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Tax Credits for Employees

The Tax Code includes two employment-related tax credits that are available to many small corporate employers—the Work Opportunity Tax Credit and the Welfare-to-Work Tax Credit. Because of the current tight labor market, it’s more likely than in the past that some of your new hires may qualify your business for these credits. This letter summarizes the rules so you can determine if your company is eligible.

Work Opportunity Tax Credit (WOTC)

This credit can be claimed by employers of persons who fit within "targeted groups" of economically disadvantaged or disabled persons. The WOTC is generally available for qualifying individuals who begin work with your company before July 1, 1999. In all likelihood, the July 1st cutoff will be extended by Congress sometime in 1999.

The credit amount equals 40% of qualified wages paid during the employer’s tax year up to a maximum of $6,000 per employee during the first year of his or her employment (the one-year period starting with the day the employee begins work). Therefore, the maximum credit is $2,400. Generally, the employee must work for at least 400 hours. However, if the employee works at least 120 hours but less than 400 hours, the employer is entitled to a reduced credit of 25%.

For qualified summer youth employees, the credit equals 40% of wages paid during any 90-day period between May 1 and September 15 up to a maximum of $3,000 of wages per employee. Thus, the maximum credit for such an employee is $1,200.

Wage deduction must be reduced. Your company’s deduction for wages generally must be reduced by the amount of the credit even if the full credit can’t be used in the year it’s earned. (Exceptions to this rule apply when you capitalize or add to inventory any wages on which the credit is based. In that situation, the inventory or depreciable asset’s basis is reduced by the amount of the credit.) Unused credits can be carried back one year or forward 20 years.

The value of the credit is the difference between the tax savings the wage deduction would otherwise generate and the dollar-for-dollar tax reduction the credit produces plus the reduced tax deduction that’s available. For example, assume a business in the 25% tax bracket can use all of the credits it earns in the current year and that it has $6,000 of wages qualifying for the WOTC. That $6,000 of wages will produce a $2,400 tax credit (that saves $2,400 of taxes) and a tax deduction of $3,600 ($6,000 – $2,400) that saves $900 of taxes. Thus, the total tax reduction from the $6,000 of wages is $3,300 ($2,400 + $900). If the business forgoes the credit, those same wages will provide a $6,000 tax deduction (that saves $1,500 of taxes). As a result, the credit is worth $1,800 ($3,300 – $1,500). That works out to a 30% after-tax return ($1,800 ¸ $6,000) on $6,000 you were going to have to spend anyway to hire someone. That’s not a bad deal!

Certification process. On or before the first day of work, the newly hired employee must obtain a certification from the designated local agency (the State Employment Security Agency or Jobs Service) that he or she is a member of a targeted group. In the likely event that this has not been done, you must obtain the employee’s signature on a "prescreening notice" indicating that the employee qualifies as a member of a targeted group. Use Form 8850 (Pre-Screening Notice and Certification Request for the Work Opportunity and Welfare-to-Work Credits) for this purpose. You must then submit Form 8850 to the local agency within 21 days after the employee begins work. The form must be filled out and signed by the day you offer the worker a job. After checking out the worker’s status, the agency will issue a certification (or a denial letter with an explanation if the worker does not qualify).

Qualified workers. New hires must fit within one or more of the following targeted groups before their wages will qualify for the credit:

Qualified AFDC recipients. These are individuals in families receiving assistance under a state program providing assistance to needy families with dependent children (Aid to Families with Dependent Children or AFDC) for any nine months during the 18-month period ending on the hiring date. The program must be approved under part A of title IV of the Social Security Act.

Qualified veterans. These are veterans who are members of families receiving assistance under a federally approved food stamp program for at least a three-month period ending during the 12-month period ending on the hiring date.

Qualified ex-felons. These are individuals previously convicted of a felony under federal or state law who are hired within one year of the date of conviction or release from prison and who are members of low-income families.

High-risk youths. These are individuals between age 18 and 24 on the hiring date who live within a federally designated empowerment zone or enterprise community during the employment period.

Vocational rehabilitation referrals. These are individuals with physical or mental disabilities who have been referred to your company upon completion of or while receiving rehabilitative services pursuant to a state plan meeting federal standards.

