Taxes can weigh heavily on the mind of a small business owner. Local, state, and federal small business taxes can eat a big chunk out of your bottom line, and sometimes, it can feel like all your hard-earned profits are going to Uncle Sam. Fortunately, tax deductions and small business tax credits can help lessen the sting of taxes.
Most small businesses are aware of the importance of tax deductions. Claiming deductions reduces your taxable income and helps you save money. However, small business tax credits can be even more powerful because they directly reduce your tax bill. We’ll help you figure out how tax credits work, which small business tax credits you should be aware of, and what forms you need to file for each one.
Small Business Tax Credits vs. Tax Deductions
The government awards small business tax credits to businesses that engage in certain types of activities that are helpful to the economy or the society as a whole. People often confuse tax credits with tax deductions, but they are not the same thing.
Companies can claim tax deductions for most ordinary and necessary business expenses. There are also specialized deductions, such as deductions for home-based businesses. Deductions decrease your taxable income, as well as the tax bracket that you fall into if you report business income on your personal tax return.
Let’s look at an example. Assume you are a sole proprietor and make $100,000 of business revenue this year. You deduct $20,000 as expenses. Now, your taxes will be calculated based on $80,000 of taxable income, instead of the full $100,000. For the 2019 tax year, a sole proprietor with $80,000 of taxable income will pay a 22% tax rate, whereas a sole prop with $100,000 of taxable income would pay a 24% tax rate. In this example, the deduction bumped you into a lower tax bracket, so you’ll pay significantly less in taxes. But even if you remained in the same tax bracket, tax deductions would still save you money by lowering your taxable income.
As a general rule of thumb, if you fall into a 12% tax bracket, $1 of deductions will save you $0.12 on your taxes. If you fall into a 24% tax bracket, $1 of deductions will save you $0.24 on your taxes. Tax deductions have a modest, but still significant, impact.
In contrast to deductions, small business tax credits reduce your tax bill on a dollar for dollar basis, making them even more impactful. For example, let’s say you owe $20,000 in small business taxes. If you claim a $5,000 tax credit, you can directly subtract that amount of money from your tax bill. This means you will owe $15,000 after taking the credit.
How to Claim Small Business Tax Credits
If you’re eligible for more than one small business tax credit, you must submit IRS Form 3800 along with your tax return. This form lists all the individual small business tax credits that your company might be eligible for. Adding up those credits, you can calculate your General Business Tax Credit.
As you might expect, there’s a limit on the amount of small business tax credits you can claim each year. This formula will give you the limit:
- Add your net income tax and alternative minimum tax.
- From that sum, subtract the greater of: Your tentative minimum tax for the tax year, or 25% of the amount of your regular tax liability that’s greater than $25,000.
Each individual tax credit requires its own form, noted below. On Form 3800, you’ll add up each of the individual tax credits to calculate the total value of your tax credits. If you’re only eligible for one small business tax credit, there’s no need to submit Form 3800. You only need to submit the form that accompanies that specific tax credit.
If you’re eligible for a small business tax credit but fail to claim it this tax year, you might be eligible to carry forward the credit to a future tax year. Just remember that whenever you do claim a tax credit, you typically can’t claim a deduction for the same expense.
The 10 Small Business Tax Credits You Should Know About
Keeping track of small business tax credits can be difficult. Congress, as well as state and local governments, regularly issue new tax credits. And old tax credits expire, making way for new ones.
Here are the most important small business tax credits that are available now:
1. Small Business Healthcare Tax Credit (Form 8941)
One of the most popular small business tax credits comes out of the Affordable Care Act, better known as Obamacare. This credit is for companies that provide small business health insurance to their employees.
The Small Business Healthcare Tax Credit is available to businesses that:
- Have fewer than 25 full-time or equivalent employees
- Pay an average wage of less than $51,600 a year
- Pay at least half of their employees’ health insurance premiums
- Purchased a qualified health plan from the Small Business Health Options Program (SHOP) Marketplace
If you qualify, this credit is equal to 50 percent of employer-paid health insurance premiums. However, you can only claim the credit for two consecutive years after 2014. That means that if you’ve already claimed the credit for two years in a row, you’re no longer eligible to claim this credit.
