Tax credits

Navigating the intricate world of tax can be a challenging task for businesses. However, tax credits emerge as silver linings, offering substantial financial advantages for businesses. By understanding and leveraging these credits, businesses can optimize their financial performance, reduce liabilities and enhance their growth trajectory.

What is a tax credit?

A tax credit is an incentive made available by both federal and state governments to encourage specific behaviors or investments. It’s designed to directly reduce the amount of taxes a company may owe. In the dynamic business operations landscape, where every dollar counts, comprehending and capitalizing on tax credits, for which the company may be eligible, becomes pivotal for financial optimization and strategic planning.

How do tax credits work?

Tax credits are designed to promote certain business behaviors and investments. Some are refundable, meaning the surplus can be refunded if the amount of the credit exceeds the business’s tax liability. Nonrefundable credits, however, only reduce tax liability up to the amount owed by the business.

It’s good tax credit strategy to be aware of eligibility criteria because there may be stipulations. Businesses must also familiarize themselves with the latest tax regulations and ensure accurate documentation to maintain compliance.

Tax credits vs. tax deductions

Leveraging both tax credits and tax deductions can significantly impact a business’s tax bill. However, knowing the difference between the two is vital for a strategic financial approach.

Tax credits for businesses

Tax credits are direct reductions in the tax amount a business owes. For example, if a company qualifies for a $5,000 tax credit, its tax liability decreases by that same amount.

Tax deductions for businesses

Tax deductions, on the other hand, decrease the taxable income upon which the tax owed is calculated. For instance, if a business has a taxable income of $100,000 and gets a $10,000 tax deduction, it will only be taxed on $90,000.

Types of tax credits

Tax credits are tools used by governments to incentivize or support specific activities or groups. Understanding the different tax credit types can lead to significant savings for businesses. Here's a breakdown:

Nonrefundable tax credits

These credits can help businesses reduce their tax liability, but they have a limit.

How they work: Nonrefundable tax credits can reduce a business’s tax liability to zero, but not below it. If the credits exceed the tax owed, the surplus can be lost unless the credit can be carried backward or forward. Strategic planning is essential to ensure maximum benefit.

Refundable tax credits

From a cash flow perspective, refundable tax credits are the most advantageous credits for businesses.

How they work: Even if a company's tax liability is zero, it can still get a refund on its tax return if it qualifies for more in credits than the tax owed.

Partially refundable tax credits

These credits offer a middle ground, providing businesses with both immediate tax relief and potential refunds.

How they work: Part of the credit reduces the tax liability (nonrefundable), and if there's a balance left, a percentage of it can be refunded.

Common business tax credits

Tax credits can be instrumental in helping businesses offset costs and invest back into their operations. Below is a breakdown of common tax credits available to eligible businesses:

Work Opportunity Tax Credit (WOTC)

Diversity in employment can lead to tax advantages. By hiring from groups that traditionally face employment hurdles — like veterans, ex-felons and others — a business can potentially reduce tax burdens.

Criteria for WOTC

WOTC incentivizes hiring from underserved populations, including:

• Qualified short-term and long-term IV-A recipients (Temporary Assistance for Needy Families)
• Qualified veterans
• Ex-felons
• Designated community residents (DCR)
• Vocational rehabilitation referrals
• Summer youth employees
• Supplemental Nutrition Assistance Program (SNAP) recipients
• Supplemental Security Income (SSI) recipients
• Qualified long-term unemployment recipients

The tax credit from the WOTC program varies by the employee's group, hours worked, and wages. As of 2020, most target groups have a maximum credit of $2,400 per new hire, with specific veterans yielding up to $9,600.

R&D tax credit

Innovation drives business forward. Companies engaging in research and development may be eligible for credits related to their endeavors.

Criteria for R&D tax credit
Learn about qualifying R&D activities

Tax credits commonly missed by small businesses

Navigating the maze of tax regulations can be challenging, especially for small business owners focused on day-to-day operations. While large corporations may have dedicated tax departments, small businesses often lean on limited resources during tax filing season. As a result, some valuable tax credits go unnoticed.

