Small Employer Health Tax Credit: Factors Contributing to Low Use and Complexity
Released: 2012-05-21T00:00:00

Letter

Background

Small Employer Health Insurance Market

Small employers with low-wage employees do not commonly offer health insurance, compared with large employers with low-wage employees, as shown in figure 1.

A combination of factors explains why small, low-wage employers tend not to offer health insurance.

For very low-wage employees, such as minimum wage employees, health insurance drives up total compensation costs for employees.

Low-wage employees working for small employers generally prefer to receive wages over insurance benefits as part of total compensation. On one hand, while employees pay both income and employment tax on wages, employees do not have to pay income or employment taxes on premiums paid by their employers for health insurance. However, for low-wage employees, the income tax exclusion is worth less relative to cash wages than for higher-income employees because low-wage employees may be in a lower income tax bracket.

In general, the federal minimum wage is $7.25 per hour. Many states also have minimum wage laws and minimum wages vary from state to state. are likely to have higher premiums or have less coverage and higher out-of-pocket costs than plans offered to large employers.

IRS Implementation and Requirements for Calculating and Claiming the Credit

IRS’s Small Business and Self-Employed Division (SB/SE) and Tax Exempt and Government Entities Division (TEGE) are primarily responsible for implementing the credit. IRS works with the Department of Health and Human Services (HHS) and the Small Business Administration (SBA) on implementation tasks, such as outreach and communication.

To be eligible, an employer must:

Be a small business or tax-exempt employer located in or having trade or business income in the United States and pay premiums for employee health insurance coverage issued in the United States.

Employ fewer than 25 full-time-equivalent (FTE) employees in the tax year (excluding certain employees, such as business owners and their family members).

Pay average annual wages of less than $50,000 per FTE in the tax year.

Offer health insurance and pay at least 50 percent of the health insurance premium under a “qualifying arrangement.” This means that the employer uniformly pays at least 50 percent of the cost of premiums for enrolled employees, although IRS did develop relaxed criteria for meeting this requirement for tax year 2010.

The President’s fiscal year 2013 budget request contains a proposal for expanding the credit’s eligibility criteria to include employers with 50 or fewer FTEs and removing the uniform contribution requirement.

The amount of the credit that employers can claim depends on several factors. Through 2013, small businesses can receive up to 35 percent and tax-exempt entities can receive up to 25 percent of their base payments for employee health insurance premiums; these portions rise to 50 percent and 35 percent, respectively, starting in 2014. Employers can receive the full credit percentage if they have 10 or fewer FTEs and pay an average of $25,000 or less in annual wages; employers with 11 to 25 FTEs and average wages exceeding $25,000 up to $50,000 are eligible for a partial credit that “phases” out to zero percent of premium payments as the FTE and wage amounts rise. Figure 2 shows the phaseout of the credit for small businesses; the phaseout for tax-exempt entities follows a similar pattern, up to 25 percent of health insurance premiums.

Further, the amount of the credit is limited if the premiums paid by an employer are more than the average premiums determined by HHS for the small group market in the state in which the employer offers insurance. The credit percentage is multiplied by the allowable premium to calculate the dollar amount of credit claimed. For example, in Alabama, the state average premium was $4,441 for a single employee in 2010. If an employer claiming the credit in Alabama paid $5,000 for a single employee’s health premium, the credit would be calculated using the state average premium of $4,441 rather than the actual premium paid. Appendix II shows the average premiums by state.

The proposal in the President’s Budget suggests beginning the phaseout at 21 FTEs, rather than 11, as well as providing for a more gradual combined phaseout for the credit percentages and removing the state market limits.

Employers are to calculate the credit amount on IRS Form 8941, “Credit for Small Employer Health Insurance Premiums.” Small businesses are to claim the credit as part of the general business tax credit (on Form 3800), and use it to offset actual tax liability. If they do not have a federal tax liability, they cannot receive the credit as a refund but may carry the credit forward or back to offset tax liabilities for other years. Credit amounts claimed by partnerships and S corporations are to be passed through to their partners and shareholders, respectively, who may claim their portions of the credit on their individual income tax returns. Tax-exempt entities are to claim the credit on Form 990-T, “Exempt Organization Business Income Tax Return,” and receive the credit as a refund even though the employer has no taxable income.

Employers that claim the credit can also deduct health insurance expenses on their tax returns but must subtract the amount of the credit from the deduction. Employers can claim the credit for up to 6 years—the initial 4 years from 2010 through 2013 and any 2 consecutive years after 2013 if they buy insurance through the Small Business Health Option Programs, which are part of the insurance exchanges to be established under PPACA.