2. Family Leave Act Tax Credit (Form 8994)
Congress authorized this tax credit in 2017 to encourage small business owners to provide paid leave to employees. This credit is not meant to incentivize vacation time, but rather leave related to the birth of a child, health emergency in the family, or another reason covered by the Family and Medical Leave Act (FMLA).
Employers are eligible for the Family Leave Act Tax Credit if they:
- Have a written policy that provides full-time employees with at least two weeks of paid family and medical leave annually (prorated for part-time employees)
- Pay employees at least 50% of their wages during leave
The credit is equal to 12.5% of the wages that are paid to qualifying employees on family and medical leave during the tax year. The credit increases incrementally if you pay employees more than half of their wages during leave. The maximum credit is 25% of wages for businesses that cover 100% of an employee’s salary during leave.
Keep in mind that if you claim the Family Leave Act Tax Credit, the amount of the credit will offset any deduction that you take for employee wages. This credit was offered for only two tax years (2018 and 2019), and the upcoming 2019 tax year is the last year that you can take advantage of it.
3. Work Opportunity Tax Credit (Form 5884)
The Work Opportunity Tax Credit incentivizes companies to hire employees from the following underserved populations:
- Family assistance or food stamp recipients
- Individuals who have been unemployed long term
- Individuals receiving Supplemental Security Income (SSI)
- Designated community residents or summer youth employees living in federal empowerment zones
The size of the tax credit depends on which category your employee falls into and how many hours they worked for your company during the tax year. In general, you can claim a tax credit of 40% of the first $6,000 of the employee’s first year wages, which equals $2,400. Higher credits are available for companies that employ veterans and long-term family assistance recipients.
4. Tax Credit for Increasing Research Activities (Form 6765)
There are several research and development (R&D) tax credits for small businesses. Although science, medical, and technology businesses are most often eligible for these tax credits, many types of companies engage in R&D activities.
Any of the following types of activities might help you qualify for an R&D tax credit:
- Developing new prototypes or models
- Developing proprietary products and seeking patents for those products
- Developing a new manufacturing process or business process
- Improving product efficiency or existing business processes
- Improving quality control processes
- Environmental or certification testing
If you qualify for this small business tax credit, you can subtract up to 10% of your R&D costs from your tax bill. Under reforms enacted by the Protecting Americans from Tax Hikes (PATH) Act of 2015, new and small businesses can use the tax credit to offset their payroll taxes. Just be sure to carefully document your R&D activities with project notes, process diagrams, lab results, etc.
5. Disabled Access Tax Credit (Form 8826)
The Disabled Access Tax Credit encourages companies to make their business locations accessible to customers with disabilities. Not only can you remove barriers to access and invite more customers into your business, but you can also be financially rewarded for your efforts.
The Americans with Disabilities Act (ADA), enacted in 1990, requires businesses with 15 or more employees to provide reasonable accommodations to employees with disabilities. Other provisions of the ADA regulate public access to certain types of businesses, such as shopping malls and restaurants.
Making your place of business accessible to people with disabilities might require expensive upgrades, such as building a ramp, placing appropriate spacing between shelves, or providing text in formats like braille. To lower the financial impact of such changes, the government offers this tax credit.
The credit is available to businesses that have total revenues of $1 million or less, or 30 or fewer full-time employees. With this credit, you can cover up to 50% of disabled access expenditures, ranging from $250 to $10,000. This means you can claim a maximum Disabled Access Tax Credit of $5,000 in one year.
6. Employer-Provided Childcare Tax Credit (Form 8882)
This tax credit targets businesses that pay for their employees’ child care expenses or help their employees obtain childcare.
