Taxes can sometimes hinder a business' growth. The difference between tax credits and tax deductions is crucial for business owners seeking to lower their tax responsibilities. 

These two tax breaks can significantly affect what a business owes the government each year. However, both work differently and have distinct criteria that must be met. 

This resource for tax credits compares the differences to help business owners understand how these tax reductions can favour their businesses.

Tax Credits vs. Tax Deductions

While tax credits and tax deductions mean lower taxes, each differs in how they work.

What Are Tax Credits For?

A tax credit is a simple subtraction from the total amount of taxes that a business owes. 

In other words, if your business meets the $2,000 tax credit requirements and you owe around $4,000, this credit would lower your total taxes to $2,000. This direct deduction makes tax credits very valuable.

What Are Tax Deductions For?

A tax deduction lowers the income that is ‘taxable’ or taxed by the government. As a result, it lowers your overall tax, but not as directly as a tax credit. 

Deductions can either be itemized, meaning you list them all on a tax form, or they can be ‘standard,’ which means you simply take a certain amount of deduction. The sum is based on various factors like the nature of the business, filing status, etc. 

Types of Tax Credits for Businesses

Tax credits are either refundable, partially refundable, or completely non-refundable.

If you somehow exceed your tax liability refundable credits, a business can get a refund of any excess. Suppose a refundable tax credit brings your company liability down to zero, and you still have credit left over. In that case, the IRS will refund that amount to you.

Non-refundable tax credits still reduce your company’s overall tax bill to zero but won’t generate a refund. Any excess credit is usually lost, although some nonrefundable credits can be carried back or forward to earlier or later tax years.

Partially refundable credits work as a hybrid of the above systems, with a portion of the credit reducing a company’s total tax payment liability and refunding one portion.

Examples of Business Tax Credits

Businesses can claim different tax credits, and each has unique qualification requirements.

  • The Work Opportunity Tax Credit (WOTC) is a credit that employers can claim if they hire individuals who have consistently experienced significant barriers when seeking employment. It incentivizes employers to recruit from targeted groups, providing tax credits for the wages paid to eligible employees.
  • The Research and Development (R&D) Tax Credit encourages business investment in innovation (Rewards costs such as wages, supplies, and contract research). Businesses working with new product development or trying new products may be eligible for this credit.
  • The Investment Tax Credit (ITC) incentive encourages green business initiatives by allowing firms to invest in green energy. This tax credit helps businesses reduce their carbon footprint and shift more of their industries to eco-friendly practices.

Types of Tax Deductions for Businesses

Tax deductions have distinct categories according to business owners' different criteria for requesting a tax Liability decrease.

Operational costs, such as rent, utilities, and office supplies, reduce the tax liability on expenses that keep your business running.

Asset depreciation is a tax deduction requested to lower taxes on major assets. It is usually issued when the value of major assets depreciates as they deteriorate during use.

Home office deduction allows business owners and startups running through a home office to get some of their home expenses written off. This is particularly important if running the business from home affects the owner’s finances.

Examples of Business Tax Deductions

Employee Salaries and Benefits: Wages, salaries, bonuses, and benefits provided to employees are deductible.

Rent and Utilities: Costs associated with business premises are fully deductible.

Advertising And Marketing: You can deduct expenses for promoting your business, including digital marketing

Key Differences between Tax Credits and Tax Deductions

The main difference between Tax credits and deductions is these three characteristics:

  • Eligibility and Use: Tax credits have cost or activity-based eligibility criteria compared to tax deductions, which can apply to more general business expenses.
  • Decrease in Tax Liability: Tax credits don’t decrease your taxable income and only subtract a certain amount from the tax your business owes.
  • Ability to Get a Cash Refund: Tax deductions don’t qualify for a cash refund, but refundable and partially refundable credits can. 

Conclusion

After reading this guide, business owners should understand the basics of using tax credits and deductions to their advantage.

Good use of tax credits and deductions can result in savings that can be reinvested into the business for further growth.

Both options should be considered as part of your business tax plan. To read a more detailed overview of Tax Credits and Deductions, you can check this resource for tax credits.

FAQs

What is the difference between tax credits and tax deductions?

Tax credits deduct a certain amount from your taxes, while tax credits reduce the tax owed on your income.

What is the difference between reduction and deduction?

A reduction generally means your business will pay less tax based on your income, which has been reduced. A tax deduction directly subtracts from your tax amount regardless of that quarter's income.

What is the difference between the standard deduction and the itemizing deductions?

A standard deduction simply lowers your taxable income by a certain amount. Itemized deductions are a more in-depth list of all eligible business expenses.