Fewer Small Employers Claimed the Credit Than Were Thought to Be Eligible Because of Factors Such as Credit Size and Complexity

Actual Credit Claims Were Much Lower Than Initial Rough Eligibility Estimates

Fewer small employers claimed the credit for tax year 2010 than were thought to be eligible based on rough estimates of eligible employers made by government agencies and small business groups. IRS data on total claimants, adjusted to account for claims by partners and shareholders, show that about 170,300 small employers made claims for the credit in 2010. (See app. III for adjustments to determine claims filed by employers.) The average credit amount claimed was about $2,700. Limited information is available on the distribution of claim amounts for business entities because IRS focuses its data collection on the taxpayers filing credit claims, who may be partners or shareholders claiming their portions of a business entity’s credit. Appendix III provides additional detail.

Selected estimates, made by government agencies and small business groups, of employers eligible for the credit range from around 1.4 million to 4 million. However, data limitations mean that these estimates are necessarily rough. Based on our review of available data sources on the three basic eligibility rules for the credit—involving wages, FTEs, and health insurance—it is not possible to combine data from various sources to closely match these rules. (See app. VI for details.) Though statistical modeling corrects for imperfect data to match these rules, models are not precise. While acknowledging the data limitations, several entities produced estimates of the number of employers potentially eligible for the credit. The Council of Economic Advisors estimated 4 million and SBA estimated 2.6 million. Other groups making estimates included small business groups such as the Small Business Majority (SBM) and the National Federation of Independent Businesses (NFIB). Their estimates were 4 million and 1.4 million, respectively.

A similar pattern is seen when the dollar value of credits actually claimed is compared to initial estimates. The dollar value of claims made in 2010 was $468 million compared to initial cost estimates of $2 billion for 2010 (a CBO and JCT joint estimate).

Most Small Employer Claims Were Reduced Because of the Phaseout Rules and Some Were Reduced by the State Average Premiums

Most of the claims were for less than the full credit percentage. Of the approximately 170,300 small employers making claims for tax year 2010, 142,200—83 percent—could not use the full credit percentage. Usually employers could not meet the average wage requirement to claim the full percentage, as about 68 percent did not qualify based on wages but did meet the FTE requirement. (See fig. 3.)

State average premiums also reduced some credit amounts by reducing the amount of the premium base against which the credit percentage is applied. This premium base may be reduced when it exceeds the state average premiums for small group plans, as determined by HHS. If so, small employers are to use the state average amount, which in essence caps the premium amount used to calculate their credit. According to IRS data, this cap reduced the credit for around 30 percent of employer claims. For example, a nonprofit representative told us that her credit dropped from $7,900 to $3,070 because of the cap in her state. (See app. II for small group average premiums in all states.)

Most Small Employers Could Not Meet the Health Insurance Requirement for the Credit and the Credit Was Not Seen as an Incentive to Start Offering Insurance

As already discussed, small employers do not commonly offer health insurance. MEPS estimates that 83 percent of employers who may otherwise be eligible for the full credit did not offer health insurance in 2010 and that 67 percent of employers who could be eligible for the partial credit did not offer insurance. Our discussion groups and other interviewees confirmed this, with comments and examples of small, low- wage employers not offering health insurance to employees.

Furthermore, the small employers do not likely view the credit as a big enough incentive to begin offering health insurance and to make a credit claim, according to employer representatives, tax preparers, and insurance brokers we met with. While some small employers could be eligible for the credit if they began to offer health insurance, small business group representatives and discussion group participants told us that the credit may not offset costs enough to justify a new outlay for health insurance premiums. Related to this concern, the credit being available for 6 years overall and just 2 consecutive years after 2014 further detracts from any potential incentive to small employers to start offering health insurance in order to claim the credit.

Complexity Deterred Small Employer Claims, According to Discussion Groups

Most discussion group participants and groups we interviewed found the tax credit to be complicated, deterring small employers from claiming it. The complexity arises from the various eligibility requirements, the various data that must be recorded and collected, and number of worksheets to be completed.

A major complaint we heard centered on gathering information for and calculating FTEs and the health insurance premiums associated with those FTEs. Eligible employers reportedly did not have the number of hours worked for each employee readily available to calculate FTEs and their associated average annual wages nor did they have the required health insurance information for each employee readily available.

Exclusions from the definition of “employee” and other rules make the calculations complex. For example, seasonal employees are excluded from FTE counts but insurance premiums paid on their behalf count toward the employer’s credit. Incorporating the phaseout also complicates the credit calculation.

