What Is a Tax Credit and How Does it Work?
As a small or medium-sized business (SMB) owner, you look for any solution you can to bolster your business. Whether that means hiring more staff, expanding your social media presence, or ensuring your tax information is correct—whatever is necessary to do, you’ll do.
In light of the COVID-19 pandemic, the IRS has launched several new income tax credit initiatives to help SMBs. Taking advantage of these new tax credits can help you save money, grow your business, and provide better services for your clients.
But you may be wondering what is a tax credit and can you get a tax break? How does it work for a small business? Let’s break this down.
Defining “Tax Credit”
A tax is simply money you pay to the government for producing, selling, or using something. For SMBs, some taxes go to your specific city or town. Some taxes you pay to your state. Others go to the federal government.
A federal tax credit is an amount of money that lowers the total sum of taxes you must pay. The official IRS website says that you can, “subtract tax credits from the amount of tax you owe.”
If you owe $100 in taxes, but qualify for a $50 income tax credit, then you actually owe only $50.
Refundable and Nonrefundable Tax Credits
The IRS designates 2 categories of tax credits:
- Refundable tax credits
- Nonrefundable tax credits
What is a refundable tax credit? A refundable credit gives you money back beyond the amount that you owe. Let’s say you owe $50 in taxes. But, you qualify for a $100 refundable credit. You’ll get $50 back from the IRS.
On the other hand, a non-refundable tax credit lowers the total sum of money that you owe in taxes. If you owe $50 in taxes for your earned income, a $100 non-refundable tax credit will lower your total to $0. Though still an advantage, it doesn’t put money back in your business as directly as a refundable tax credit.
What’s The Purpose of Tax Credits?
Governments use tax credits on earned income to encourage businesses to take specific actions—actions that add value to the business itself, the government, or the economy as a whole. Often, a federal tax credit is designed to motivate the business to do something innovative or try something new. Or, the credit might pay the business back for something they’re already adept at doing. The tax credit program can serve as tax relief for business owners.
For example, IRS Form 3800 is the General Business Credit. It includes tax credits for businesses involved in activities like:
- New markets
- Increasing research activities
- Enhanced oil recovery
- Non Conventional source fuel
- Low-income housing
Can Tax Credits Help During The Pandemic?
The COVID-19 pandemic left the future of many small businesses in doubt. Many business owners wondered what they could do to protect their livelihoods. To afford employees the opportunity for job security, Congress enacted the Families First Coronavirus Response Act.
Due to the pandemic, the FFCRA provided employees extended opportunities for leaves of absence. Business owners (with fewer than 500 employees) who paid sick leave under the FFCRA were compensated with a refundable tax income credit.
In 2021, Congress passed the American Rescue Plan Act. It extends sick leave tax credits from the FFCRA into 2021. So if you’re an SMB, this particular earned income credit could help ease some of the financial burdens of the COVID-19 pandemic.
What About Self-Employed Tax Credit?
Perhaps you’re a freelancer or entrepreneur. You’re self-employed, but you’re still a business owner. Is a self-employed tax credit available to someone in your position?
The Families First Coronavirus Response Act does provide tax credits for self-employed individuals. If you’re self-employed and took sick leave (for yourself or to care for a family member), you may qualify for this earned income credit. See IRS Form 7202 for more information.
But the advantage of self-employment is the preponderance of tax deductions. According to the IRS, “subtract tax deductions from your income before you figure the amount of tax you owe.” Tax credits reduce the amount of taxes you must pay. Tax deductions lower the amount of your income that can be taxed.
How Do Tax Credits And Deductions Work For Small and Medium-Sized Businesses?
You can read the information on tax credits and deductions until your head spins. But what is a tax credit and tax deduction in real life? How does it help an SMB and provide tax relief? How does it help someone who is self-employed?
Below are a few examples of local businesses that reaped benefits from tax credits and allowable deductions.
L’Chaim Foods, San Francisco, CA
Alex Shandrovsky, the owner of the kosher sushi restaurant L’Chaim Foods, hired three formerly incarcerated persons as employees. These three were eventually promoted to Director of Operations, Sous Chef, and Executive Chef.
In addition to L’Chaim Foods increasing revenue (by 51% from the previous tax year), the business also qualified for a tax credit. The IRS affords the Work Opportunity Tax Credit to SMBs who hire formerly incarcerated individuals. In the case of L’Chaim Foods, the Work Opportunity tax credit ranged from $1,200 to $9,600.
My IT Companion, Memphis, TN
Jared R. is a self-employed IT professional in Memphis, TN. His entrepreneurial journey has lasted over a decade. As the sole owner of My IT Companion, LLC, he provides IT support services specifically for solopreneurs and SMBs.
Like many self-employed people, Jared works from home. This means that he gets to take advantage of what the IRS refers to as a home office deduction. Put simply, if you’re self-employed and you use part of your home to conduct your business, you can reduce your taxable income.
“It makes a difference in my utilities,” said Jared. “Like anybody, I use the internet a lot for my business as well. That also counts as a deduction. Anything that I use for my business, I deduct.”
