Are you looking for a way to defray the costs of running a business and get a little money back in your bank account at tax time? Look no further than small business tax credits.
As a small business, you are entitled to claim tax credits that reduce the amount of tax you pay to the government. Businesses of all sizes usually file for tax credits (and their cousins, tax deductions) as part of their annual tax filing process.
However, tax time tends to bring out anxiety and confusion among many business owners. That’s why we’re breaking down everything you need to know about small business tax credits, including:
- What are tax credits and why do they exist?
- What’s the difference between tax credits and tax deductions?
- A comprehensive list of small business tax credits you need to know about
- Specific tax credits created to support small businesses through COVID-19
This guide will help small business owners understand the power of tax credits and discover which ones are relevant to their enterprise.
Table of Contents
What Are Small Business Tax Credits and Why Do They Exist?
Governments around the world “reward” individuals and businesses with tax credits for small and large acts like strengthening the economy, fighting climate change, being an employer, and improving other people’s lives.
Tax credits are offered to businesses as incentives for activities that benefit employees, specific industries, and society at large. For example, businesses can claim tax credits for doing research and development (improving society/industry), providing benefits for their employees (enhancing people’s lives), and buying electric vehicles (fighting climate change).
It’s important to be aware of tax credits for which your small business may be eligible because they can make a dramatic difference to your bottom line. That’s because tax credits cut the actual tax you pay as a small business owner.
In fact, small business tax credits are dollar for dollar. This means every dollar of credit cuts your tax by a full dollar. This is huge for small businesses because it allows you to recover some of the costs of running a business and keep much-needed capital that will allow you to grow and prosper.
If you owe $15,000 in small business taxes, for example, but claim a $5,000 tax credit, you can subtract that full amount from your tax bill. Your new tax bill would be $10,000. Small business tax credits add up quickly!
It literally pays to pay attention to the way small business tax credits—and your very own business—change. This is an activity you and your tax professional will want to schedule in every year at tax time.
What’s the Difference Between a Tax Deduction and a Tax Credit?
Being aware of tax credits can make a dramatic difference to your bottom line.
You’ve probably heard about tax deductions. As a small business owner, you receive a tax deduction for every business-related expense you claim on your taxes, including rent, supplies, travel, and business-related subscriptions.
Deductions cut your taxable income, so every dollar of deductions will cut your total tax by a percentage of that deduction, depending on your tax bracket. Tax deductions become more valuable as your taxable income rises. For example, if you’re in the 15% bracket, every dollar you deduct cuts your tax by 15 cents. If you’re in the 35% bracket, that same dollar deduction cuts your tax by 35 cents.
In contrast, tax credits are like turbocharged tax deductions because every dollar of credit cuts your tax by a full dollar. Plus, tax credits are more valuable for taxpayers in lower brackets. If you’re in the 35% bracket, you need $2,857 in deductions to equal a $1,000 credit. In the 15% bracket, you’d need a whopping $6,667 in deductions to equal that $1,000 credit.
14 Tax Credits You Should Know About
Ready for the good stuff? Browse through the following list to see if your small business is eligible for any of these valuable tax credits. This comprehensive compilation does not include every last small business tax credit available (some of them are very obscure!), but these are the ones that many small enterprises should know about and potentially pursue.
A word of caution: Before you start adding up your savings, remember that these small business tax credits have limits and qualifications that your business must meet to receive the credit. Flag the ones that seem like a good fit and make a note to discuss them with a trusted tax professional.
1. General Business Tax Credit
This catchall tax credit is comprised of a number of individual tax credits designed to motivate business owners to undertake specific activities, such as purchasing qualified electric vehicles, getting into new markets, and retaining employees. Some of these tax credits are covered below.
You’ll need to fill out a separate form for each of these credits and then you can add them all up on the General Business Tax Credit—Form 3800.
2. Credit for Small Employer Health Insurance Premiums
If you want to provide health insurance coverage to your employees—and get a tax credit in the process—this one is for you. According to the IRS, the credit can be up to 50% of the premiums you paid for health insurance coverage under a qualifying arrangement, or, if you’re an eligible tax-exempt employer, up to 35% of the premiums you paid. Either way, it’s a significant tax credit.
You’re eligible for the year if you:
- Paid premiums for employee health insurance coverage that you purchased through the SHOP Marketplace under a qualifying arrangement.
- You had fewer than 25 full-time equivalent employees for the tax year
- You paid average annual wages for the tax year of less than $56,000
3. Credit for Paid Family and Medical Leave
This tax credit was authorized by congress in 2017 to motivate small business owners to provide paid leave to their employees covered by the Family and Medical Leave Act (FMLA). FMLA provides certain employees up to 12 weeks of unpaid, job-protected leave, plus access to group health benefits, every year.