In our discussion groups with tax preparers, we heard that small business owners generally do not want to spend the time or money to gather the necessary information to calculate the credit, given that the credit will likely be insubstantial. Tax preparers told us it could take their clients from 2 to 8 hours or possibly longer to gather the necessary information to calculate the credit and that the tax preparers spent, in general, 3 to 5 hours calculating the credit. We did hear from a couple of participants— a small business owner and a nonprofit representative—that they did not find the credit overly burdensome.

Tax preparers we interviewed said that IRS did the best it could with the Form 8941 given the credit’s complexity. IRS officials said they did not receive criticism about Form 8941 itself but did hear that the instructions and its seven worksheets were too long and cumbersome for some claimants and tax preparers. On its website, IRS tried to reduce the burden on taxpayers by offering “3 Simple Steps” as a screening tool to help taxpayers determine whether they might be eligible for the credit. However, to calculate the actual dollars that can be claimed, the three steps become 15 calculations, 11 of which are based on seven worksheets, some of which request multiple columns of information. Figure 4 aligns IRS’s “3 Simple Steps,” with the seven worksheets in the instructions for Form 8941 and the lines on Form 8941. (See app. V for full text for this figure.)

Given the effort involved to make a claim and the uncertainty about the credit amounts, a few discussion group participants said it would be helpful to be able to quickly estimate employers’ eligibility for the credit and the amount they might receive; this would help them to decide whether the credit would be worth the effort, although this would not reduce the complication of filing out Form 8941 because, to fill out the form, full documentation would need to be reviewed. IRS’s Taxpayer Advocate Service is developing a calculator for IRS’s website to quickly estimate an employer’s eligibility, but this will still require gathering information such as wages, FTEs, and insurance plans. We also heard concerns that a calculator could cause confusion for clients who find they are eligible when quickly estimating the credit but then turn out to be ineligible or find they are eligible for a smaller credit when their accountant fills out Form 8941.

The Extent to Which Lack of Awareness Is a Factor Limiting More Claims Is Unknown, Although IRS Did Significant Outreach

Many small businesses reported that they were unaware of the credit. The NFIB Research Foundation and the Kaiser Family Foundation both estimated that approximately 50 percent of small businesses were aware of the credit, as of May 2011, or more than 1 year after Congress authorized this credit.

The extent to which being unaware prevented eligible employers from claiming the credit for tax year 2010 is not known. Some discussion group participants raised concerns about unawareness, but they also cited other factors limiting credit claims for tax year 2010. If 50 percent of small businesses knew about the credit, then the approximately 170,300 claims is a relatively small proportion of those that were knowledgeable. This indicates that other factors contributed to employers not claiming the credit. Further, it is hard to interpret the impact of awareness on claims because these surveys included an unknown number of small business employers that would not be eligible for the credit regardless of their awareness. For those employers that were unaware, the surveys did not account for their accountants or tax preparers that may have known about the credit but did not tell their clients about it because they did not believe their clients would qualify or because the credit amount would be very small. In addition, the surveys did not cover tax-exempt entities.

To raise awareness of the credit, IRS did significant outreach. IRS developed a communication and outreach plan, written materials on the credit, a video, and a website. IRS officials also reached out to interest groups about the credit and developed a list of target audiences and presentation topics. IRS officials began speaking at events in April 2010 to discuss the credit and attended over 1,500 in-person or web-based events from April 2010 to February 2012. Discussion of the credit at the events varied from being a portion of a presentation covering many topics to some events that focused on the credit with a dedicated discussion period.

IRS does not know whether its outreach efforts actually increased awareness of the credit or were otherwise cost-effective. It would be challenging to estimate the impact of IRS’s outreach efforts on awareness with a rigorous methodology; however, based on ongoing feedback they received from interest groups, IRS officials told us they believe their efforts have been worthwhile. IRS used some feedback from focus groups of tax preparers and from other sources to revise its outreach efforts. For example, IRS modified its outreach from initially focusing on tax preparers and small employers to including insurance brokers in 2012.

Addressing Factors and Expanding Credit Use May Require Substantive Design Changes

Given that most small employers do not offer insurance and what we heard about the size of the credit not being big enough to incentivize offering health insurance,credit use without changing the credit’s eligibility. Most claims were for partial credits and many people we spoke with view the credit amount as it may not be possible to significantly expand too small and temporary to justify providing health insurance when none is provided now. In addition, given that IRS has conducted extensive outreach about the credit, it is not likely that more outreach would significantly increase the number of businesses claiming the credit. Amending the eligibility requirements or increasing the amount of the credit may allow more businesses to take advantage of the credit, but these changes would increase its cost to the Federal government. Options include the following: Increasing the amount of the full credit, the partial credit, or both. Increasing the amount of the credit for some by eliminating state premium averages.