Jared services clients throughout the metropolitan Memphis area (over 4,500 square miles). Therefore, his business expenses include his mileage, fuel, and vehicle maintenance.
“It costs a lot to run a business,” Jared noted. “So the deductions help out a lot. When I travel, I’m racking up miles. I’m not going places just because. I’m going for a legitimate business need.”
Wayside Restaurant, Montpelier, VT
The history of the Wayside Restaurant in Montpelier, VT goes back a century. Effie Ballou opened the Wayside in 1918, the same year as the Spanish flu. With the outbreak of COVID-19, the Wayside has survived not one, but two pandemics.
The Wayside’s owners, Brian and Karen Zecchinelli, benefit from the Consolidated Appropriations Act of 2021. Among the CCA’s provisions is an important standard deduction for SMBs in the restaurant industry. The CCA allows business owners to deduct 100% of business meals.
Business owners who dine at the Wayside to conduct business get to subtract the price of their meals from their taxable income. At the same time, local businesses like the Wayside continue to stay open in this unprecedented time.
Board & Brush, Memphis, TN
David W. is the owner of Board & Brush in Memphis, TN. Board & Brush runs DIY wood crafting classes. David pays rent for the space his business occupies. The business likewise requires storage areas for supplies and merchandise.
“My business owns a vehicle,” said David. “It’s paid for by the business. It belongs to the business. That’s its only purpose. So I make a point to take advantage of the tax deduction.”
David credits Robert Kiyosaki’s work as an inspiration. He recommends Kiyosaki’s book Rich Dad Poor Dad for any business owner. “In that book, Kiyosaki says that a good business owner owns little to nothing,” said David. “I want to own as little as possible. I only buy things for my business that it needs. But I also make sure that anything it requires, I get for it. Those tax deductions make a difference.”
The More You Know, The More You Grow
Tax credits represent money that you don’t owe the government. It's money you get to hang on to. You can invest that money back into your SMB or enjoy an extra security cushion yourself.
The more you learn about tax credits and other cost-saving opportunities for your business, the more your business will grow and evolve.
How Can Nextdoor Help?
Nextdoor is the neighborhood hub. Whether you’re a restaurant in Montpelier, VT, or an IT solopreneur in Memphis, TN, Nextdoor focuses on all things local. If you own an SMB, you’re part of a broader community.
Use Nextdoor to find local tax professionals if you have further questions about tax credits. Furthermore, if you’re a tax professional looking to support local SMBs, Nextdoor can facilitate that connection.
Sources:
Census Report. Memphis, TN-MS-AR Metro Area. https://censusreporter.org/profiles/31000US32820-memphis-tn-ms-ar-metro-area/
H & R Block. What is the Difference Between a Tax Deduction and a Tax Credit? https://www.hrblock.com/tax-center/filing/credits/difference-between-tax-deduction-and-tax-credit/
IRS. Credits and Deductions for Individuals. https://www.irs.gov/credits-deductions-for-individuals
IRS. Form 3800 General Business Credit. https://www.irs.gov/pub/irs-pdf/f3800.pdf
IRS. Form 7202 Credits for Sick Leave and Family Leave for Certain Self-Employed Individuals. https://www.irs.gov/pub/irs-pdf/f7202.pdf
IRS. New IRS form available for self-employed individuals to claim COVID-19 sick and family leave tax credits under FFCRA. https://www.irs.gov/newsroom/new-irs-form-available-for-self-employed-individuals-to-claim-covid-19-sick-and-family-leave-tax-credits-under-ffcra
IRS. Work Opportunity Tax Credit. https://www.irs.gov/businesses/small-businesses-self-employed/work-opportunity-tax-credit
Kagan, Julia. Investopedia. Income Tax Terms Guide: Taxes. https://www.investopedia.com/terms/t/taxes.asp
Library of Congress. H.R.133 - Consolidated Appropriations Act, 2021. https://www.congress.gov/bill/116th-congress/house-bill/133/text
Library of Congress. H.R.1319 - American Rescue Plan Act of 2021. https://www.congress.gov/bill/117th-congress/house-bill/1319/text
Metropolitan Catering. http://metropolitansfcatering.com/about/
R., Jared. Personal Interview. myitcompanion.com
Shah, Kinjal Dagli. Gusto. Why This Small Business Owner Only Hires Ex-Felons. https://gusto.com/blog/growth/hire-ex-felons
U.S. Department of Labor. Families First Coronavirus Response Act: Employee Paid Leave Rights. https://www.dol.gov/agencies/whd/pandemic/ffcra-employee-paid-leave
University of Central Arkansas College of Business. How Do Small Businesses Respond to COVID-19? https://uca.edu/business/2020/03/23/how-do-small-businesses-respond-to-covid-19/
W., David. Personal interview. https://boardandbrush.com/memphis/
Wall, Alix. The Jewish News of Northern California. L’Chaim kosher sushi on a new roll with change of ownership. https://www.jweekly.com/2020/02/18/lchaim-kosher-sushi-on-a-new-roll-with-change-of-ownership/
Wayside Restaurant, Bakery, & Creamery. A Little Wayside History. https://www.waysiderestaurant.com/history/
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