What Are Business Tax Credits?
Business tax credits reduce a business’ tax liability and are offered to encourage businesses to engage in certain practices deemed positive by the government.
Tax credits of any sort reduce the amount of taxes owed on a dollar-for-dollar basis and are different from tax deductions. Tax credits might be refundable or nonrefundable.
In the U.S., tax credits offset a company’s financial obligation to the state or federal government. The Internal Revenue Service (IRS) oversees the application of business tax credits.
Key Takeaways
- Business tax credits are created to encourage companies to behave in certain ways.
- Tax credits of any sort reduce taxes owed on a dollar-for-dollar basis.
- They are more lucrative than tax deductions, which only reduce taxes by a percentage of the total deduction.
- Tax credits might be refundable or nonrefundable.
- The IRS oversees the application of tax credits, including those for businesses.
Understanding Business Tax Credits
There are many types of business tax credits. Two common ones reward companies for investing resources in research and for hiring workers who face barriers to employment.
Governments offer tax credits for different reasons, including to spur particular types of corporate action and to support the expansion of particular industries. Businesses pursue them in order to lower their taxes.
Claiming Tax Credits
Sometimes there is flexibility in terms of the tax year for which business tax credits are applied. For example, if a business has exceeded its tax credits for the current tax year but not the previous one, it may be able to apply those credits retroactively to the previous year’s tax return.
Alternatively, the business may be able to apply eligible tax credits to a future tax return. (The IRS calls this action a “carryforward.”)
Businesses claim their tax credits when they file their annual tax return. IRS Form 3800, General Business Credit is used to tally the various credits and determine the total monetary amount.
The credits are also claimed separately using the individual forms applicable to each. These forms can be found on the IRS website.
Importantly, credits and forms may change from year to year, so be sure to consult the IRS website—or an accountant or a licensed tax professional—before filing.
You can find a list of current business tax credits (and deductions) on the IRS website.
Types of Business Tax Credits
The U.S government offers a number of different business tax credits. Companies working in certain sectors may be eligible for specific tax credits aimed at bolstering those sectors and the industries within them. Or, the government may want to encourage certain behaviors it deems favorable to society. For example:
- U.S. companies that produce alcohol fuels (or alcohol fuel mixtures) that are sold or used in the U.S. may be eligible for the biofuel producer credit.
- The orphan drug credit motivates the pharmaceutical industry to engage in business activities that may lead to treatments for rare diseases, including qualified clinical trials.
- Employers who hire Native Americans may be eligible for the Indian employment credit (IEC).
Business Tax Credit vs. Business Tax Deduction
The main difference between a business tax credit and a business tax deduction is that the former reduces a business’ total tax bill on a dollar-for dollar basis, while the latter reduces total taxable income on a dollar-for-dollar basis, which results in lowering the tax bill by a percentage of the deducted amount.
For example, a business tax deduction of $5,000 saves a business a percentage of that $5,000; if the corporation is in a 20% tax bracket, the $5,000 deduction is worth $1,000 in reduced taxes ($5,000 X 20% = $1,000).
However, if the corporation qualifies for a $5,000 tax credit, its tax liability is reduced by the full $5,000.
Example of a Business Tax Credit
ABC Corporation is in the process of filing its annual tax return and realizes it may be eligible for a tax credit because the company has an on-site daycare center.
When the company files its tax return, it includes Form 8882, Credit for Employer-Provided Childcare Facilities and Services. However, the amount of money the company is claiming is higher than this year’s allowable tax credit amount.
Because it didn’t claim this tax credit for its daycare center in the previous year, it can retroactively apply a portion of the credit to the prior tax year.
How Do Tax Credits Work?
A tax credit reduces the amount of money owed to the government in a given tax year by the amount of the tax credit. So, if the credit is $3,000, your taxes are reduced by $3,000. In contrast, a tax deduction reduces your total amount of taxable income (and indirectly your tax bill). If you qualify for a tax deduction of $3,000, your taxes are reduced by a percentage of $3,000 dictated by your tax bracket. Thus, if you are in a 20% bracket, your tax bill would be reduced by $600.
What Is the General Business Credit?
The general business tax credit aggregates all individual tax credits that a business might claim in a year. A business must file the appropriate form for each tax credit it claims as well as Form 3800 for the general business tax credit.
Who Qualifies for the Employee Retention Credit (ERC)?
The ERC was created to help businesses and tax-exempt organizations during the COVID-19 pandemic. Unfortunately, the ERC is no longer available for most businesses; the passage of the Infrastructure Investment and Jobs Act (IIJA), signed on Nov. 15, 2021, largely eliminated it after Sept. 30, 2021. As of 2024 it only applies to “wages paid before October 1, 2021” or a “recovery startup business” as defined by the IRS.
The Bottom Line
A business tax credit isan amount of money that companies can subtract from their federal and/or state taxes owed. It reduces a business’ tax bill on a dollar-for-dollar basis. That's different from a business tax deduction, which only reduces taxes by a percentage of the total deduction taken. Businesses apply the credits when they file their annual tax return.
