Let’s just be straight about it—we all want to save money on our taxes. Anything that allows hard-working creatives, small business owners, and generally awesome individuals to (legally) keep more of their hard-earned cash is a huge win.
While most people immediately think of deductions as the way to reduce their tax load, I’m going to let you in on another secret to cutting down your bill: tax credits. Better yet, deductions and credits can be used in tandem for the ultimate savings come April.
Here’s everything you need to know about this tax-reducing magic.
The Difference Between Tax Deductions and Tax Credits
At the core, the difference between tax deductions and tax credits is pretty simple—it all comes down to when in the process of calculating your taxes the savings occur.
Tax deductions reduce your taxable income. The value is taken out before you calculate your tax liability, but you still owe your typical percentage of taxes on every dollar remaining. So the value of your deductions isn’t actually how much you save—$5,000 in deductions only saves someone in the 22% tax bracket $1,100 in taxes owed. Still awesome, but not quite as awesome.
Tax credits reduce your tax liability. Once all the calculations are said and done, you can subtract the amount of your tax credits from your tax bill. This means you save exactly how much in taxes as the credit is worth (with some limitations). So a $5,000 tax credit generally means you’ll be paying $5,000 less in taxes.
As you can see in the chart below, dollar for dollar tax credits save you more than tax deductions. But, even better is when you can use them together.
| Tax Deductions vs. Tax Credits | |||
|---|---|---|---|
| Tax Deduction | Tax Credit | Both | |
| Adjusted Gross Income | $75,000 | $75,000 | $75,000 |
| Tax Deductions | ($5,000) | none | ($5,000) |
| Taxable Income | $70,000 | $75,000 | $70,000 |
| Tax Rate | 22% | 22% | 22% |
| Tax Subtotal | $15,400 | $16,500 | $15,400 |
| Tax Credit | none | ($5,000) | ($5,000) |
| Final Tax Due | $15,400 | $11,500 | $10,400 |
Taking Advantage of Tax Deductions as a Small Business Owner
Since tax deductions are the bread and butter of saving on taxes, I’ve already written extensively about them but I’ll give you the quick run-down here: Many expenses involved in building or running your business are tax-deductible, meaning you can subtract those costs from your taxable income. You’ll want to make sure to track and categorize these expenses carefully throughout the year, keeping receipts (physically or digitally) in case you get audited.
You’ll want to familiarize yourself with all the possible deductions out there to make sure you’re taking full advantage of these savings, and talk to your accountant if there’s anything you’re spending money on but aren’t sure if you can deduct. I’ve written a comprehensive guide to the most commonly-used tax deductions for small business owners to help you out!
Taking Advantage of Tax Credits as a Small Business Owner
As you saw above, tax credits are powerful opportunities for saving, but are less used by small business owners. Part of this is just a lack of awareness—you’re already one step ahead there! Part of this is because there are fewer tax credits out there and many of them apply to very specific situations or have lots of limitations. You’ll want to make sure you 100% qualify for any given tax credit before claiming it, so it’s usually a good idea to consult with a CPA for help.
That said, there are some great tax credits that help plenty of creative small business owners save lots of moo-lah. Common ones I see my clients use, either to reduce their individual or business tax load, include:
- Earned income tax credit – This provides a tax break to people who work but still earn low to moderate income. The income cap for this credit varies widely depending on marital status and number of children—ranging from and adjusted gross income $15,820 if you’re single with no children to $56,884 for couple filing jointly with three or more kids in 2020—and the credit you can earn also varies based on number of children. There are a few other factors that determine if you’re eligible, but generally I find this credit valuable for my clients who are just getting their business off the ground and not making much yet. You’ll file this as part of Form 1040 and include Schedule EIC if you have qualifying children.
- Work opportunity tax credit – If your business has employees, pay attention—the work opportunity tax credit could give you a break if you hire people who typically have a harder time getting jobs. These targeted groups include veterans, ex-felons, certain folks with mental or physical disabilities, and more. There are several steps involved with claiming this credit—more info here.
- Plug-in electric drive vehicle credit – Going green? You could get a tax break of anywhere from $2,500 to $7,500 for buying an electric car. If you’re looking into purchasing a new ride, check out the full list of qualifying cars and their credits here. You’ll use Form 8936 to calculate and claim this credit.
- Employer-provided childcare credit or individual childcare tax credit – Taking care of kids so you can get your work done is expensive! This tax credit can help. If you’re an employer that provides childcare facilities for your employees or contracts an external facility for the benefit of your employees, you can get back some of those costs in a tax credit, calculated using Form 8882. On the flip side, if you’re an individual who pays out of pocket for childcare costs so you can work or look for work, you may be able to get some of those costs reimbursed as a tax credit. Here’s info on how to figure out if you qualify, as well as Form 2441 for calculating the credit.
- Small employer health insurance premiums or premium tax credit on healthcare – Also expensive? Health insurance. Similar to childcare, there are credits to help, whether you’re an employer providing insurance to others or an individual purchasing your own insurance on the marketplace. If you’re a business owner, this applies if you have fewer than 25 full-time equivalent employees, pay an average wage of less than $51,600 a year, and pay at least half of employee health insurance premiums, You’re also generally required to purchase these plans on a Small Business Health Options Program Marketplace. Here’s more info as well as Form 8941 for filing. For individuals who purchased through the Health Insurance Marketplace, you may be eligible for a credit to cover some of the cost of your premiums based on your income—you can even take advantage of this throughout the year to reduce your monthly payment. More info here and Form 8962 for filing.
- Retirement plans startup costs tax credit – This credit makes it easier for small businesses to start retirement plans for their employees by reimbursing some of the ordinary and necessary costs of starting a SEP, SIMPLE IRA or qualified plan. More info here on who qualifies, and Form 8881 for filing.
One final note about tax credits—they cannot reduce your tax liability to less than zero, and most are non-refundable. In other words, if you owe $10,000 in taxes and have $15,000 worth of credits, you’re most likely just going to lose that extra $5,000.
Abridged by Amy
- Tax deductions reduce your taxable income, whereas tax credits reduce how much you owe in taxes, dollar for dollar.
- While deductions are more commonly used, tax credits can significantly reduce your tax load. (And it’s even better when you use them together!)
- Tax credits have very specific requirements to qualify and specific steps for filing them—make sure to do your research or consult with your CPA before claiming one!