Expanding eligibility requirements by increasing the number of FTEs and wage limit allowable for employers to claim the partial credit, the full credit, or both. This expansion would not, however, likely affect the smallest employers which do not offer health insurance.

Simplifying the calculation of the credit in the following ways:

Using the number of employees and wage information already reported on the employer’s tax return. This could reduce the amount of data gathering as well as credit calculations because eligibility would be based on the number of employees and not FTEs. A trade-off with this option would be less precision in targeting the full and partial credit amount to specific small employer subgroups.

Offering a flat credit amount per FTE (or number of employees) rather than a percentage, which would reduce the precision in targeting the credit.

The data limitations that made it difficult to estimate the number of businesses eligible for the current credit also make it difficult to estimate the impact of any design changes.

IRS Is Implementing Several Practices from Prior Compliance Efforts, but Additional Steps Could Be Taken

IRS Incorporated Practices from Strategic Objectives and Prior Compliance Efforts

IRS’s compliance efforts for the credit incorporate practices that have been shown effective in helping to ensure compliance with other tax provisions or are consistent with IRS strategic objectives. Some of those practices were used for the Telephone Excise Tax Refund (TETR) and Consolidated Omnibus Budget Reconciliation Act (COBRA) subsidies for health insurance for the unemployed, according to IRS officials.Specifically, IRS is doing the following:

Using computerized filters to review credit claims on Forms 8941 for certain errors or potential problems that may trigger an examination of the claim.

Transcribing more lines of data from Form 8941 into IRS computer systems which should make the filters more effective. Although transcribing more lines increases processing and data storage costs, IRS plans to transcribe more lines for tax years 2011 and 2012 claims to ensure better verification of eligibility.

Freezing refunds of tax-exempt entities whose returns have been selected for examination, which avoids the costs of trying to recover funds.

Considering the documentation burden on claimants. IRS did not require claimants to submit documentation on health insurance premiums with their Form 8941 because IRS officials said they will review examination results and may revisit the decision not to require documentation if results suggest that such documentation would improve compliance checks.

Modifying filters, as needed, in response to observed trends. For example, a filter that applies to tax-exempt organization claims was tripped by about a quarter of claimant organizations, as of December 31, 2011. IRS officials said some eligible tax-exempt entities tripped the filter because it was too broad. To address this, IRS modified the filter to more clearly identify qualifying tax-exempt organizations.

Completing a risk assessment on compliance issues related to the credit. The assessment identified risks involving refunds for tax- exempt entities, difficulties verifying employment tax return information for certain employers, and not using existing Math Error Authority (MEA).

Considering the costs and benefits of MEA for the credit. IRS officials identified three filters whose type of errors could be addressed with MEA. They noted that less than 1 percent of Forms 8941 tripped one or more of those filters, which IRS officials said does not justify the costs to develop procedures to use MEA, if it were granted.

Filters Check Some Eligibility Criteria, but Are Limited by Available Data

IRS developed 21 filters for Form 8941, some of which apply differently to SB/SE and TEGE taxpayers. The filters cover some of the eligibility requirements for the credit. Errors on about 3.5 percent (11,763) of Forms 8941 for tax year 2010 tripped 1 or more filters; almost half of those forms were from tax-exempt entities. According to IRS officials, the filter failure rate is consistent with other recent tax credits.

The filters do not cover all of the credit’s requirements for several data- related reasons. In one case, data are not included on Form 8941 but may be included on worksheets required to be retained by claimants (e.g., information on business owner family members or seasonal employees included in credit calculations); in another case, certain data are not transcribed (e.g., the credit amount for certain claimants). For other requirements, IRS officials stated that reasonable filters cannot easily be developed because of challenges with matching data.

Some Form 8941 filters also face limitations mainly because of problems with data or IRS’s systems.

Filters are mutually exclusive, meaning that filters on related requirements are viewed in isolation. However, according to IRS officials, IRS has ways to identify whether a form failed more than one filter, which IRS considers when identifying returns for potential examination.

Some filters may mistakenly target eligible claimants because the filters rely on general thresholds in Form 8941 data or, in some cases, other IRS data (such as employee-level data) that are not exact matches to data on the Form 8941.