Here are some commonly overlooked tax credits that can create opportunity and elevate small businesses:

Disabled Access Tax Credit

Businesses taking steps to make their establishments more accessible for disabled individuals can benefit from the Disabled Access Tax Credit.

Criteria for the tax credit

• Organizations must comply with Americans with Disabilities Act (ADA) requirements.
• Businesses must earn revenue of $1 million or less and employ 30 or fewer full-time workers.
• The maximum credit claimable is $5,000 annually.

Small Business Health Care Tax Credit

Businesses prioritizing employee health can take advantage of this credit to offset their premium expenses.

Criteria for the tax credit

• Businesses must have fewer than 25 full-time or equivalent employees.
• The average wage for full-time employees is under $50,000.
• Businesses must cover at least 50% of the cost of health care coverage for each employee (employee only, not dependents).
• Premiums must be for a qualified health plan from the SHOP Marketplace (or qualify for a limited exception requirement).
• Eligible businesses can claim 50% of employer-paid health insurance premiums. This credit is claimable for two consecutive taxable years.
• The maximum credit is 50% of premiums paid for small business employers and 35% of premiums paid for tax-exempt, small business employers.

Employer Tax Credit for Paid Family and Medical Leave

Businesses providing paid family and medical leave under the Family and Medical Leave Act of 1993 can claim a tax credit to help them support their employees during challenging times without facing undue financial strain.

Criteria for the tax credit

• Employers must provide at least two weeks of paid family medical leave annually and pay at least 50% of their employees’ wages during leaves of absence.
• The credit is a minimum of 12.5% of the wages paid to qualifying employees, increasing incrementally based on the wage percentage covered during leave.
• Credit can be claimed on wages paid during tax years beginning in 2018 through 2025.

Rehabilitation, Energy and Reforestation Investment Tax Credit

Environmentally conscious investments can lead to substantial tax savings. Whether restoring historical buildings, engaging in reforestation projects, or harnessing solar and wind energy, businesses can claim a credit covering 10% of such investments, with an annual maximum of $10,000.

Criteria for the tax credit

Business should refer to the Department of Energy's website for more specific details regarding the Rehabilitation, Energy and Reforestation Investment Tax Credit.

Alternative fuel tax credits

A transition to greener fuels offers both environmental and financial benefits. Some of the tax credits available include:

• Biodiesel and Renewable Diesel Fuels Credit
• Alternative Fuel Vehicle Refueling Property Credit
• Biofuel Producer Credit
• Qualified Electric Vehicle Credit

Criteria for the tax credits

Credits vary based on the specific fuel or vehicle type.

Tipped employee tax credits

For hospitality businesses, credits linked to tipped employees can offset some of the Social Security and Medicare tax costs.

Criteria for the tax credit

The credit usually matches the employer's Social Security and Medicare taxes paid for tips received by employees.

Pension Plan Startup Tax Credit

Small businesses aiming to provide retirement benefits to employees can claim credits to offset the costs of starting pension plans.

Criteria for the tax credit

• Eligible businesses had 100 or fewer employees received at least $5,000 in wages during the preceding tax year.
• Businesses have not set up a retirement plan for the same group of employees in the past three years.
• At least one plan participant was a non-highly compensated employee
• Most retirement plans, like 401(k) plans and simplified employee pension (SEP) individual retirement account (IRA) plans, qualify for this credit.

Employer-Provided Child Care Credit

Offering childcare solutions can net businesses a credit, capping at $150,000 annually.

Criteria for the tax credit

• Businesses have expenditures for construction, remodeling, expansion or operation of a childcare facility.
• Organizations incur costs from providing child care through a qualified facility, child care resources or referral services.
• Businesses can claim 25% of child care expenditures and an additional 10% of child care resource and referral expenses.

Note: This tax credit is different from the Child and Dependent Care Credit (CDCC), sometimes called the Child Tax Credit, which is for consumers.

New Markets Tax Credit (NMTC)

Reinforcing community development is at the heart of the NMTC. Businesses can expect tax incentives by investing in organizations focused on job creation in underserved communities.

