What is a tax credit?

A tax credit is an amount that a business can deduct from its tax liability. For example, let's say a company's tax liability is $1,000,000, and it claims tax credits totaling $250,000. In that case, it now only has to pay $750,000 to the IRS for its tax bill.

The federal government offers tax breaks to businesses to encourage beneficial behaviors that advance society. This includes stimulating the economy, supporting underrepresented groups, preserving the environment, and rehabilitating historic buildings.

How much tax credit a business is awarded is usually based on several factors, including total business income and filing status. Tax credits often have strict eligibility criteria and set limits on the number of credits a business can claim. Some tax credits also have time limits for claiming them.

Types of Tax Credits for Businesses

The question ""What is a tax credit?"" doesn't always have a straightforward answer. That's because ""tax credits"" is a broad term that includes three different categories. Each affects the maximum amount that can be applied to your taxes and how they're paid.

Refundable Tax Credit

Refundable tax credits are paid to the business in full, even if the credit exceeds the tax due. This means that if the credit is enough to reduce the company's tax liability to zero, the business will receive a refund of whatever is left. That refund cannot be applied to the tax liability.

For example, suppose a company has a tax liability of $450,000. If it receives a tax credit of $500,000, the company will receive a refund of the remaining $50,000.

Business tax credits do not typically fall into this category. The most recent example  was the employee retention tax credit  , which was available during tax year 2021 for employers who continued to employ people during the global health emergency.

Partially Refundable Tax Credit

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

Continuing with the previous example, suppose a business with a tax liability of $450,000 receives a tax credit of $600,000. A partially refundable tax credit may allow a company to receive only a portion of the $150,000 remaining after paying taxes.

Partially refundable tax credits for businesses are almost 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 a business to reduce its tax liability to zero. As a result, there will be no refund – not even a partial one – if the amount of the credit exceeds the liability.

For example, if a company has a tax liability of $450,000 and receives a tax credit of $600,000, no refund will be issued for the remaining $150,000 credit. That money will not carry over to the next tax year and will go straight into the hands of the government.

You may be wondering: what good are federal tax credits if businesses can't get a refund for unused parts? It's important to remember that tax credits still reduce a company's tax liability, leading to significant cost savings. They also help the government encourage investment in certain areas, such as the economy or the environment.

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

What is the difference between a tax credit and a tax deduction?

Both tax credits and  tax deductions  can reduce 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 owed by the business to the IRS, a tax deduction reduces the amount of a company's taxable income in the first place. This, in turn, typically reduces the total amount of taxes owed by the business.

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

Just like tax credits, there are different types of tax deductions. Above-the-line deductions are subtracted from a company's income before calculating its adjusted gross income, while below-the-line deductions are subtracted from its AGI.

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

Examples of Common Tax Credits for Employers

While some tax credits have come and gone, many have stood the test of time. While tax credits continue to evolve over time, 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 diversity in the workplace by providing incentives for employers to hire individuals from what the IRS   refers to as "" target groups ."" Some of these groups are:

• Giants
• formerly incarcerated person
• Summer Youth Staff
• Long-term unemployment recipients
• Supplemental Security Income (SSI) recipients
• Supplemental Assistance Nutrition Program (SNAP) benefit recipients

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

Empowerment Sector Employment Loan

 This credit is promoted by the HUD Office of Community Renewal. It offers employers a tax credit of up to $3,000 per employee who lives and works in Renewal Communities and Empowerment Zones. 

These are urban neighborhoods that have been identified by HUD as distressed areas. The incentives are designed to attract businesses to the identified locations to encourage continued economic growth.

Employer-Provided Child Care Credit

Many employers provide childcare services to attract top talent. The IRS offers incentives through tax credits to help employers keep these programs going, as they help keep parents in the workforce. This special credit provides  up to $150,000 per year  . It offsets 25% of facility expenses and 10% of resource and referral expenses.

Clean Vehicle Credit

In an effort to promote clean air and environmental responsibility, the federal government offers a tax credit to businesses that purchase or lease electric or hybrid vehicles for business use. The tax credit provides  up to $7,500 for vehicles weighing less than 14,000 pounds  and up to $40,000 for vehicles weighing more than that.

Energy-Efficient Home Construction Credit

Eligible contractors who build new energy-efficient homes may receive a tax credit for them. The home must be built under either the Zero Energy Ready Home program or the Energy Star program.

Contractors will receive between $1,000 and $2,000 for homes purchased before 2023,   and up to $5,000 for homes bought during or after that year. The credit a contractor receives depends on the program under which the home was built.

Rehabilitation Loan

Also known as the historic preservation tax credit, it encourages businesses and individuals to rehabilitate historic buildings. Eligible buildings must be listed on the National Register of Historic Places or recognized as a significant contribution to a registered historic district. The  National Park Service  outlines other requirements as well.

Employers taking on these projects  can receive up to 20% of qualified rehabilitation expenses.  The credit must be claimed over five years, beginning with the year the building was placed in service.