Data on Forms W-2 (employees’ annual Wage and Tax Statement) could provide additional data for filters once the provision in PPACA is implemented that requires employers to report the cost—including both employer and employee contributions—of certain types of health insurance provided to an employee. IRS officials said the data have limited use because, among other things, they would not provide details for determining whether an employer met the credit’s requirements for health insurance; therefore, IRS officials will not pursue using the data at this time. Nevertheless, the data could be used in a filter to identify claimants who reported no health insurance contributions on Form W-2 and therefore may not be offering health insurance. In the absence of other documentation or third-party reporting on health insurance, using Form W-2 data in a filter could be a cost-effective, rough indicator of whether a claimant is paying employee health insurance premiums, without increasing taxpayer burden. However, IRS provided transition relief to employers that file fewer than 250 Forms W-2 per year, and issued guidance stating that these employers will not be required to report the data until further guidance is issued. As a result, it is unlikely that the data could be useful before 2014, the year when the credit will only be available to employers for any 2 consecutive years.

Examination Instructions Cover Most Eligibility Requirements, but Gaps Exist

After the filters are run, IRS creates lists of claims to consider for further examination. SB/SE wanted enough examination cases to spot check different filters and claims from different regions, to enable them to establish a field presence and to learn about compliance risks with the credit, according to an SB/SE official. Examination staff in SB/SE and TEGE are to follow a set of instructions when doing examinations.

SB/SE’s examination instructions address all of the credit’s requirements for small businesses to claim the credit except that they do not include specific instructions for examiners on determining eligibility of claimants with non-U.S. addresses. An employer located outside of the United States with a business or trade interest in the United States may claim the credit only if the employer pays premiums for coverage issued in and regulated by one of the states or the District of Columbia. Without a prompt in examination instructions, IRS examiners may overlook claimants that do not comply with the address requirements. An SB/SE official said IRS has no instructions for examiners to review claimants with non-U.S. addresses during an examination on the credit because potential compliance problems with businesses with non-U.S. addresses exist for other tax credits. This, however, was not IRS’s approach for another general business tax issue relevant to the credit—whether claimants that carry back the credit to offset tax liabilities in previous years did so properly. Near the end of our work, SB/SE added guidance to one of its examination instruction documents to cover the carry back issue.

Instructions for TEGE examiners also address most of the eligibility requirements to claim the credits, but, like SB/SE’s, TEGE examination instructions do not address how to review claimants with non-U.S. addresses. Further, TEGE instructions for some of the credit’s requirements have less detail compared to SB/SE’s instructions. TEGE’s instructions provide steps on how to determine if an employer’s insurance premiums paid met “qualifying arrangement” and other criteria, but they provide less detail than SB/SE instructions. For example, SB/SE guidance instructs examiners to review health insurance policies and invoices to confirm premium payments, and to review other documentation to check whether the employer offers health benefits that are not eligible for the credit. TEGE instructions do not suggest these steps and also do not provide a prompt for examiners to ensure that insurance premiums paid on behalf of seasonal employees are included in calculations.

According to IRS officials, the TEGE examiners are trained specifically for doing examinations on the credit and therefore need less guidance than SB/SE examiners, who work on multiple issues simultaneously. However, TEGE examination documents contain detailed guidance in a workbook format for these trained examiners on other credit requirements. Without detailed guidance for TEGE examiners that instructs them on how to examine health insurance documents, examiners may not consistently identify noncompliance, which could lead to erroneous credit refunds. This could particularly be the case as examining health insurance documents to check eligibility for this new credit has not been typical work for these examiners.

Examinations Under Way, but IRS Needs to Develop a Plan for Efficiently Analyzing Results on Credit Compliance

For tax year 2010, SB/SE plans to conduct over 1,500 examinations related to the credit, and TEGE anticipates about 1,000 examinations. An SB/SE official said the number of examinations is expected to provide initial compliance information and allow IRS to establish a compliance presence without committing too many resources initially. TEGE selected its number of examinations based on resource decisions, before tax year 2010 claims began. Neither SB/SE nor TEGE adjusted the number of examinations once actual claim numbers were known. As a result, the percentage of TEGE claims being examined is high, according to a TEGE official. Table 1 summarizes the status of IRS’s examinations on the credit.

IRS’s database on examination results tracks the aggregate dollar amount of tax changes as a result of the examination but does not contain the reason a change is made. Consequently, IRS is not able to isolate and analyze examination results related to the credit versus other tax issues. This is particularly a problem for SB/SE examinations, which Instead, as initial examinations may cover issues other than the credit.have closed, IRS officials said that management has spoken with examiners about findings related to the credit. This has been possible because of the relatively low initial volume of cases, but this approach may not be feasible as results accumulate. Therefore, it is not clear how IRS can efficiently analyze results to decide whether changes are necessary in how it examines the credit or how it educates small employers about how to comply with the credit’s rules, and whether it committed too many or too few resources to examinations of the credit.

