Understanding Tax Credits for Businesses and Individuals

Whether you file federal income taxes as an individual or on behalf of your business, a basic understanding of the tax landscape and its rules can help save you money and prevent potentially costly IRS action. Tax credits, for example, offer you the opportunity to reduce your tax obligation. Knowing who qualifies and how to avail yourself of tax credits can substantially reduce your tax burden.

So let’s get into the details.

What Is a Tax Credit?

Simply put, a tax credit is money that taxpayers can take directly on their tax return, dollar for dollar. As Steve says, “I am constantly looking for available tax credits because a tax deduction only benefits a taxpayer in the amount of his marginal tax bracket.” A tax credit is not a percentage—it holds the same value for each taxpayer who claims it. So for example, a family earning $100k and a family earning $50k can each take advantage of a $5k tax credit, if they qualify. Because the credit represents a dollar-for-dollar reduction in tax obligation, each family will see a $5k reduction in their federal tax burden.

Most tax credits are nonrefundable, meaning that a tax credit may not reduce your tax burden to a number below zero. This means that lower income families may not be able to avail themselves of all available tax credits, as doing so would reduce their tax burden to a negative number.

Unlike personal tax credits (such as a child tax credit), business tax credits are intended to spur business activity and growth, often in a specific area. To put it another way, if a tax credit exists, it means that the federal government is rewarding a certain action or program.

How Tax Credits Differ from Tax Deductions

It’s not uncommon to experience confusion between tax credits and tax deductions, but the difference is worth noting. While a tax credit represents a dollar-for-dollar reduction in tax obligation, tax deductions reduce a filer’s taxable income and subsequently, reduce the filer’s tax liability. Or more simply, a deduction reduces the gross income to be taxed, while a credit directly reduces your tax burden. Tax credits, as a consequence, are doled out more sparingly than are tax deductions. An additional distinction is that tax deductions may place you in a lower tax bracket, but a tax credit will not.

Types of Tax Credits

Earlier, we mentioned that most tax credits are nonrefundable, meaning that a filer cannot take advantage of a credit that would lower his or her tax burden below zero. These are not the only type of tax credits available.

  • Nonrefundable tax credits: As noted above, a nonrefundable tax credit cannot bring your tax owed to a number below zero, which would effectively mean that the IRS owes you money. Unfortunately, you won’t be getting a check from the IRS, and that money is effectively lost.
  • Refundable tax credits: A refundable tax credit is paid out in full, regardless of the taxpayer’s liability. An example is the Earned Income Tax Credit (EITC). A taxpayer who qualifies will receive the full credit amount, regardless of income or tax liability. Another example is the premium tax credit, which allows filers to receive credit for the amount paid in healthcare premiums purchased in the insurance marketplace.
  • Partially refundable tax credits: Some credits are considered partially refundable, meaning that if you can avail yourself of only part of the credit, you may take the rest in cash. An example is the American Opportunity Tax Credit (AOTC). Also, in 2018, the child tax credit was made refundable up to $1400 per child.

Common Business Tax Credits

If you operate your own business, tax credits can vastly reduce your tax obligation. Here are some commonly used business tax credits you should get to know.

  • Credit for Small Business Health Insurance Premiums: Part of the Affordable Care Act, this tax credit is available to businesses with fewer than 25 employees and an average worker salary under $55k. To qualify, companies must pay at least half of their employees’ insurance premiums and must have purchased health insurance through the Small Business Health Options Program Marketplace.
  • Employee Retention Tax Credit (ERC): As part of the COVID stimulus legislation, The Employee Retention Credit is a refundable tax credit against certain employment taxes equal to 50% of the qualified wages an eligible employer pays to employees after March 12, 2020, and before January 1, 2021. Eligible employers can get immediate access to the credit by reducing employment tax deposits they are otherwise required to make. Also, if the employer’s employment tax deposits are not sufficient to cover the credit, the employer may get an advance payment from the IRS. See our other blogs and webinars regarding ERC here and here.
  • Employer Credit for Paid Family and Medical Leave: Designed to give family members paid leave to care for a neonate or an ill family member, the family and medical leave tax credit equals 12.5% of the wages paid to qualifying employees on family and medical leave during the tax year. The credit maxes out at 25% of wages for businesses that cover a worker’s salary in full during leave.
  • Work Opportunity Credit: This credit incentivizes employers to hire workers from marginalized groups, such as veterans, ex-felons, and the long-term unemployed.
  • Disabled Access Credit: To encourage businesses to remove barriers that would hinder disabled workers, the federal government offers a tax credit aimed at deferring capital improvement costs for wheelchair ramps, curb access ramps, elevators, or other improvements that aid the disabled.

Common Personal Tax Credits

When it comes to personal tax credits, the Earned Income Credit is the most popular, with 17.7% of filers claiming the credit. Other popular personal tax credits include:

  • The Child Tax Credit 14.4%
  • Additional Child Tax Credit 12.0%
  • Nonrefundable Education Credits 5.7%
  • Refundable American Opportunity Credit 5.3%
  • Retirement Savings Contributions Credit 5.7%
  • Foreign Tax Credit 5.7%
  • Child Care Credit 0.3%
  • General Business Credit 0.1%
  • Elderly/Disabled Credit < 0.1%

Tax Planning Is a Year-Round Activity

So how can you be sure you’re getting the most out of your return? The best and easiest way is to partner with an experienced tax professional who understands how to navigate U.S. tax law. Unlike tax preparation, which tends to heat up in the months preceding April 15th, tax planning involves strategy and year-round vigilance.

By partnering with a tax professional who understands your financial goals as well as your current obligations, you’ll be sure to know if you are eligible for tax credits helping to reduce your tax obligation. At Moskowitz LLP, we’ve built our reputation helping clients like you clear their tax hurdles and plan for future growth. Contact us today to schedule a no charge, initial consultation.