What is the business tax credit?
Business tax credits are an amount that businesses can subtract from taxes owed to a government. Business tax credits are applied against taxes owed, as opposed to a deduction which is used to reduce taxable income. Businesses apply the tax credits when they file their annual tax return. In the United States, the Tax Service (IRS) oversees the application of business tax credits since the credits are used to offset a business’ financial obligation to the federal government.
Understanding business tax credits
The business tax credit is a generic way of designating tax credits aimed at stimulating a particular type of business transactions. Business tax credits can take many forms, but some of the common business tax credits target activities such as hiring employees who face employment barriers, investing in research, retrofitting a building to make it more efficient, etc. The fact that a business tax credit exists for an activity means that the government seeks to reward and encourage that activity.
Unlike an allowable deduction, business tax credits are targeted. Indeed, they represent more of a tax reduction opportunity for companies, which directly corresponds to less tax revenue for the government. It is in a company’s best interest to use any credits for which it is eligible to reduce the amount of money owed to the federal government at tax time.
Key points to remember
- Business tax credits are designed by the government to encourage a particular type of business behavior.
- Business tax credits provide businesses with a direct reduction in tax payable in exchange for a particular measure.
- Many business tax credits have broad application, supporting things like workers’ pensions and employment opportunities for groups facing barriers to employment.
- Governments are also targeting tax credits at particular industries to support continued expansion.
In addition to their value to businesses in reducing taxes in a current filing year, business tax credits often provide some flexibility with respect to their application to past and future filings. If a company has exceeded its tax credits for the taxation year, but not the previous year, they can carry these credits back and apply them to tax returns they have already filed. Similarly, if they have more credits than allowed in the current tax year, they can carry forward the balance of those credits to the next tax year. This is called a deferral.
Business tax credits versus business tax deductions
Business tax credits tend to be used sparingly by governments because they are a powerful incentive. As such, people often confuse them with the more well-known business tax deductions. The main difference between a business tax credit and a business tax deduction is that tax deductions are used to reduce taxable income whereas a tax credit directly reduces tax payable. This means that a business tax deduction of, say, $5,000 will only save the business a percentage of that $5,000. If a corporation is in a 20% tax bracket, the $5,000 deduction is only worth $1,000 in reduced taxes. However, if the corporation is eligible for a tax credit of $5,000, it benefits from the full tax reduction of $5,000.
US business tax credits
In the United States there are a number of business tax credits and they often carry their destination in the title. The Indian employment credit, for example, provides a tax credit to employers who hire Native Americans. Businesses can also apply for business tax credits that are clearly targeted to particular industries and sectors, such as the credit for biofuel producers and the orphan drug credit.
When filing, the General business tax credit form 3800 is used to add up many of the separate tax credits to determine the overall allowable credit. These credits must still be claimed individually using the specific form found on the IRS websiteor by consulting a accounting or certified tax practitioner. The credits available, as well as their applicable forms, can change from year to year, so it is important to check the IRS website before filing.
Example of how companies use business tax credits
Imagine ABC Corporation is in the process of filing its annual tax return. They look through the list of available tax credits and realize that they can claim the credit for employer-provided child care facilities and services, since they have day care on site. Using Form 8882, they list this credit. However, the amount of money they are claiming is more than the eligible amount for this year. Since this tax year was the first year they provided on-site child care, they can retroactively apply part of the credit to the previous tax year.
However, ABC Corporation is not done, and they have discovered that they can also claim additional tax credits. Since they have reached the maximum of their credits for this year, they will apply the remainder of these credits to the next tax year. With all the tax credits available to businesses that they were able to take advantage of this year, ABC Company owed a much smaller amount to the government this year. Next year, they will already have several credits to apply to their remaining obligation, even if they have no new tax credits to claim.