What is a Tax Credit?
A tax credit reduces the amount of tax a business or individual has to pay. The government uses tax credits to encourage or reward behavior that they find beneficial. For example, the government can give a tax credit to people for replacing old appliances with new, energy efficient ones. Most tax credits are given to benefit the economy or environment; however, the government can create tax credits for any reason.
Tax Credits cover expenses that you have paid during a tax year. In most cases, you have to meet certain requirements in order to qualify for a tax credit. Because there is such a wide range of tax credits, it is good practice to check with your accountant before you make purchases that could be tax credit. Once you are aware of the qualifications for each credit, you can follow the regulations so you can claim the tax credit.
Both tax credits and tax deductions reduce the amount of tax liability, but there is a difference between the two. Tax credits directly reduce your taxes. Tax credits are “dollar-for-dollar,” meaning that if you owe $1,000 in taxes, but have $1,000 of tax credits, then you would owe zero dollars in taxes. A tax deduction, on the other hand, decreases your taxable income. If you made $100,000 but had $20,000 in tax deductions, you would only be taxed on the $80,000 for that tax year.
Tax Credit Scenario
Derek is a doctor of chiropractic and owns his own business. As a small business owner, Derek tries to take advantage of as many tax credits and deductions as he can. After reviewing the business tax credits, he’s decided to make some changes in his business so that he can take advantage of these credits.
First, Derek is going to start a retirement plan so that he can take advantage of the Credit for Small Employer Pension Plan Startup Costs. Most employers with fewer than 100 employees don’t have retirement plan options. The government encourages business owners to start pension plans by offering a tax credit. The Pension Plan Startup Costs tax credit offers a credit of 50% or $500 a year for three years. This should help offset the costs of setting up a plan and educating employees about it,
Another tax credit Derek can take advantage of as a small business owner is the Credit for Employer-Provided Childcare Facilities and Services. Derek has a few working mothers on his staff. To help ease the burden on them he has decided to pay for some of their child care services. The employer-provided childcare services tax credit offers small business owners a 25% credit or up to $150,000 a year.
Finally, Derek is going to take advantage of the Credit for Small Employer Health Insurance Premiums. The small employer health insurance tax credit rewards small business owners who pay for insurance coverage for their employees. However, it is a little harder to take advantage of. You must have at least 10 full-time (or full-time equivalent) employees. Those employee must have wages under a certain amount, which changes each year. Small business owners must purchase plans through the Small Business Health Options Program (SHOP.) Finally, you can only claim the credit for two consecutive years.
When Derek does his taxes for the next year these tax credits will be deducted from the taxes he owes and will lower what he pays in taxes.
Frequently Asked Questions:
1. What is a tax credit?
A tax credit is a financial incentive provided by the government that directly reduces the amount of tax a business or individual has to pay. Unlike deductions, which reduce taxable income, tax credits lower the actual tax liability dollar-for-dollar.
2. How does a tax credit differ from a tax deduction?
A tax credit directly reduces your tax bill, meaning if you owe $1,000 in taxes and have $1,000 in tax credits, you owe nothing. A tax deduction, on the other hand, lowers your taxable income, which reduces your tax liability indirectly by lowering the amount of income subject to tax.
3. What types of expenses can qualify for a tax credit?
Tax credits can cover a wide range of expenses, such as energy-efficient home improvements, retirement plan startup costs for small businesses, and employer-provided childcare services. The specific expenses that qualify depend on the type of tax credit and the criteria set by the government.
4. Are there specific requirements to qualify for a tax credit?
Yes, most tax credits have specific eligibility requirements that must be met to qualify. These requirements vary depending on the type of credit. It’s advisable to consult with an accountant to understand the qualifications and ensure you meet them before claiming a tax credit.
5. Can a small business owner claim multiple tax credits?
Yes, a small business owner can claim multiple tax credits, provided they meet the eligibility requirements for each. For example, a business owner might claim credits for starting a retirement plan, providing childcare services, and offering health insurance to employees, all within the same tax year.
