The new economic stimulus law subsidizes the cost of continuing COBRA medical coverage for some employees who have lost, or will lose, their jobs. But the burden of paying the rest of the premiums has shifted to employers.

Strategy: Recoup the cost ASAP. If your business is required to pick up the slack for premium payments, it can claim a special tax credit on the quarterly employment tax return (Form 941). Alternatively, you can reduce employment tax deposits by the amount of the subsidy payments.

The IRS has issued initial guidance on the new COBRA premium assistance credit. (IRS News Release IR-2009-15) 

Here’s the whole story: COBRA (Consolidated Omnibus Budget Reconciliation Act) allows an employee who is terminated from employment to continue employer-provided health insurance coverage for up to 18 months. The law extends the maximum continuation period to 29 months for an employee who suffers a disability; 36 months for a spouse or dependent facing loss of coverage due to death, divorce or legal separation.

The employee generally has to pay the full cost of the premiums to the employer plus a 2% administrative fee to compensate for the hassle.

Now the new law offers beleaguered taxpayers a discount. An employee who is “involuntarily terminated” from the job between Sept. 1, 2008, and Dec. 31, 2009, may elect to pay only 35% of the required premiums for a nine-month stretch (see box). It’s up to the employer to pick up the remaining 65% of the tab.

This seems like a pretty tough pill for your business to swallow. But the prognosis isn’t as dire as it first seems. If you’re forced to cough up COBRA subsidy payments for employees who have been laid off or fired, your business is eligible for the new COBRA premium assistance credit. The credit is generally claimed on Form 941 for the quarter in which subsidy payments are made (or an annual Form 944 if your employment tax liability for the year is $1,000 or less). You can take the credit in a subsequent quarter in the same calendar year.

The new IRS guidance clarifies that your company can’t claim the credit until it has received the 35% payment from the former employee. Although this provision took effect March 1, you can start subsidy payments in May as long as you provide reimbursement or credit against future payments within 60 days.  

No other information is required. However, keep supporting documentation—including proof of eligibility of COBRA coverage and records of employee payments and your company’s subsidy payments—in your files. If the credit exceeds the amount of employment taxes that are due, the IRS will reimburse you for the difference.

Another option: Instead of claiming the new credit, your business can reduce its regular employment tax deposits. For this purpose, treat the COBRA premiums as having been made on the first day of the quarter and apply them against your deposit requirements.

However, this does not otherwise affect your obligation to pay employment taxes in a timely fashion. It’s likely that the COBRA subsidy payments won’t exceed the taxes due, so you’ll probably still have to make quarterly payments.

Tip: Usually, it’s better to offset employment tax deposits than to wait for a credit refund.

Relief is fleeting for some taxpayers

If you or a family member is in the other boat, be aware that relief from the new law comes with strings attached.

Alert: The COBRA subsidy phases out for high-income taxpayers. Single filers with an AGI exceeding $125,000 and joint filers with an AGI exceeding $250,000 must repay all or part of the subsidy amount as an additional tax with their 2009 Form 1040. The phaseout is complete at $145,000 of AGI for single filers and $290,000 for joint filers.

The new law doesn’t explicitly define an “involuntary termination,” but House Committee reports indicate this generally would not apply to an employee who is fired due to gross misconduct. Furthermore, the subsidy for continued coverage isn’t available for the family of an employee who dies.

Also, it is unclear if domestic partners would qualify for the COBRA premium reduction.

Tip: Under a separate new law provision, an individual may receive up to $2,400 in unemployment benefits tax-free in 2009.