Furthermore, IRS does not have criteria for deciding whether the resources spent on examinations of the credit are appropriate, given the amount of errors found. IRS officials said that for future years they plan to select the number of credit examinations based on past results, identified compliance risks, and available resources. However, without criteria to assess the results in concert with these risks and resources, IRS is less able to ensure that examination resources target errors with the credit, rather than examining compliant claimants.

For example, early examination results (as of February 2012) show that 67 percent of the examinations completed were closed without changing the credit amount. Examinations without a change burden taxpayers and use IRS resources. We recognize that few of the planned examinations have been completed and the “no change” percentage could change. According to IRS officials, cases resulting in “no change” tend to be the first cases closed because they close more quickly than cases requiring a change. However, IRS is not using change rate information from prior tax credits to determine if examinations for the credit have a “high” no-change rate, which could be one indicator to help decide how many examination resources to apply to the credit. IRS officials said they do not plan to use data from examinations of other tax provisions to benchmark measures— such as the no-change rate or length of time an examination is open— because results would not be comparable.

A summary of examination results specific to the credit could also inform decisions about using additional compliance tools such as soft notices.In the past, IRS has used soft notices to correct errors and collect funds without initiating an examination.implementing the credit said IRS has not ruled out using soft notices, but examination results would need to identify an issue that would justify their use. He said soft notices are not effective for all taxpayers or situations. He said IRS would consider using soft notices if officials found a series of returns with mistakes from the same tax preparer or promoter of tax schemes. Furthermore, soft notices may necessitate follow-up, which would negate some of the advantages of the notices. If IRS analysis showed that examinations were not a cost-effective way to pursue certain errors made in claiming a credit, a soft notice may offer another approach to improving compliance with lower costs to IRS and less burden on claimants.

Data to Evaluate Many Questions about the Effects of the Credit Are Not Available

There are a variety of research questions that could be of interest to policymakers about the effects of the credit that cannot be evaluated with data currently available. Figure 5 shows how the credit may influence employer behavior and, ultimately, employees.

To answer research questions about the credits potential outcomes shown in figure 5, the following are examples of data that might be needed: number of small, low-wage employers offering health insurance, before and after the credit was available; number of employees at small, low-wage employers, who have or could obtain health insurance through their employers; and amount of annual health insurance premium costs for small, low-wage employers before and after the credit.

None of these data are readily available or free of limitations, which complicates an evaluation. For example, the available data on employer- sponsored health insurance do not align with the credit’s eligibility criteria, according to our interviews with subject matter specialists and our review of the data (see app. VI for a summary of the data sources), nor could we identify a data source that tracks when, and why, employers begin offering insurance. As a result of the limitations with all three types of data, it would be difficult to precisely measure changes in health insurance availability, offering, and costs because of the credit, without collecting additional data. Isolating influential factors—such as those shown in figure 5—that may contribute to the effects of the credit would also be a challenge in an evaluation.

IRS officials said they will not collect data on credit claimants, outside of those collected on Form 8941. IRS’s position on data collection for all provisions of the tax code is that it only collects data it needs to ensure compliance with the tax laws.

Collecting additional data needed for policy evaluation would have costs, and the magnitude of those costs would depend on the type and amount of data needed, which depends on the research questions being asked. An additional consideration in thinking about the benefits and costs of additional data collection for policy evaluation purposes is the time limits on claiming the credit. The current version of the credit runs through the end of 2014. Policymakers’ conclusions about the questions to be answered by any evaluations of the credit’s effects would determine the type of data that would need to be collected.

Conclusions

The Small Employer Health Insurance Tax Credit was intended to offer an incentive for small, low-wage employers to provide health insurance. However, utilization of the credit has been lower than expected, with the available evidence suggesting that the design of the credit is a large part of the reason why. While the credit could be redesigned, such changes come with trade-offs. Changing the credit to expand eligibility or make it more generous would increase the revenue loss to the federal government.

In administering the credit to ensure compliance, IRS employed a number of practices that were shown effective for other tax provisions or are consistent with IRS strategic objectives. Nevertheless, we identified several opportunities for IRS to either improve compliance or perhaps reduce the resources it is devoting to ensuring compliance. Without additional guidance for examiners on employers with non-U.S. addresses, there is a risk of improper credit claims being allowed. Without more systematic attention to early examination results, IRS could lock itself into devoting more scarce resources than needed to examinations.

