Tax Credits vs Tax Deductions: Understanding the Difference
Tax deductions are great, but tax credits are even better! So what's the difference? Glad you asked!
A tax deduction is what most small businesses think of when working with taxes. You know, things like rent, payroll, etc. Often entrepreneurs have questions about what QUALIFIES as a tax deduction (can I deduct this?), but the idea is straightforward. You only pay taxes on what is left over after paying your expenses.
For your reference, the IRS says that in order for an expense to qualify as a tax deduction, it has to be:
Ordinary: common and accepted in the industry.
Necessary: helpful and appropriate for the business.
Obviously that is a broad definition, and often it comes down to individuals facts and circumstances.
Unlike tax deductions, which reduce the amount of taxable income, a tax credit reduces your TAX. Think of them as extra tax payments on your behalf. A tax deduction will save you whatever your tax rate is (e.g. 35%), but a tax credit is worth 100%. One caveat, however, generally the IRS doesn't let you deduct the expenses that generated the tax credit. No double dipping.
There are literally hundreds of federal and state tax credits, and many of them have very narrow applicability. Many of them are for individuals, not businesses. A popular example is the Child Tax Credit that are taken on your individual income tax return (form 1040). Others geared towards businesses will either be taken against the business tax liability or will flow through to your individual return. There are some credits that can be taken by either individuals or businesses (e.g. electric car credit).
One other thing to note. Credits come in two flavors, refundable and nonrefundable. Nonrefundable simply means that you can take the credit to the extent you have a tax liability. In other words, can't go below zero. Some nonrefundable credits can be carried forward for future years, while others are not. Refundable credits act like a cash tax payment to the government. If there is a negative balance, they send you the balance. The most popular example of a refundable credit is the Earned Income Tax Credit for individuals.
Here is a list of popular business tax credits for federal income taxes:
It is best to work with a professional when trying to minimize your taxes. There are a lot of opportunities that frankly you don't really want to research. Give us a call to discuss how we can help your business.
Graduate from the University of Oklahoma with a Bachelor of Accountancy. Handles the firm administration, Business Advisory services and business succession planning for our clients.
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