Tax Credit

What Is a Tax Credit?

A tax credit is an amount of money a business can subtract from its tax liability. For example, suppose that the company’s tax liability is $1,000,000, and it claims tax credits totaling $250,000. In that case, it would now owe the IRS only $750,000 for its tax bill.

The federal government offers tax credits to businesses to encourage beneficial behaviors that move society forward. These include stimulating the economy, supporting underrepresented groups, preserving the environment, and rehabilitating historic buildings.

How much of the tax credit a business is granted is usually based on a number of factors, including total business income and filing status. Tax credits often have strict qualification parameters and cap the amount of credit the business can claim. Some tax credits also have time limits for claiming them.

Types of Tax Credits for Businesses

The question of “What is a tax credit?” doesn’t always have a straightforward answer. This is because “tax credit” is an umbrella term that encompasses three distinct categories. Each one affects the maximum amount that can be applied to your taxes and how they’re paid out.

Refundable Tax Credits

Refundable tax credits are paid out in full to the business, even when the credit is greater than the tax owed. This means that if the credit were to be enough to reduce the company’s tax liability to nothing, the business would receive a refund of whatever is left. That refund could not be applied to the tax liability.

For example, consider a company with $450,000 in tax liability. If it receives a tax credit worth $500,000, the business will receive a refund for the remaining $50,000.

Business tax credits do not typically fall under this category. The most recent example was the Employee Retention Tax Credit, which was available through tax year 2021 for employers that continued to employ people during a global health emergency.

Partially Refundable Tax Credits

Partially refundable tax credits are those that allow the business to receive only a partial refund when a tax credit reduces the tax liability to less than zero. The IRS may cap the refund at a certain dollar amount or allow the business to receive only a percentage of the refund.

In line with the previous example, say that the business with $450,000 in tax liability receives a tax credit of $600,000. A partially refundable tax credit may only allow a company to receive a portion of the remaining $150,000 once the tax is paid.

Partially refundable tax credits for businesses are nearly as rare as fully refundable ones. The Research and Development Tax Credit, which is for companies conducting research or developing new products, allows a portion of the credit to be applied to a future tax year. However, the business will not receive a monetary refund.

Non-Refundable Tax Credits

Non-refundable tax credits are the most common type of business tax credit made available by the IRS. These credits only allow the business to reduce its tax liability to zero. Consequently, there will be no refund—not even a partial one—if the amount of the credit exceeds that of the liability.

For example, if a company’s tax liability is $450,000 and it receives a tax credit of $600,000, no refunds will be issued for the remaining $150,000 in credits. That money will not carry over into the next tax year and will simply go back into the government’s hands.

You may be wondering: What is a federal tax credit good for if businesses can’t receive a refund for unused portions? It’s important to remember that tax credits still reduce a company’s tax liability, which brings significant cost savings. They also help the government incentivize investments in certain areas, like the economy or environment.

There are plenty of non-refundable tax credits available for businesses of all sizes. One example is the Work Opportunity Tax Credit, which provides a 40% credit for wages paid to individuals hired from certain targeted groups.

What Is the Difference Between a Tax Credit and a Tax Deduction?

A tax credit and a tax deduction can both lower your tax liability; the difference between them is the method they use to do so.

While a tax credit is a dollar-for-dollar reduction in the amount of money the business owes to the IRS, a tax deduction reduces the amount of taxable income the company has in the first place. This, in turn, usually reduces the total amount of taxes the business owes.

For example, a business in the transportation industry earning $25,000,000 per year may have a tax deduction for vehicle depreciation totaling $500,000. This deduction would reduce the company's taxable income to $24,500,000, resulting in less taxes owed to the IRS.

Much like tax credits, there are different types of tax deductions. Above-the-line deductions get subtracted from the company’s income before calculating the adjusted gross income, whereas below-the-line deductions are subtracted from its AGI.

How much of a tax deduction the business qualifies for depends on a number of factors. Some deductions apply the same standard to everyone (such as the standard vehicle mileage deduction of 67 cents per mile). Others vary according to business expenses and other elements.

Examples of Common Tax Credits for Employers

Though some tax credits have come and gone, many have stood the test of time. While tax credits tend to evolve with the times, here are some of the most common business tax credits that are still bringing cost savings to employers across the country.

Work Opportunity Tax Credit

The Work Opportunity Tax Credit is designed to promote workplace diversity by providing incentives for employers to hire individuals from what the IRS refers to as “targeted groups.” Some of these groups include:

• Veterans
• Formerly incarcerated individuals
• Summer youth employees
• Long-term unemployment recipients
• Supplemental Security Income (SSI) recipients
• Supplemental Assistance Nutrition Program (SNAP) benefit recipients

Employers are eligible to receive a credit for 40% of up to $6,000 in wages paid to these individuals who work at least 400 hours in their first year of employment. This usually adds up to a maximum of $2,400 per employee.

Empowerment Zone Employment Credit

This credit is promoted by the HUD Office of Community Renewal. It provides employers with a tax credit of up to $3,000 per employee living and working in Renewal Communities and Empowerment Zones.

These are urban neighborhoods that have been identified by HUD as distressed areas. The incentive is designed to attract businesses to the identified locations to stimulate consistent economic growth.

Employer-Provided Child Care Credit

Many employers provide childcare services to attract top talent. The IRS provides an incentive via a tax credit to help employers keep these programs functioning, as they help keep parents in the workforce. This particular credit offers up to $150,000 per year. It offsets 25% of facility expenses and 10% of resource and referral expenditures.

Clean Vehicle Credit

In an effort to promote clean air and environmental responsibility, the federal government offers tax credits to businesses purchasing or leasing electric or hybrid vehicles for business use. The tax credit provides up to $7,500 for vehicles less than 14,000 pounds and up to $40,000 for vehicles exceeding that weight.

Energy-Efficient Home Building Credit

Eligible contractors building new energy-efficient homes may be able to receive tax credits for them. The home must be built under either the Zero Energy Ready Home program or one of the Energy Star programs.

Contractors will receive between $1,000 and $2,000 for homes acquired prior to 2023 and up to $5,000 for homes acquired during or after that year. The credit the contractor gets depends on the program the house was built under.

Rehabilitation Credit

Also known as the Historic Preservation Tax Credit, this incentivizes businesses and individuals to rehabilitate historic buildings. Eligible buildings must be listed in the National Register of Historic Places or recognized as contributing significantly to a registered historic district. The National Park Service outlines other requirements, too.

Employers who take on these projects can receive up to 20% of qualified rehabilitation expenses. The credit should be claimed over five years, starting the year that the building was placed in service.