Recommendations for Executive Action

To help ensure thoroughness and consistency of examinations on the credit, we recommend that the Commissioner of Internal Revenue take the following two actions: 1. Revise the SB/SE and TEGE examination instructions to include instructions for examiners on how to confirm eligibility for the credit for small employers with non-U.S. addresses. 2. Revise the TEGE examination guidance to include more detailed instructions for examiners on how to confirm that claimants properly calculated eligible health insurance premiums paid for purposes of the credit. The SB/SE examination instructions could serve as a model.

To help ensure that IRS uses its examination resources efficiently, we recommend that the Commissioner of Internal Revenue take the following two actions: 3. Document and analyze the results of examinations involving the credit to identify how much of those results are related to the credit versus other tax issues being examined, what errors are being made in claiming the credit, and when the examinations of the credit are worth the resource investment. 4. Related to the above analysis of examination results on the credit, identify the types of errors with the credit that could be addressed with alternative approaches, such as soft notices.

Agency Comments and Our Evaluation

In an April 30, 2012, letter responding to a draft of this report (which is reprinted in app. VII), the IRS Deputy Commissioner for Services and Enforcement provided comments on our findings and recommendations as well as information on additional agency efforts related to implementing the Small Employer Health Insurance Tax Credit in PPACA. IRS generally agreed with all four of our recommendations. Regarding our recommendation on examination instructions related to small employers with non-U.S. addresses, IRS stated that SB/SE will provide additional guidance in its instructions and that TEGE has added guidance to its instructions. On May 1, 2012, IRS provided a copy of the TEGE instructions, which we are reviewing. On our recommendation on revising TEGE’s examination guidance, IRS’s letter said that on April 13, 2012, TEGE implemented more detailed instructions in its examination guidance related to confirming proper calculations of eligible health insurance premiums paid for purposes of the credit. These instructions were also included in the TEGE document provided on May 1, 2012.

With regard to analyzing credit examination results to identify compliance issues specific to the credit, IRS said it regularly analyzes audit results to determine whether resources are expended efficiently, though its information systems do not currently capture adjustments by issue, such as this tax credit. IRS agreed to leverage existing information systems and, as appropriate, to allocate resources to manually analyze examination results. IRS said this will include, as feasible, identifying the types and amounts of errors related to the credit. We reiterate the benefit of documenting and analyzing the results of examinations involving the credit. If it does not do so, IRS will not have information for determining whether examinations of the credit are worth the resource investment.

Regarding our fourth recommendation on using examination results to determine whether alternative compliance approaches, such as soft notices, could help address errors with the credit, IRS agreed to continue to review its compliance efforts to determine whether soft notices would be appropriate.

As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies to the Chairmen and Ranking Members of other Senate and House committees and subcommittees that have appropriation, authorization, and oversight responsibilities for IRS. We will also send copies to the Commissioner of Internal Revenue, the Secretary of the Treasury, the Chairman of the IRS Oversight Board, and the Director of the Office of Management and Budget. In addition, the report will be available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions or about this report, please contact me at (202) 512-9110 or at whitej@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix VIII.

Appendix I: Scope and Methodology

To assess the extent to which the Small Employer Health Insurance Tax Credit (referred to in this report as the credit) is being claimed, we obtained and analyzed Internal Revenue Service (IRS) data on the claims on Form 8941 for tax year 2010. We interviewed responsible IRS staff and examined background materials. IRS provided a report from the Form 8941 data and we reviewed the programming code that created that report. We corroborated the results of this IRS report with a Treasury Inspector General for Tax Administration (TIGTA) report published in November and found similarities. The data were found to be sufficiently reliable for our purposes. We identified estimates of employers that were potentially eligible to claim the credit by reviewing reports and websites of government agencies, think tanks, and interest groups. When possible, we interviewed officials from the government agencies and business groups that developed estimates.

To identify any factors limiting credit claims, we interviewed groups representing employers, tax preparers and insurance brokers and to assess how these factors could be addressed, we analyzed our interview results as well as relevant documents. Specifically, we spoke with representatives of the National Federation of Independent Businesses, the National Council of Nonprofits, the Small Business Majority, the U.S. Chamber of Commerce, the American Institute of Certified Public Accountants, America’s Health Insurance Plans, the National Society of Accountants, the National Association of Enrolled Agents, and the National Association of Health Underwriters. We worked with some of these groups to assemble discussion groups with tax preparers, health insurance brokers, and employers to discuss potential factors and ways to address them. Discussion groups were, for the most part, telephone conferences. We also spoke with insurance and tax preparation companies, specifically, BlueCross Blue Shield of Kansas City, Independent Health of New York, H&R Block’s Tax Institute, and Jackson Hewitt Tax Service. We used qualitative analysis software to do a content analysis of the interviews and discussion group comments.