Criteria for the tax credit

• Businesses must be certified as a Community Development Entity to be eligible for this credit.
• Projects usually involve real estate acquisition, renovation, construction or business expansion in low-income areas.
• Examples include constructing educational facilities, hospitals or industrial buildings that create jobs.
• To be eligible, projects must be in areas with a 20% poverty rate or where median family incomes don't exceed 80% of the area median income.

Other tax credits

• Electric Vehicle Credit: The shift towards electric transportation offers businesses a chance to claim sizable credits. Depending on the vehicle's battery capacity, this credit can range from $2,500 to $7,500.
• Alternative Motor Vehicle Credit: Alternative fuel vehicles, like hydrogen fuel cell cars, offer tax relief. The potential credit of up to $7,500 can be a substantial boon for eligible businesses.
• Enterprise Zone Employment Credit: Businesses operating in designated "enterprise zones" can claim this credit if they hire employees living within these areas. It's designed to boost economic growth in distressed regions.

Terminating tax credits

Understanding the rules around termination is crucial for businesses navigating tax credits. Whether a business is wrapping up a particular initiative, restructuring or transitioning away from a specific tax credit program, here are some key considerations:

Credit lifecycle management

Tax credits often have specified lifetimes. When businesses terminate their involvement with a particular tax credit, it's essential to ensure they’ve maximized the credit's value during its active period. Businesses should audit their records to confirm they’ve claimed every dollar they’re entitled to.

Documentation and compliance

Maintaining thorough records is crucial even after terminating association with a tax credit program. Audits can occur years after a credit has been claimed, so businesses must keep comprehensive documentation to validate their eligibility and the amount claimed.

Future implications

Terminating from one tax credit doesn't preclude participation in others. Businesses should stay informed about evolving tax credit opportunities that may align with future goals. Engaging with a tax consultant to keep a pulse on changing landscapes can be helpful.

Transition and overlaps

When moving from one tax credit program to another, it’s critical to ensure a smooth transition. There might be overlapping periods where businesses can claim credits from both programs or specific protocols might need to be followed when shifting focus.

Example of a tax credit

Consider a small business dedicated to inclusivity. Recognizing the need for a more accessible workspace, it makes renovations tailored to individuals with disabilities, embodying corporate responsibility. These commendable efforts cost $8,000.

The Disabled Access Tax Credit would cover 50% of eligible expenses (capped at $5,000 annually), equaling $4,000. Come tax season if the business’s initial tax liability stands at $6,000, it might be eligible for another $2,000 tax credit.

Take advantage of your eligible business tax credits

Tax credits, while beneficial, require businesses to be proactive, informed and timely. Staying ahead of the curve and understanding the ins and outs of tax credits can translate to significant savings, all while promoting socially responsible business practices. Take advantage of your eligible tax credits and incentives with ADP SmartCompliance for tax credits and start saving.

Frequently asked questions about tax credits

Is a tax credit a refund?

No. A tax credit isn't an immediate refund. It operates as a reduction of your business's owed amount of income tax on a dollar-for-dollar basis. If tax credits bring your tax liability to zero, only refundable credits will potentially lead to a refund.

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

A tax credit decreases your company's tax obligation, whereas a tax refund represents the overpayment returned to your business after accounting for all taxes paid over the year. For example, if your business owes $1,000 in taxes and you're eligible for a $300 tax credit, your tax liability drops to $700. Alternatively, consider that your company pays $1,200 in taxes during the year, but after all deductions and credits, it owes just $1,000. Your business would get a $200 tax refund.

Is a tax credit actual money?

A tax credit isn't immediate cash in hand. It's an offset against your business's tax due. Yet, if the refundable tax credits surpass your business's tax obligation, the IRS will remit the extra amount as a refund. This transforms the credit into a tangible monetary return for your business.

Remember, while tax credits can be a strategic move for business growth and savings, it's essential to understand their nuances. Always seek advice from a tax professional to ensure you maximize the benefits while supporting compliance.

This guide is intended to be used as a starting point in analyzing tax credits and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.