Reasons for a leave include the birth of a child or a health emergency in the family. The IRS says that eligible employers may claim the credit, which is equal to a percentage of wages they pay to qualifying employees while they’re on family and medical leave.
Small business owners are eligible for this tax credit if they have a written policy that meets the requirements, including providing at least two weeks of paid family and medical leave every year to all qualifying employees who work full-time. (This is prorated for part-time employees.) The paid leave should also not be less than 50% of the wages normally paid to the employee.
In 2023, qualifying employees must have worked at least a year for the employer and earned less than $81,000 in the previous year. The tax credit ranges from 12.5% to 25% of the wages paid to qualifying employees on family or medical leave for up to 12 weeks, depending on the amount of the employee’s normal wages.
4. Alternative Fuel Credits
These niche tax credits are calculated from the costs associated with the production of alcohol-based fuels such as methanol and ethanol and other alternative fuels including biodiesel or renewable diesel. The idea behind it is to encourage business owners to invest in other fuels to reduce the U.S. dependence on imported oil.
Please note that they will only apply if you happen to be involved in the production of fuels, not the consumption of them.
5. Commercial Clean Vehicle Credit
Take advantage of a tax credit of up to $40,000 that encourages the purchase of a qualified commercial clean vehicle. This does not apply to hybrids or electric vehicles since they use conventional fuel sources.
The IRS currently doesn’t publish a list of vehicles that are eligible for the credit, but it does provide a list of qualified manufacturers. You can rely on the manufacturer’s certification that the specific make, model, and year of the vehicle you purchase qualifies for the credit and the amount of the credit for which the vehicle qualifies.
Qualifying vehicles must have a battery capacity of at least 15 kilowatt hours (7 kilowatt hours for vehicles that weigh less than 14,000 pounds) and be charged by an external electricity source. In addition, you have to be the original owner of the vehicle—used vehicles don’t qualify.
Related tax credits include:
- Alternative Fuel Vehicle Refueling Property Credit (Form 8911)
- Qualified Electric Vehicle Credit (Form 8834)
6. Disabled Access Credit
This tax credit encourages businesses to make their offices and other facilities fully accessible to people with disabilities. This might include installing ramps, improving storage and display units, upgrading restrooms, and providing text in braille.
Your small business is eligible for this credit if you have a total revenue of $1 million or less, or have 30 or fewer full-time employees. You can cover up to 50% of disabled access expenditures ranging from $250 to $10,250. However, you can’t claim a credit for the first $250 of expenditures, so the maximum credit available is $5,000 on $10,250 of expenditures.
Claim this credit on Form 8826.
7. Credit for Employer-Provided Childcare Facilities and Services
Here’s a tax credit for businesses that directly pay the childcare expenses for their employees or help their employees secure childcare. The credit is for 25% of expenses, plus 10% of childcare resource and referral expenditures. The maximum credit is $150,000 a year.
Fun fact: Employees can actually realize a greater benefit from the Employer-Provided Child Care Tax Credit than they would from the Child and Dependent Care Tax Credit they could claim on their own personal tax return. Let’s say an employee pays $3,000 for childcare, the maximum credit they can take on their return is $1,050 ($3,000 x 35%). The employee effectively paid $1,950 for childcare services ($3,000 – $1,050 = $1,950).
If the employer pays $3,000 to a childcare facility for an employee’s child, the employee saves the $1,950. It is important to note that the employer is not subject to the $3,000 limitation per child when calculating the credit. On average, full-time care for a child costs $229 per week ($11,908 per year). Thus, savings for most employees would be substantial, although childcare payments made in excess of $5,000 are added to the employee’s gross wages.
Keep in mind if you are incorporated and an employee of the corporation, you could also be eligible for the same benefits that you offer to the rest of your employees.
Claim this tax credit on Form 8882.
8. Rehabilitation, Energy, and Reforestation Investment Credit
This tax credit is for investments in reforestation, building rehabilitation, and alternative energy property used in business. The credit is generally 10% of expenditures and is limited to $10,000 per year.
Claim this tax credit on Form 3468.
9. Increasing Research Activities Credit
These small business tax credits are designed to encourage domestic research and development. The calculation of the credit can be very complex, but it can also provide substantial tax savings.
This definition is relatively broad but encompasses activities such as:
- Developing new or improved products, processes, or formulas
- Prototype or model development
- Developing or applying for patents
- Certification testing
- Developing new technology
- Environmental testing
- Developing or improving software technologies
- Building or improving manufacturing facilities
- Streamlining internal processes
This credit is open to individuals, partnerships, and corporations and can cover up to 20% of expenses. However, only some types of research qualify, and sorting out if yours does can be challenging. Check out the instructions for Form 6765 or consult a tax expert to figure out if your research is eligible.