Qualified summer employees. These are individuals hired to work between May 1 and September 15 who are age 16 or 17 on the later of May 1 or the hiring date and who live within federally designated empowerment zones or enterprise communities.

Qualified food stamp recipients. These are individuals between age 18 and 24 on the hiring date who are members of families receiving assistance under federally approved food stamp programs for the six-month period ending on the hiring date or for at least three months during the five-month period ending on the hiring date.

Qualified SSI recipients. These are individuals receiving supplemental security income benefits under title XVI of the Social Security Act for any month ending within the 60-day period ending on the hiring date.

Note: The instructions to Form 8850 include more details on the targeted group qualification rules. Workers will typically be unaware that they fall within a targeted group that qualifies the employer for tax credits. So it is up to you to ask new hires enough questions to make an initial "guess" regarding eligibility and then submit Form 8850 to the local agency for certification.

Creditable wages generally include compensation payments subject to the Federal Unemployment Tax Act (so-called FUTA wages).

The WOTC cannot be claimed for wages paid to:

1. a relative or dependent of the employer,

2. employees for whom the employer is receiving federal job-training funds or work supplementation payments,

3. rehired employees who were not members of a targeted group when employed earlier, or

4. replacement workers during a strike or lockout.

Welfare-to-Work Tax Credit (WTWC)

This credit equals 35% of qualified first-year wages and 50% of qualified second-year wages paid during the employer’s tax year to employees who are long-term family assistance recipients and who begin working for you after 1997. Only the first $10,000 of wages in each year are taken into account. Thus, the maximum credit is $8,500 per worker.

Under current law, the WTWC is available for employees who begin work before July 1, 1999. However, Congress will likely extend the deadline sometime in 1999.

If an employee is eligible for this credit for the tax year, he or she cannot be considered a member of a targeted group for that tax year for purposes of the WOTC explained above.

Wage deduction must be reduced. Your company’s wage deductions must be reduced by the amount of the credit in the same manner as with the WOTC. Unused credits can be carried back one year or forward 20 years.

Certification process. On or before the first day of work, the newly hired employee must obtain a certification from the designated local agency (the State Employment Security Agency or Jobs Service) that he or she is a long-term family assistance recipient. As with the WOTC, in the likely event that this has not been done, you must obtain the employee’s signature on a "prescreening notice" indicating that the employee qualifies. Use Form 8850 (Pre-Screening Notice and Certification Request for the Work Opportunity and Welfare-to-Work Credits) for this purpose. It must be filled out and signed by the day you offer the worker a job. You must then submit the Form 8850 to the local agency within 21 days after the employee begins work. After checking out the worker’s status, the agency will issue a certification (or a denial letter with an explanation if the worker does not qualify).

Qualified workers. Businesses are eligible for the credit with respect to wages of new hires who are members of a family that:

1. has received Aid to Families with Dependent Children (AFDC) payments for at least 18 consecutive months ending on the hiring date;

2. receives assistance payments from AFDC for any 18 months (whether or not consecutive) beginning after August 5, 1997; or

3. stops being eligible for assistance after August 5, 1997 because federal or state law limits the maximum duration for such payments and is hired within two years of when eligibility stops.

Creditable wages generally include compensation payments subject to FUTA. However, the following forms of tax-free compensation are also included:

1. employer contributions to accident and health plans,

2. qualified employer educational assistance payments, and

3. qualified employer payments for dependent care assistance.

The WTWC cannot be claimed for wages paid to:

1. a relative or dependent of the employer,

2. employees for whom the employer is receiving federal job-training funds or work supplementation payments,

3. rehired employees who were not long-term family assistance recipients when employed earlier,

4. replacement workers during a strike or lockout, or

5. employees who do not work for you a minimum of 180 days or 400 hours (whichever is less).

Conclusion

Just a few years ago, it was much less likely that your business would hire workers who meet the qualification rules for the Work Opportunity or Welfare-to-Work credits. However, in today’s extremely tight job market, almost everyone who wants to work has a chance to be employed. Don’t overlook the possibility that your company may now be eligible for valuable tax breaks because of "liberalized" hiring policies.