What is a tax credit?
Once you’ve finished completing your tax return, you’re left with either a tax refund or a tax liability (tax you owe, also called a tax bill). If you have a tax liability, tax credits reduce the amount you owe. Each dollar you have in tax credits count as a dollar reduction to the amount of tax you pay.
Governments offer tax credits as a way to encourage businesses to take a specific action. For example, businesses can get tax credits for increasing energy efficiency or developing new products or processes.
Does a tax credit increase my tax refund?
There are three main types of tax credits. Two increase your tax refund, while the other doesn’t.
Refundable tax credits increase your refund. Even if your tax bill is $0 or you’re owed a refund, you will receive the full amount of the tax credit. If you have a $1,000 tax bill but $3,000 in refundable tax credits, you will receive a tax refund of the difference: $2,000. An example of a refundable tax credit is the Earned Income Tax Credit (EITC).
Partially refundable tax credits provide refunds up to a certain amount. For example, consider a tax credit worth $2,000 of which $1,400 is partially refundable. You are guaranteed the partially refundable portion ($1,400). But the full credit can only be used if your tax bill is greater than the credit amount ($2,000). If your tax bill is over $2,000, the tax credit reduces your bill by $2,000—the full credit amount. But if your bill is less than $2,000, the credit will reduce your tax bill to $0 and provide a maximum refund amount of $1,400 (see breakdown below). An example of a partially refundable tax credit is the American Opportunity Tax Credit.
Nonrefundable tax credits reduce how much you owe in taxes down to $0, but do not provide a further refund. Some nonrefundable tax credits remaining after your tax bill reaches $0 can be carried over into the next year. An example of a nonrefundable tax credit is the Lifetime Learning Credit.
What is a tax deduction?
Tax deductions are accumulated through certain expenses you pay throughout the year. Qualifying expenses are generally either 50% or 100% deductible. This means a dollar spent on a tax deductible expense generally creates a tax deduction of $0.50 or $1.00. There are some restrictions and limitations based on factors like your business income and total expense levels.
Whereas tax credits reduce your tax bill, tax deductions reduce your taxable income. Your taxable income is the income you pay taxes on.
Some notable expenses that are tax deductible include:
- Marketing and advertising - 100% deductible
- Business meals - 50%
- Business related travel - 100% deductible
- Qualified Business Income deduction - 20% of your qualified business income
Further reading: The Big List of Small Business Tax Deductions
The standard deduction vs itemized deductions
For the self-employed, taxable income is your adjusted gross income (AGI) minus the total of your standard deduction or your itemized deductions. Note that self-employed tax deductions from your self-employed business expenses are applied during the calculation of your AGI.
After AGI is calculated, all individual taxpayers then take either the standard deduction or itemized deductions. The choice applies to everyone (even non-business owners) on certain personal expenses.
Counting up your qualifying expenses after calculating AGI and determining your tax deduction is called itemizing or the itemized deduction. The following personal expenses can be included in your itemized deduction calculation:
- Medical and dental expenses (must be greater than 7.5% of your AGI)
- State and local taxes paid (limited to $10,000)
- Mortgage interest paid (on the first $750,000 if purchased after December 16, 2017, on the first $1,000,000 if prior to December 16, 2017)
- Gifts to charity
- Casualty and theft losses from a federally declared disaster
The alternative is the standard deduction is a flat amount you can choose to take instead of itemizing. In 2023, the standard deduction is $13,850 for single filers and those married filing separately, or $20,800 if you’re a head of household. Married couples have a standard deduction of $27,700 if filing jointly.
You choose between the standard deduction and the itemized deduction on Schedule A of Form 1040. If you’re self-employed and file a Schedule C, that’s the form you report any business expenses and tax deductions on. You take a standard or itemized deduction in addition to your business’s tax deductions.
How much is a tax deduction worth?
Corporations are taxed at a flat rate of 21% of their taxable income. Since every dollar of a tax deductible expense reduces their taxable income by a dollar, a tax deduction is effectively worth $0.21 in savings.
Pass through entities
All other for-profit business types are taxed slightly differently. This includes sole proprietors, partnerships, limited liability companies (LLCs), and S corporations. These business types are known as pass through entities, meaning they pass any profit (or losses) onto the shareholders and business owners. Because of this, the business earnings are reported on the personal tax returns of the business owners.
On personal tax returns, you are taxed based on your tax bracket. To learn how this relationship works, check out our guide on how to calculate your tax bill based on your tax bracket.
Your personal income determines what tax bracket you fall in. The greater your income, the higher the rate of taxation on every consequent dollar. Because of this, a dollar in tax deductions can mean savings ranging from $0.10 to $0.37. Simply put, the greater your income, the greater a tax deduction is worth to you.
The difference between tax credits and tax deductions
Both tax credits and tax deductions can reduce your tax bill. But they are important at different stages of the tax filing process.
Tax deductions are earned before you calculate your tax bill. They reduce your taxable income which is used to calculate your tax bill.
By spending money on deductible expenses throughout the year, you are reducing your taxable income which, in turn, reduces your tax bill. But how much it reduces your tax bill depends on multiple factors like your business type and tax bracket.
Tax credits come into play after your tax bill is calculated. For every dollar of tax credits you have, your tax bill is reduced by that amount. You may even get a refund so long as those tax credits are refundable.
An example of tax credits vs tax deductions
Belle Pointe is the primary owner of Pens Inc., a C corporation. In 2023, her business exceeded expectations and she expects to finish this year with $100,000 in taxable income. Knowing that will mean a large tax bill at tax time, Belle is trying to decide how to spend money to earn tax credits or tax deductions. After reviewing her income statement, balance sheet, and cash flows, she decides she has $10,000 to spend.
Belle is considering two options. She wants to cut her business’s energy usage. She knows that there’s a tax credit for cutting her energy usage by 50%. By using the full $10,000, Belle knows she can hit this 50% mark. The tax credit is valued at $1.80 per square foot. With an office of 1,200 square feet, her tax credit would be worth $2,160 (1,200 x $1.80).
She also knows that advertising is 100% tax deductible. If she spends the full $10,000 on advertising, she will make $10,000 in tax deductions. Her C corp has a federal tax rate of 21% meaning her tax deduction would be worth $2,100 (0.21 x $10,000).
By comparing the value of the tax credit and the tax deduction, Belle knows that pursuing the tax credit will reduce her tax bill the most.
How Bench can help
Tax credits and tax deductions are the key to a smaller tax bill, but it’s difficult to know if you left money on the table. Bench offers small business tax services that give you unlimited access to a tax professional year-round to ensure you take advantage of every credit and deduction available to you. While spending your money right can decrease your tax bill, the confidence of going into tax season knowing it will be the smallest bill possible is priceless.