Successful entrepreneurs must possess several types of skills. There’s industry-related skills, like strategizing and problem-solving. Then you have business-related skills, like marketing and managing. Unfortunately, these aren’t the only skills required for building and maintaining a successful business. You also need financial skills, which ensure that you are properly compensated for your hard work and expertise. Examples include making the most out of your resources, spotting wise investments, and of course, preventing taxes from limiting your business’s profitability.
You’ve probably heard about the importance of tax deductions for new entrepreneurs. Tax deductions reduce your taxable income, which therefore reduces your tax liability at the local, state, and federal level. However, the amount of money you can save from tax deductions may pale in comparison to what you can save with tax credits. Instead of reducing your taxable income, tax credits lower your tax bill directly. Though tax credits may be harder to qualify for than tax deductions, the potential savings are simply too great to ignore.
In this guide, we’ll explain the difference between tax credits and tax deductions along with which tax credits are most accessible and how to file for them.
What are Small Business Tax Credits?
Every year, the federal government awards tax credits to businesses in exchange for making decisions that will positively impact the economy, the environment, or certain types of people. These decisions are clearly geared towards helping the greater good, as opposed to the business itself.
Tax Credits vs Tax Deductions
It’s easy to confuse tax deductions and tax credits. After all, they have the same general objectives: saving money and protecting profitability. But the two are actually very different.
The biggest difference is that compared to tax deductions, much fewer businesses can meet the requirements for tax credits. But this could change very soon, as the small business community becomes more progressive and altruistic.
Tax deductions and tax credits lower your tax bill in very different ways. The former directly impacts your taxable income. The less money you claim to make, the less taxes you will have to pay. If you report business income on your personal tax return, tax deductions can also lower your tax bill by putting you into a lower personal tax bracket.
With tax credits, on the other hand, you can literally subtract the dollar value of the credit from your final tax bill. For example, if you are awarded a tax credit of $10,000, you can just subtract $10,000 from your tax bill to determine how much you owe. The ability to deduct $10,000 in expenses doesn’t mean you will pay $10,000 less in taxes. That amount would instead be converted into a percentage.
Another major difference is that deductions usually come from very typical business expenses. This can include inventory, utilities, rent, and even advertising.
Also, while tax deductions can be big and small, virtually any tax credit can have a significant impact on your tax bill.
Credits vs Deductions: Example
The businesses that reap the greatest rewards from tax deductions do so by lowering their personal tax bracket. Let’s say you’re a sole proprietor and your business earns $95,000 in taxable income this year. When tax season rolls around, you find out you have $15,000 in business expenses that can be deducted from your taxable income. This would put your taxable income at $80,000.
According to the 2020 tax brackets, a sole proprietor who makes $80,000 pays a tax rate of 22%. A sole proprietor who makes $95,000 belongs to the 24% tax bracket. The deductions bumped you down to a lower tax bracket. This could save you thousands of dollars come tax season.
You would probably save more, however, with a tax credit valued much lower than $15,000, even with fewer deductions.
The example above would produce a tax bill of approximately $17,600. Let’s say you were only able to deduct $7,000 in business expenses, but you were also awarded a tax credit of $5,000. You would still fall into the 24% bracket at $88,000, which gives you a tax bill $21,120. When you subtract your tax credit, you’d get $16,120.
As you can see, the $5,000 tax credit and $7,000 in deductions allows you to save more than just $15,000 in deductions.
How to Claim Small Business Tax Credits
Before exploring the criteria for different tax credits, you must first determine the amount of tax credits you can claim each year. To find your tax credit limit, start by adding your net income and alternative minimum tax. The latter can be easily calculated via most tax software tools.
You can use the same software to calculate tentative minimum tax, which you’ll need for the second part of the formula. After adding together your net income tax and alternative minimum tax, you must then determine which number is greater: your tentative minimum tax for the tax year or 25% of your usual tax bill that’s greater than $25,000.
Whichever number is greater; subtract that from the sum of your net income tax and alternative minimum tax.
Tax credits are claimed by submitting the forms attached to each specific credit alongside your tax return. If you discover that you are eligible for more than one tax credit, you must additionally submit IRS Form 3800 (a.k.a. the General Business Credit Form). On this form, you will add up each individual credit you are eligible for to calculate the total value.
