For some business owners, the term "tax credit" signifies something good, but they are not sure what the term means, or how tax credits are different from tax deductions.
As you will see, tax credits are better than deductions. Take a look at some of the most common tax credits businesses can use to lower their taxes.
Tax Credits vs. Tax Deductions
Tax credits are given to businesses and individuals as incentives for certain kinds of activities. For example, businesses can get tax credits for purchasing energy-efficient vehicles or building with "green" materials. In the cases below, the actions benefit the economy, the environment, or business development, or have other positive business purposes. Usually, a tax credit is offered for a specific time period.
Tax credits are superior, in terms of tax savings, to deductions. Tax credits are deducted from income before gross income is determined. Tax deductions are taken in the next step of the tax process, reducing the net taxable income.
Tax Credits for Purchases
For tax credits for business purchases, you must have purchased and put into service (meaning you've started using) the equipment, vehicle, or facility in the year in which you claim the tax credit.
COVID-19 Tax Credits
In response to the COVID-19 pandemic, some additional tax credits were made available to businesses:
- An employee retention credit to give businesses an incentive to keep employees working
- Sick leave and family leave credits to help companies with the cost of leaves
You can take these tax credits by deferring payment of your employer part of Social Security taxes withheld from employees on Form 941, the quarterly payroll tax report. The Internal Revenue Service (IRS) published FAQs on deferring tax credits in 2020 to explain the process.
Here are more details about tax credits you may be able to use to help you lower your tax burden.
Employee Retention Tax Credit
As part of the 2020 CARES Act, the IRS created an employee retention tax credit to incentivize employers to keep employees on their payrolls.
This fully refundable tax credit was for 50% of qualified employee wages (up to $10,000) paid after March 12, 2020.
Effective Jan. 1, the amount of the credit was increased to 70% of qualified wages, including the cost of health benefits, with a cap of $7,000 per employee per quarter. With the passage of the American Rescue Plan Act (ARPA), the credits are extended through Dec. 31, 2021.
Employers who receive Paycheck Protection Program (PPP) loans may still qualify for this tax credit, but not for wages paid for with forgiven PPP proceeds. Also, group health plan expenses can be considered qualified wages in some circumstances.
Tax Credits for Paying Employees on Sick Leave and Family Leave
The 2020 Families First Coronavirus Response Act (FFCRA) offered tax credits to employers that provide sick leave and family leave to employees.
These credits are for small and mid-size employers (those with fewer than 500 employees) who give paid sick time to employees who stayed home for their own illness or for someone who needed their care. They also provide paid family leave for employees to care for a child.
Employers who paid these expenses can get tax credits for part of the cost of providing these payments to employees. They can take the tax credits by deferring the employer's part of Social Security benefits on the employees' wages.
The program originally ended Dec. 31, 2020, but Congress extended the credits, first through March 31, 2021, and then through Sept. 30, 2021, under the ARPA.
The Affordable Care Act (also known as Obamacare) includes a small employer health insurance tax credit to encourage small employers to offer health insurance for the first time or maintain coverage they already have.
The credit is available to small businesses that pay at least half the cost of single coverage for their employees. If your business and your plan meet the qualifications, you can get a credit of up to 50% of the health insurance premiums you paid for employees, but not for yourself as the business owner.
To be eligible for the credit, you must:
- Have fewer than 25 full-time equivalent employees
- Have average wages be less than $54,200 for the tax year
- Pay for these premiums using an IRS-qualified arrangement
Self-Employment Health Insurance Deduction
If you are self-employed, you can get a similar tax deduction for yourself, your spouse, and your dependents. This self-employed health insurance deduction is available for the costs of medical insurance, dental insurance, and long-term care policies. You can deduct these costs up to the total of your self-employment income.
Research and development tax credits have been available for many years, but the owners of small businesses often don't realize they can qualify for these credits. This credit is specifically for increasing research activities. A sole proprietor, partnership, or non-public corporation is eligible.
Even if your business doesn't do traditional scientific research, you may be eligible for this tax credit for other kinds of research, including:
- Product development
- Surveys or studies
- Improving product quality, reliability, or function
- Improving business performance
It may also be applied to payments to outside researchers or employees who do research.
Qualified research activities must be able to show a connection between the expenses claimed and the research activity.
The credit is for up to 20% of qualified research expenses, up to $250,000 annually.
If you make changes to your business location to accommodate employees and customers with disabilities, you may be eligible for disabled access tax credits.
To qualify for this credit, your business must earn $1 million or less and have no more than 30 full-time employees the previous year.
Your business may also be able to take a tax deduction for removing architectural and transportation barriers for employees and others. You can get this deduction in addition to the tax credit described above.
Making changes to your business with equipment to make it more energy-efficient or more environmentally friendly can benefit you through tax credits. In addition to the tax credits, you may also be eligible for tax deductions for changes made to your business facilities.
For example, the Business Energy Tax Investment Credit gives businesses credit for purchasing or implementing energy-saving activities, such as fuel cells and wind and solar energy.
To qualify, your business must own or have built the equipment and it must meet specific quality and performance standards.
Tax Credits for New All-Electric and Plug-in Hybrid Vehicles
If you buy a new all-electric car or a plug-in hybrid vehicle, you may be eligible for a federal income tax credit of up to $7,500. The amount of the credit varies depending on the battery used to power the vehicle. You can't use the credit for a used vehicle for your business.
The credit is for vehicles bought after Dec. 31, 2009, and it starts phasing out when at least 200,000 qualifying vehicles have been sold. To claim the credit, use IRS Form 8936 Qualified Plug-In Electric Drive Motor Vehicle Credit.
The Work Opportunity Tax Credit allows employers to get a business tax credit for hiring new employees in certain categories:
- TANF Recipients (Long-Term Temporary Assistance for Needy Families)
- SNAP (food stamp) recipients
- Designated Community Residents (living in Empowerment Zones or Rural Renewal Counties)
- Vocational Rehabilitation Referrals
- Supplemental Security Income recipients
- Summer youth employees living in Empowerment Zones
The credit is taken against the employer's share of the employees' Social Security tax (6.2% of wages).
Before You Apply, Discuss with Your Tax Professional
All tax credits come with restrictions and qualifications that you must meet. You can't apply for a tax credit until you have spent money on the purchase or the activity, so get help from your tax professional before you make this commitment.