To provide additional support for discussion group and interview findings we reviewed documents and, where possible, we identified data from IRS, the 2010 Medical Expenditure Panel Survey, or the 2011 Kaiser Family Foundation Health Benefits Survey. At IRS, we interviewed officials from the Small Business/Self-Employed Division (SB/SE), including officials in the Communications and Liaison Office; the Tax Exempt and Government Entities Division (TEGE); the Research and Analysis for Tax Administration division, and the Taxpayer Advocacy Service.

To assess how fully IRS is ensuring that the tax credit is correctly claimed by eligible employers, we reviewed IRS’s compliance plan and filters and instructions for IRS staff conducting examinations, and compared these documents with compliance practices used for prior tax provisions and found in IRS strategic objectives. We also highlighted any gaps between filters and examination instructions and the credit’s eligibility rules. We reviewed the filter results for tax year 2010 claims and interviewed SB/SE and TEGE officials about compliance efforts.

To assess what would be needed to evaluate the effects of credit, we conducted a literature review and interviewed representatives of the forenamed groups and subject matter specialists from government, academia, research foundations and think tanks. We selected the specialists based primarily on our literature review and spoke with individuals at the University of Massachusetts, Boston; Massachusetts Institute of Technology; the Commonwealth Fund; the Urban Institute; the Kaiser Family Foundation; the American Enterprise Institute; the Employee Benefit Research Institute; the RAND Corporation; the Small Business Administration Office of Advocacy; and the Office of Tax Policy at the Department of the Treasury. We reviewed available data in commonly cited surveys with questions on employer health insurance, and identified how the questions and variables match to the eligibility criteria for the credit.

We conducted this performance audit from July 2011 through May 2012 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: State Average Premiums for Small Group Markets for 2010 and 2011

The Small Employer Health Insurance Tax Credit is based on a percentage of the lesser of (1) the premiums paid by the eligible small employer for employees during the taxable year and (2) the amount of premiums the employer would have paid if each employee were enrolled in a plan with a premium equal to the average premium for the small group market in the state (or in an area in the state) in which the employer is offering health insurance. The Secretary of Health and Human Services determines whether separate average premiums will apply for areas within a state and also determines the average premium for a state or substate area. Table 2 shows the average premiums for the small group market in each state for tax years 2010 and 2011.

Appendix III: Adjustments in Counting Total Small Employer Claims and Total Credit Amount Claims for Tax Year 2010

Internal Revenue Service (IRS) data for tax year 2010 show 335,600 total claims filed. This total must be adjusted to avoid counting the 110,800 S corporation and partnership claims that were passed through to 165,300 respective shareholders and partners who then filed their claims separately. Excluding the 165,300 shareholder and partner claims filed leaves 170,300 small employer claims filed. To capture the number of credit amounts claimed and avoid the amounts that were claimed by the S corporations and partnerships as well as their respective shareholders and partners, we excluded the 110,800 S corporation and partnership claims to arrive at 224,800 credit amounts claimed. (See fig. 6.)

Appendix IV: Credit Claims by Employer Size and Wages Paid, Tax Year 2010

Appendix V: Form 8941 and Worksheets for Claiming the Small Employer Health Insurance Tax Credit

This appendix contains the noninteractive Form 8941 and worksheets, shown in figure 4 in the letter.

Appendix VI: Publically Available Data on Small Employer Health Insurance

Through our literature review and interviews, we identified several commonly cited non-Internal Revenue Service data sources on employer health insurance. Each source has different variables related to the key eligibility requirements for the Small Employer Health Insurance Tax Credit. Table 3 summarizes each source, its basic methodology, and whether its data matches with these requirements for the credit. The table only considers data that are readily accessible in public-use data sets.

Appendix VII: Comments from the Internal Revenue Service

Appendix VIII: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, Thomas Short, Assistant Director; Susan Baker; Amy Bowser; Ellen Grady; George Guttman; Donna Miller, Ruben Montes de Oca, Edward Nannenhorn; Robert Gebhart; Crystal Robinson; Cynthia Saunders; and Lindsay Swenson made key contributions to this report.