calculate the credit. Small businesses claim the credit as part of the general business credit on their income tax return. Eligible tax-exempt organizations must report the credit in Part III of Form 990-T, Exempt Organization Business Income Tax Return, on the line designated by the instructions for that year, since the IRS renumbers these lines from time to time. Filing Form 990-T is required to claim the credit, even for organizations that are not otherwise required to file the form.

The Section 125 “Double-Dip” Exclusion

A Section 125 cafeteria plan is an employer-sponsored benefit program that allows employees to choose from a list of qualified, nontaxable benefits instead of receiving their full compensation as taxable income. These plans provide benefits on a pre-tax basis. However, when calculating the Small Business Health Care Tax Credit, remember that any premiums paid by employees through a Section 125 cafeteria plan are excluded from the calculation. The reason is that these amounts are already exempt from federal income and payroll taxes; therefore, the IRS does not allow them to be counted again as a credit to prevent “double dipping.” Only the “employer-paid” portion of the premium, the amount paid out of the employer’s pocket, qualifies.

Benefits to Employers

The Small Business Health Care Tax Credit can be particularly beneficial for employers, many of whom operate small businesses. Salons, spas, and other beauty businesses often employ a mix of full-time, part-time, and seasonal staff, making them strong candidates for this tax credit.

Employers who operate as sole proprietors or own a majority share in the business would be excluded from the FTE count, but their employees would still qualify. Even though seasonal employees hired during busy periods may not count against the FTE limit, premiums paid for their coverage can still contribute to the total credit calculation.

An employer that runs a Section 125 cafeteria plan is not disqualified from the credit. What the rules exclude is the employee salary reduction portion of the premium, which is treated as an employee contribution and is already exempt from federal income and payroll taxes. The employer’s own contributions still count.

By claiming this credit, employers can reduce the financial burden of offering group health coverage, potentially saving thousands of dollars over a two-year period.

Employers interested in how to take advantage of this credit can book a complimentary 30-minute consultation online at AzarvandTaxLaw.com or by sending us an email at Info@AzarvandTaxLaw.com.