One of the hardest parts about managing accounting systems and processes is the vocabulary. This is an especially tricky learning place when it comes to annual tax filings, and today we want to break down one of the questions we get asked often: what’s the difference between tax credits and tax deductions?
TAX CREDITS
As defined by the IRS, a tax credit subtracts from the amount of tax you owe. This means if you have tax due on your return, a credit can reduce that total amount so that you end up paying less when you file. There are two types of tax credits:
A nonrefundable tax credit means you get a refund only up to the amount you owe. For example: After preparing your return the remaining tax due is $1,000. You are eligible for a credit of $2,000. For a nonrefundable credit, you can reduce your tax owed down to zero but you can’t get money back.
A refundable tax credit means you get a refund, even if it's more than what you owe. For example: After preparing your return the remaining tax due is $1,000. You are eligible for a credit of $2,000. With a refundable credit, you could receive a refund of $1,000 for the amount left over after covering what you owe.
Individual credits include those related to healthcare, education, and child and dependent care. Businesses may be able to take advantage of some tax credits as well, including opportunity zone credits.
TAX DEDUCTIONS
On the other hand, tax deductions reduce the amount of income that is taxed, not the actual tax due. Let’s clarify the term since the word “deduction” is often used interchangeably for individuals and businesses.
When we look at deductions for individuals, we are determining whether someone should itemize or take the standard deduction. Itemized deductions include items like medical expenses, some homeowner costs, and charitable contributions. The process begins by adding all eligible itemized deductions and totaling to see if the amount is higher than the standard deduction the taxpayer qualifies for (based on filing status). If the itemized total is higher, you include that amount as a deduction on your return. If the standard deduction (as determined by the IRS) is higher, you will disregard the amounts that were itemized, and use this number instead.
Business deductions are actually expenses incurred that taxpayers can use to reduce the amount of taxable income. Your business type will determine the form used to reflect this information, and you will include all revenue earned, reduced by all deductible business expenses. In essence, the lower amount of taxable income leads to a lower tax burden, even though the deductions themselves don’t directly bring down your tax due. Examples of business deductions include marketing, office supplies, and travel costs.
If you’re a sole proprietor, freelancer, or sole member LLC, you will want to take advantage of both types of deductions on the same tax return. Incorporated businesses will reflect itemized or standard deductions on their personal returns, and business deductions on the company tax filing. Either way a basic outline of how deductions are applied is provided below:
$50,000 income - $12,000 deductions = $38,000 of taxable income
Think of it this way: if you add another $3,000 in deductions, your taxable income would go down by that amount, but your total amount of tax due would only decrease by a percentage of that amount.
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