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Using Credits Can Reduce Your Tax Bill

Filed under Federal Taxes. Fact checked on February 10, 2014.

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Once you have scoured your records for every available tax deduction, you need to be as diligent in chasing down any credit that you can claim.

Tax credits are generally better than deductions because credits are subtracted directly from your tax bill. Deductions, in contrast, are subtracted from the income on which your tax bill is based. This means that a dollar's worth of tax credit reduces your tax bill by a dollar, but a dollar's worth of deductions lowers your tax bill by only 35 cents, if you're in the 35 percent bracket.

Therefore, if you have the option of claiming a credit or a deduction for a particular expense, you're generally better off claiming the credit.

Most Credits Are Highly Specific

Unfortunately, while most deductions are widely available, most tax credits are available only in very limited situations. Many of them apply only to certain industries, such as restaurants and bars or energy producers, or for certain very specific activities, such as hiring a veteran or producing biomass fuel. In addition, most credits have very complicated rules that you must follow in order to claim them.

As noted above, most federal income tax credits available to small business owners are very narrowly targeted to encourage you to take certain actions that lawmakers deem desirable. In addition, there are also a few credits designed to prevent double taxation, and a few designed to encourage certain types of investments that are considered socially beneficial. The following are some of the better known tax credits.

Credits for certain taxes. Some of the more useful credits are those that offset the sting of certain taxes, including:

  • FICA taxes on tips for food and beverage establishment employees,
  • foreign taxes,
  • a portion of prior alternative minimum tax (AMT) liability, and
  • gasoline taxes paid by farmers or off-highway-vehicle users.

Credits for implementing certain programs. For example, one of the most valuable credits currently available to a small business owner is the credit for providing health insurance to your employees. Another example is the credit available for setting up a retirement plan.

Credits for activities that benefit disadvantaged or low-income persons. There are a number of credits designed to encourage employment or investment that benefits certain groups, although many of these are scheduled to expire at the end of 2013:

  • the welfare-to-work credit,
  • the disabled access credit,
  • the empowerment zone employment credit,
  • the Indian employment credit,
  • the low income housing credit,
  • the credit for contributions to Community Development Corporations,
  • the Work Opportunity Tax Credit.

Credits for activities that benefit the environment. Currently, the largest group of credits are those for investment in equipment or processes that save energy or protect the environment in some way. Unfortunately, many of these credits are predicated on equipment and processes that are out of reach for most small businesses—either because of cost or because they simply make no sense for your type of business. The major credits in this category are

  • the alternative fuels credit,
  • the credit for qualified electric vehicles,
  • the energy credit,
  • the alcohol fuel credit,
  • the enhanced oil recovery credit, and
  • the renewable resources electricity production credit.

Credits for certain other investments.The smallest (and shrinking) group of credits relates to certain investments that are deemed socially beneficial:

  • the rehabilitation credit for old or historic buildings,
  • the orphan drug credit and
  • the research and development credit.

Many Credits Roll Up Into the General Business Credit

Most of the credits mentioned above must be computed on their own special IRS forms. However, in addition to the forms used to claim specific credits, you will need to file Form 3800, General Business Credit if you meet any of the following conditions:

  • you claim more than one of the components of the general business credits;
  • if you have a carryback or carryover; or,
  • if you have a credit from a passive activity.

What Is the General Business Credit?

In order to provide some uniform rules regarding dollar limitations, carrybacks and carryforwards, and other technical details, many of the federal income tax business credits are treated as components of the general business credit. Most of these individual credits (see the list later in this article) have their own form to complete as well.

Multiple Credits Make Up the Investment Tax Credit

The investment tax credit is itself one of the components of the general business credit and is subject to the limitations, carryback and carryforward rules, etc. that apply to all the other components of that "umbrella" credit.

The investment tax credit is a credit against your federal income tax that consists of several components. The ones most likely to be of interest to small businesses are the rehabilitation credit and the energy credit. The investment credit first is claimed on Form 3468, Investment Credit and the credit amount is carried over as a component of the General Business Credit.

Claiming the ITC requires basis adjustment. When you claim an investment tax credit for a business asset, you must generally reduce the property's depreciable tax basis. The basis reduction equals to 100 percent of the rehabilitation credit you claimed, and 50 percent of the reforestation and energy credits.

Recapture of investment tax credits. If you stop using in your business any assets on which you've already claimed an investment tax credit, you may have to "pay back" to the IRS some or all of the credit you've received. In tax-speak, the credit is "recaptured." This is done by adding a percentage of the credit back to your current year's tax liability. Most commonly, recapture will occur if you sell the property, convert it to personal use, give it away, or lose it through a casualty or theft, within five years of claiming the credit.

Form 3800 Aggregates Specific Tax Credits 

Most of the credits must be computed on their own special IRS forms, as indicated in the articles that deal with the specific credit. In addition to the forms used to claim specific credits, you will also need to file Form 3800, General Business Credit, to compute your credit if you 

  • are claiming more than one of the components of the general business credit
  • have a carryback or carryover, or 
  • have a credit from a passive activity.

What Is the General Business Credit?

In order to provide some uniform rules regarding dollar limitations, carrybacks and carryforwards, and other technical details, many of the federal income tax business credits are treated as components of the general business credit. Most of these individual credits have their own form to complete as well.