If you are only eligible for one tax credit, you can simply submit the form required for that credit alongside your tax return.
10 Popular Small Business Tax Credits
Earlier, we noted that tax credits aren’t used as frequently tax deductions. This is largely because the federal, state, and your local governments issue new tax credits every year. Certain credits from the previous year are no longer available.
So, in order to figure out which credits you may be eligible for, you must keep tabs on the release of new credits as well as the expiration of old credits.
This is why we’ve compiled a list of tax credits that are very popular. The following credits probably aren’t going anywhere anytime soon:
1. Small Business Health Care
This product of the Affordable Care Act (a.k.a. Obamacare) is among the most popular tax credits at this moment in time. It is awarded to smaller businesses that provide health insurance to employees and cover half of the costs themselves.
In order to qualify, your business must have less than 25 full-time employees and pay those employees an average wage of less than $55,000 per year. This number will likely go up as the average full-time salary in the US does the same.
Qualifying businesses must have also purchased a qualified health plan from the Small Business Health Options Program (SHOP), and currently pay at least half of their employees’ health insurance premiums.
The Small Business Health Care Tax Credit’s dollar amount is equal to 50% of the combined costs of your employees’ health insurance premiums. This credit cannot be claimed more than two years in a row. You can claim it more than twice, just not two consecutive years.
2. Increasing Research Activities
“Research and Development” (R&D) is a notoriously vague term that can be applied to a host of activities. This credit usually goes to science, medical, and IT-related businesses. However, many other types of businesses engage in the activities required for eligibility.
These include developing new proprietary products and applying for patents, developing a new manufacturing system, improving the efficiency of a product or improving quality control processes. The aforementioned three industries are the most common recipients. They tend to release highly innovative and technical products requiring extensive research and testing. Any businesses that wishes to qualify must have documented evidence of their progress like notes, diagrams, or results from lab tests or trials.
Qualifying businesses can subtract up to 10% of their R&D costs from their tax bills.
3. Alternative Motor Vehicle, Electric Vehicle, and Alternative Fuel Credits
A number of tax credits are available for businesses that use or produce alternative energy sources. Examples of such energy sources include renewable diesel fuels, lithium batteries for electric cars, wind energy, solar energy, or even a vehicle that runs on alternative fuel.
Businesses that use electric cars can apply for The Qualified Electric Vehicle Credit. The value of this credit depends on the caliber of the vehicle’s lithium battery. Businesses that use renewable fuels can apply for the Biodiesel and Renewable Diesel Fuels Credit, the Alternative Fuel Vehicle Refueling Property Credit, or the Biofuel Producer Credit. These final four tax credits can carry very different values. For more details about eligibility, visit the website of the US Department of Energy.
4. Disabled Access
The Disabled Access Tax Credit is awarded to businesses that make their physical locations more accessible to disabled individuals. Examples of such improvements include building a ramp at your entrance, providing braille text to mark different parts of a store, or even spacing your shelves farther apart. These upgrades can be expensive. For this reason, the Disabled Access Tax Credit targets smaller businesses. To qualify, your business cannot earn more than $1 million per year and have more than 30 full-time employees.
Qualifying businesses can receive up to 50% of the costs of disabled access upgrades that cost up to $10,000. Thus, the maximum amount you can receive from this credit is $5,000 per year.
5. Family Leave Act
Though it’s only been available for two years, this credit will be discontinued in 2020. This is the last year you can take advantage of the Family Leave Act Tax Credit. It incentivizes small businesses to provide paid family and medical leave to employees.
In order to qualify, your business must have a documented policy that provides at least two weeks of paid family and medical leave to all full-time employees per year. The compensation must amount to at least 50% of the employee’s wages.
Qualifying businesses will receive the equivalent of 12.5% of the wages that were paid to employees who went on family or medical leave last year. If you paid more than 50% of your employees’ wages when they were on paid or medical leave, you’ll receive more than 12.5%. If you cover 100% of your employees’ wages during paid or medical leave, you can receive up to 25% of the employee wages you paid.
