Tax credits and tax deductions create significant tax-saving potential for small business owners, enabling them to mitigate the cost of certain expenditures. For small business owners, the difficulty typically lies in knowing which credits and deductions to claim. In this article, we explore the key differences between tax credits and tax deductions, outlining both of their potential to save your business substantial sums at tax time.
Tax Credits Versus Tax Deductions – Which Is Better?
A tax credit confers a dollar-for-dollar reduction in taxes, directly decreasing the tax liability of your small business.
A tax deduction reduces your taxable income, decreasing the amount on which you pay taxes.
Since tax credits are deducted directly from your tax bill, at first glance, they may be the preferential option. However, both tax credits and tax deductions can be limited by your income, so choosing the right one to claim can be challenging.
By seeking out the services of a seasoned tax professional, small business owners can potentially save themselves thousands in the long run, gaining valuable insights into the credits and deductions they are eligible to claim.
Tax Credits Explained
A tax credit directly reduces the amount of income tax you owe, and it may be refundable or non-refundable. A non-refundable tax credit could potentially reduce your tax liability to zero, but a refundable tax credit has an added benefit. With a refundable tax credit, if there is any amount left over after reducing your tax liability to zero, you can claim the balance of this credit back as a tax refund.
Common refundable small business tax credits include:
- Premium Tax Credit: This covers premiums for health insurance purchased via the federal health insurance marketplace.
- Child Tax Credit: This is for workers with dependents under 17.
- Earned Income Tax Credit: This is for workers with a modest income.
Non-refundable small business tax credits include:
- Adoption Expense Credit: This is for tax filers who have paid adoption fees.
- Retirement Savings Contribution Credit: This is available to individuals who made eligible contributions to an employer retirement plan or IRA.
- Foreign Tax Credit: This provides credit for taxes paid in a foreign country to help US taxpayers avoid double taxation.
- Child and Dependent Care Credit: This is available to workers who paid for childcare or incurred fees for the care of a qualifying dependent.
Taxpayers can report refundable tax credits using Schedule 5 of form 1040, while non-refundable tax credits are reported using Schedule B.
A tax preparer can help in identifying which credits you qualify for, although if they are acting for you for the first time, it is important to notify them of credits you are carrying over from previous years. A good tax software program can also help small business owners with questions related to tax credits, helping to identify credits for which they qualify.
Tax Deductions Explained
Designed to help small business owners with operational costs, tax deductions reduce taxable income. The key difference between tax deductions and tax credits lies in the fact that while tax credits represent a direct, dollar-for-dollar reduction of your tax liability, tax deductions reduce the amount of income on which you pay taxes. Nevertheless, diligent business owners who claim all of the tax deductions they are eligible for can significantly reduce their tax bill.
Common small business tax deductions include:
- Business Meals: This enables business owners to deduct up to 50% of the cost of qualifying purchases of food and drink.
- Travel Expenses: This includes airfare, hotels, tips, rental car expenses, meals, dry cleaning, and more.
- Home Office Expenses: This enables small business owners to deduct $5 per square foot of their home that is used for business purposes, up to a maximum of 300 square feet.
- Office Supplies: This includes computers, printers, software, paper, pens, and shipping costs.
Both tax credits and tax deductions have vast potential in terms of reducing small business owners’ IRS tax bill. At first glance, with tax credits representing a dollar-for-dollar reduction from the actual amount you owe, these offer greater tax savings. Nevertheless, tax deductions are also incredibly useful in terms of lowering your tax liability. Even though they only shave off a percentage, small business owners can achieve some impressive tax savings by ensuring they claim all of the deductions for which they qualify.
According to a study published by the leading B2B research company Clutch, 30% of small business owners admit overpaying their taxes by missing out on credits and deductions. In contrast, 93% of small business owners are confident of their tax filing capabilities. As Maventri Managing Partner Wanda Medina explains, in the long run it’s important to have an accountant who knows the latest rules and is up to date with the IRS policies. In terms of tax-saving potential, a small short-term investment could pay off in dividends in the long