Another thing to note: Small businesses don’t have to use this credit to offset income taxes directly. You can file Form 8974, which offsets up to $250,000 of the employer’s share of social security taxes for that year.
10. Small Employer Pension Plan Startup Costs Credit
This is a small business tax credit designed to offset the costs of starting a pension. The credit is limited to $500—or 50% of your startup costs. You can claim it for the first three years of your plan.
To be eligible, your business must:
- Have fewer than 100 employees who receive at least $5,000 in compensation
- NOT have had an existing 401(k) or other qualifying retirement plan for the past three years
To claim this tax credit, fill out Form 8881.
11. Work Opportunity Credit
This is a tax credit available to businesses that hire employees who have traditionally faced significant barriers to employment. Many job seekers experience one or more barriers to employment during their careers. Although this makes finding or keeping a job more difficult, it’s not impossible. Some barriers, such as lack of transportation, are temporary and easier to address than others like education, childcare, or disabilities.
There are 10 categories of eligible workers, including:
- Unemployed veterans, including disabled veterans
- Long-term family assistance recipients
- Summer youth employees living in empowerment zones
The credits are calculated based on wages paid to the employees and can provide up to a $9,000 savings over two years.
You’ll need to ask a tax professional to help you optimize the Form 5884 tax credit.
12. Empowerment Zone Employment Credit
Here’s a tax credit for businesses that hire someone who lives and works in a low-income area. The U.S. Department of Housing and Urban Development created empowerment zones to stimulate development in low-income areas. Visit the IRS website to see the zones.
Although the empowerment zones expired at the end of 2017, the Consolidated Appropriations Act of 2021 provides for an extension of these designations to the end of 2025. Qualifying businesses can receive up to $3,000 for each full- or part-time employee who lives in an empowerment zone. This comprises up to 20% of the first $15,000 in wages.
Claim this tax credit on Form 8844.
13. New Markets Credit
This tax credit supports businesses that invest in qualified community development entities (CDEs), which are organizations that help low-income communities.
Most eligible projects involve acquiring, renovating, or building real estate in low-income areas, such as:
- Educational facilities or community centers
- Hospitals or healthcare facilities
- Industrial buildings that create jobs
- Facilities that serve women, minorities, or other underserved communities
Your project must be located within an area that has a 20% poverty rate or with median family incomes that don’t exceed 80% of the area median income. When you’re ready, file for this tax credit on Form 8874.
14. Employee Retention Credit
Also in response to COVID-19, a tax credit was created as part of the CARES Act to help incentivize businesses to keep their employees on the payroll. A business is eligible for the Employee Retention Credit if they still keep their employees employed despite a business closure or a decline in business receipts. This credit is worth up to $5,000 per employee for 2020 and $7,000 per employee per quarter for 2021.
Although the Employee Retention Credit ended in 2021, businesses that were eligible to claim the credit in 2020 or 2021 can amend their previously filed uarterly employment tax returns (Form 941) to claim the credit retroactively.
However, it’s important to be aware that this program has been rife with abuse. As a result, the IRS is taking extra time to audit previously filed ERC claims and new applications it receives. If you believe you may qualify for the credit, it’s important to work with a trusted tax professional who can help you assemble the documentation needed for a valid claim.
In order to claim the new credit, eligible employers will report their total qualified wages and the related health insurance costs on their quarterly employment tax returns (Form 941).
BONUS: Qualified Business Income Deduction
Since 2017, the Tax Cuts and Jobs Act (TCJA) allows owners of “pass-through” entities, including sole proprietorships, S-corporations, and partnerships, to deduct up to 20% of their qualified business income.
Although there are several limits and hoops to jump through to calculate the credit, entrepreneurs in any industry may take the 20% deduction if they have taxable income that’s under $182,100 if they’re single, or $364,200 if they’re married.
You should know that claiming a tax credit isn’t a one-and-done activity. It’s something you need to review carefully every year at tax time because your eligibility for certain tax credits will change. For example, you can claim a tax credit for a business purchase or activity only for the year that you started using the product (e.g., an electric vehicle), or doing the activity (i.e., research and development), not every year into perpetuity. Conversely, as your business evolves, you may be able to claim tax credits that weren’t available to you previously.
Small business tax credits can be hard to parse and challenging to keep track of, but they are worth every minute of your time—or the expense of a qualified tax professional to review the ones for which your business is eligible.
One way to make things easier at tax time is to have all of your accounting numbers in order. Many cloud accounting solutions categorize and present small business financial information into tax-ready accounting reports.
A little organization and investigation into small business tax credits go a long way!
This post was updated in October 2023.