The following expenses are covered by the Employer-Provided Childcare Tax Credit:
- Expenses used to construct, remodel, or expand a childcare facility
- Expenses used to operate an existing childcare facility, such as caregiver salaries
- Expenses used to provide childcare to employees’ children, through a contract with a qualified childcare facility
- Expenses used to provide childcare resources and referrals through a contract with a childcare provider
Businesses that qualify for this tax credit can claim 25% of their expenditures on childcare, plus 10% of childcare resource and referral expenditures. The credit is limited to $150,000 per tax year. All facilities must be qualified childcare facilities, meaning that they must comply with the licensing requirements of the state or locality in which they are located.
7. Alternative Motor Vehicle, Electric Vehicle, and Alternative Fuel Credits
The IRS offers several tax credits related to alternative energy use. If you produce or use alternative fuels in business, use an electric vehicle, or use a vehicle that runs on alternative fuel, then you might be able to claim one of these small business tax credits:
- Biodiesel and renewable diesel fuels credit (Form 8864)
- Alternative fuel vehicle refueling property credit (Form 8911)
- Biofuel producer credit (Form 6478)
- Qualified electric vehicle credit (Form 8834)
- Investment credit for rehabilitation and alternative energy (Form 3468)
The amount of these tax credits varies based on which credit you claim. For example, the qualified electric vehicle credit is worth between $2,500 to $7,500 based on the vehicle’s battery capacity. Check out the Department of Energy’s website for more details on these tax credits.
8. Tax Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips (Form 8846)
Individuals who work in the food and beverage industries rely heavily on tips. If employees in your food or beverage establishment receive tips, you can claim a tax credit for the social security and Medicare payroll taxes that you’ve paid on those tips.
In most cases, the credit equals the amount of employer social security and Medicare taxes that you paid for tips received by the employee. However, the amount of the credit is reduced for businesses that don’t pay their employees at least the federal minimum wage that was in effect on January 1, 2007 ($5.15 per hour). The federal minimum wage is higher today, but for purposes of calculating this credit, you must reference the 2007 minimum wage.
9. Tax Credit for Small Business Pension Plan Startup Costs (Form 8881)
This tax credit helps to lower the cost of setting up a retirement plan for your team. Businesses are eligible for the tax credit if:
- They had 100 or fewer employees during the tax year, all of whom who received at least $5,000 in wages
- They have not previously had a retirement plan in place over the last three years for the same group of employees
Most common retirement plans, including 401(k) plans, SEP IRA plans, and SIMPLE IRA plans, qualify under this tax credit. The credit is worth $500, to be claimed for administrative costs and money spent to inform employees about their benefits and options under the plan.
People who contribute to a retirement plan, including self-employed individuals, can take advantage of a retirement savings contribution tax credit if they fall into a lower income bracket.
10. New Markets Tax Credit (Form 8874)
The last tax credit we want to bring your attention to is the New Markets Tax Credit. This credit expires at the end of 2019, so this is the last tax year you can use it unless Congress extends the credit (which they’ve done on several occasions before). This tax credit supports businesses that invest in Community Development Enterprises (CDEs) and Community Development Financial Institutions (CDFIs), which are organizations that aid low income communities.
Projects that qualify for the credit typically involve the acquisition, renovation, or construction of real estate in low-income areas, or the expansion of existing businesses in those areas. Example projects include:
- Construction or rehabilitation of educational facilities or community centers
- Fix and flip businesses that renovate residential property
- Construction or rehabilitation of hospitals and other health facilities
- Construction or rehabilitation of industrial facilitates that create jobs
- Construction or rehabilitation of facilities that provide services to women, minorities, or other underserved communities
In order to be eligible for the New Markets Tax Credit, a project must be located within a census tract that has a poverty rate of at least 20% or with median family incomes that do not exceed 80 percent of the area median income. The Department of the Treasury has a tool to find CDEs and CDFIs near you if you’re interested in getting involved.
Ask Your Tax Professional About Small Business Tax Credits
Be sure to ask your tax professional which small business tax credits your business is eligible for. The 10 credits shown above are just the beginning. There are additional federal small business tax credits, and states and local governments often offer tax incentives of their own. However, tax credits often expire in a few years, so you need to act quickly to take advantage of them. The best way to ensure that you’re taking advantage of all the credits and deductions that are available to you is to work with a qualified tax professional.