What’s the Difference Between a Tax Credit and a Tax Deduction?

Tax law can feel like a minefield for even the most knowledgeable business owners. There are innumerable rules and regulations to follow in order to get your returns done correctly. We want to boil down to a few of the basics, looking at tax credits and tax deductions.

Last week, we wrote about the Employee Retention Tax Credit which can still be claimed by employers who suffered losses during the pandemic. This is just one example of the many credits a business can earn, but tax deductions must first be taken into account before you dive into tax credits.

What is a Tax Deduction?

When you file for taxes, you work to determine the amount of taxable income you have in order to calculate the tax you owe. Deductions play a role in finding that amount.

You will first need to determine your gross income. This would be the total amount of potentially taxable income before you apply deductions (or credits). Once you have your gross total, you will look at which tax deductions you’re eligible for in order to lower that total dollar amount.

There are numerous deductions you may be eligible for, but they each fall into two categories:

  • Above-the-Line Deductions: These are deductions that subtract from your gross income before calculating your adjusted gross income (AGI). They are referred to as “adjustments to income” and help lower your AGI, allowing you to be eligible for more below-the-line deductions.
  • Below-the-Line Deductions: These deductions come into play after you’ve already calculated your gross adjusted income by applying above-the-line deductions. If you itemize your deductions, you can claim certain expenses such as medical or dental expenses that exceed 7.5% of your AGI, charitable contributions, and more.

To give an example, say you own a business and have a gross income of $150,000. After this, you would look at above-the-line deductions and see that you can deduct certain costs like a $20,000 contribution to a qualifying retirement plan and $5,000 to an HSA. That would reduce your adjusted gross income to $125,000 – at which point you would look at below-the-line deductions and determine you made a $5,000 donation to a cause you care about along with paying a $7,500 property tax bill. This would lower your final taxable income amount to $112,500.

What is a Tax Credit?

A tax credit will lower the amount of tax you owe or increase the amount you’re owed by the IRS once your tax rate is calculated. If you go through the deduction portion of your return and were determined to owe $5,000 in taxes then you can lower that amount (and even end up being owed) by applying for tax credits.

These credits are generally dollar-for-dollar credits, meaning a $1,000 tax credit will reduce what you owe by $1,000. If we follow the example above, the business owner had a final taxable income of $112,500. This individual would owe $14,751 plus 24% of the excess above $86,375 for 2021. This would leave you with a tax bill of $21,021 ($112,500 – $86,375 = $26,125 x 24% = $6,270 + $14,751 = $21,021).

After this, you can apply the credits you are eligible for. For this example, let’s say you end up having $25,000 worth of tax credits – leaving you with a net positive of $3,979 in taxes for the fiscal year.

Of course, this is all a very simplified version of how deductions and credits impact your return. There are many more deductions and credits that business owners should be aware of when it comes time to file their taxes. Attorney Tyler Q. Dahl has his masters in tax law and knows the ins and outs of these important tax factors. Contact our office if you need help navigating the credits and deductions you may be eligible for.

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