6. Employer-Provided Child Care
The Employer-Provided Child Care Tax Credit is awarded to businesses that cover their employees’ child care expenses. Examples of such expenses include the monthly costs of using a child care facility or paying the salary of a caregiver who looks after an employee’s child. Eligible businesses can also cover the costs of granting employees access to child care services.
Various types of expenses can qualify for this tax credit. They just have to go towards the costs of operating or expanding an existing child care facility. Businesses must also prove that the facility involved in the claim is in compliance with state and local licensing requirements.
If you qualify, you can claim 25% of employee child care expenses plus 10% of expenses associated with helping employees obtain child care services. The maximum credit is $150,000 per tax year.
7. Employer Social Security and Medicare Taxes Paid on Certain Employee Tips
If you run a full-service restaurant, many of your employees probably make most of their money from tips. Some restaurants actually pay social security and Medicare taxes on tips for certain types of employees. This tax credit allows businesses in the food and beverage industry to claim a credit on these payroll taxes.
For most recipients, the tax credit is the equivalent of the amount of social security and Medicare taxes that the employer pays on tips received by each applicable employee.
In order to qualify, however, your employees must also receive hourly salaries of at least $5.15 per hour. This was the federal minimum wage in 2007. Today’s minimum wage is obviously much higher. But for calculations’ sake, the requirements for this tax credit are still based on the 2007 minimum wage.
8. Small Business Pension Plan Startup Costs
This tax credit is worth a maximum of just $500. However, the requirements are arguably easier to meet than most other credits on this list. The Tax Credit for Small Business Pension Plan Startup Costs is designed to help cover the costs of implementing retirement packages for your employees. You may incur administrative costs and other expenses when informing your employees about the new package and their investment options.
In order to qualify, you must have had up to 100 employees who earned at least $5,000 in wages during the tax year. Eligible businesses also cannot have had a previous retirement plan set up for the same employees who will be receiving the new plan, unless that previous plan was set up more than three years ago.
Most types of retirement plans, such as 401(k) plans, SEP IRA plans, and SIMPLE IRA plans, can qualify.
9. New Markets Tax Credit
The New Markets Tax Credit has been renewed several times. Still, Congress could very well decide to change their minds at the end of 2020. In other words, this tax credit might not be available next year. It is awarded to businesses that invest in Community Development Enterprises (CDEs) and Community Development Financial Institutions (CDFIs). These are organizations designed to bolster the economy and quality of life in low-income areas. You can find CDEs and CDFIs closest to you through this tool provided by the Department of Treasury.
In order to qualify, you must have contributed to the construction and/or rehabilitation of certain types of community-oriented businesses. Examples include educational facilities, community centers, health facilities, industrial facilities, or facilities that provide services to underserved groups (minorities, veterans, ex-felons, etc.). These businesses must be located in areas with a poverty rate of at least 20%, or a median family income that is lower than 80% of the median income for the area as a whole.
10. Work Opportunity Tax Credit
As of now, the Work Opportunity Tax Credit will expire at the end of 2020. So, this may be your last year to take advantage of this tax credit. The Work Opportunity Tax Credit encourages businesses to hire types of people who have historically struggled to get jobs. This includes veterans, food stamp recipients, family assistance recipients, ex-felons, individuals who receive Supplemental Security Income (SSI), and individuals who have been unemployed for long periods of time.
The size of the credit depends on which of these categories your employee belongs to, how many of those employees you hired the past year, and how many hours they worked. Businesses that employ veterans and long-term family assistance recipients reportedly tend to receive the highest credits.
For each employee, you can claim a credit of 40% of their first $6,000 in wages, which comes out to $2,400.
Ask Your Tax Professional About Small Business Tax Credits
The tax credits on this list are certainly among the most popular for small businesses. But that doesn’t mean they are the most accessible. Your CPA or another tax professional should be able to tell you which tax credits you can qualify for. The federal government offers plenty of additional tax credits. Your state and local governments also have their own tax incentives with the same basic function.
But regardless of which government they come from, tax credits are usually available for just a few years. The businesses that take full advantage of tax credits do so by keeping tabs on new releases, often with the help of a tax professional. Yes, this may require a little extra effort. But the perfect tax credit for your business may not be around again for a very long time. So, you might as well put in that extra effort under the assumption that you won’t have another opportunity like this anytime soon.