Multiple Credits Comprise the Investment Tax Credit

The investment tax credit is itself one of the components of the general business credit and is subject to the limitations, carryback and carryforward rules, etc. that apply to all the other components of that "umbrella" credit. The investment tax credit is a credit against your federal income tax that consists of several components. The ones most likely to be of interest to small businesses are the rehabilitation credit and the energy credit. The investment credit first is claimed on Form 3468, Investment Credit and the credit amount is carried over as a component of the General Business Credit.

Claiming the ITC Requires Basis Adjustment.When you claim an investment tax credit for a business asset, you must generally reduce the property's depreciable tax basis. The basis reduction equals to 100 percent of the rehabilitation credit you claimed, and 50 percent of the reforestation and energy credits.

Recapture of investment tax credits. If you stop using in your business any assets on which you've already claimed an investment tax credit, you may have to "pay back" to the IRS some or all of the credit you've received. In tax-speak, the credit is "recaptured." This is done by adding a percentage of the credit back to your current year's tax liability. Most commonly, recapture will occur if you sell the property, convert it to personal use, give it away, or lose it through a casualty or theft, within five years of claiming the credit.

Computing Your Tax Credits

The forms and procedures used to calculate and claim business tax credits are quite complicated. In fact, we recommend that you leave the technical details to a tax professional. However, this article provides an outline of the basic rules regarding the dollar limits, carryback and carryforward rules, and recapture rules of common credits. This information can help you decide whether to pursue arranging your business affairs to take advantage of a credit.

There are a number of steps you must take in the process of computing and claiming your tax credits.

Step One: Compute Your Regular Tax Liability

Before you can determine the amount of your credits, you need to know what your income is for the year, subtract all your allowable deductions, and compute your tax liability on that basis (as if you had no credits).

If you're a sole proprietor part of the process will be completing Schedule C (Profit or Loss From Business), so you can determine your net income for your business. If the credit was earned by a corporation, compute the corporation's regular tax liability. If the credit was earned by a business organized as a partnership (or some entity taxed as a partnership, such as an LLC), the credits will be computed at the business entity level, and then passed through to the partners or members.

Step Two: Compute Your AMT Liability

Generally, credits cannot be claimed to the extent that they would reduce your tax bill below your tentative minimum tax.

Warning

However, the interplay of credits and the AMT is highly complex!

If you have AMT, you not to be working with a tax professional.

Step Three: Compute and Subtract Nonrefundable Credits in the Proper Order

Most of the credits that comprise the General Business Credit are first calculated using a form specific to that credit. Then the amount is carried over to the General Business Credit form. The order is important because each credit is limited to the amount of the tax minus the credits previously taken.

Claim credits in the following order:

  • personal nonrefundable credits, including credits such as:
    • the credit for child and dependent care,
    • the credit for the elderly and disabled,
    • the adoption credit, the child credit,
    • education credits, and
    • the credit for interest on certain home mortgages
  • the foreign tax credit
  • the alternative fuels credit
  • the credit for qualified electric vehicles
  • the general business credit, which is made up of the following parts:
    • investment credit (Form 3468)--which is composed of the
      • rehabilitation credit,
      • energy credit,
      • qualifying advanced coal project credit,
      • qualifying gasification credit,
      • qualifying advanced energy project credit, and
      • qualifying therapeutic discovery credit
    • work opportunity credit (Form 5884)
    • alcohol and cellulosic biofuel fuels credit (Form 6478)
    • credit for increasing reaserch activities (Form 6765)
    • low-income housing credit (Form 8586, Part I)
    • disabled access credit (Form 8826)
    • renewable electricity, refined coal and Indian coal production credit (Form 8835)
    • empowerment zone employment credit (Form 8844)
    • the Indian employment credit (Form 8845)
    • employer Social Security and Medicare taxes paid on certain employee tips (Form 8846)
    • orphan drug credit (Form 8820)
    • new markets credit (Form 8874)
    • credit for small employer pension plan startup costs (Form 8881)
    • credit for employer-provided child chare facilities and services (Form 8882)
    • qualified railroad track maintenance credit (Form 8900)
    • biodiesel and renewable diesel fuels credit (Form 8864)
    • low sulfur diesel fuel production credit (Form 8896)
    • distilled spirits credit (Form 8906)
    • nonconventional source fuel credit (Form 8907)
    • energy efficient home credit (Form 8908)
    • energy efficient appliance credit (Form 8909)
    • alternative motor vehicle fuel credit (Form 8910)
    • alternative fuel vehicle refueling property credit (Form 8911)
    • mine rescue team training credit (Form 8923)
    • mine rescue team training credit (Form 8923)
    • agricultural chemicals security credit (Form 8931)
    • credit for employer differential wage payments (Form 8932)
    • carbon dioxide sequestration credit (Form 8982)
    • qualified plug-in electric drive motor vehicle credit (Form 8936)
    • qualified plug-in electric vehicle credit (Form 8834, Part I)
    • credit for small employee health insurance premiums (Form 8941)
    • new hire retention credti (Form 5884-B)
    • general credits from an electing large partnership (Schedule K-1, Form 1065-B)

Step Four: Compute Any Carryback or Carryover Amounts

If you are unable to subtract the full amount of your nonrefundable credits, you will be able to carry the unused amount back to prior tax years or forward to subsequent tax years. The carryover period depends upon the credit.

The foreign tax credit may be carried backward into the past two tax years and forward for five years, if necessary to use it up. Most of the components of the general business credit, including the investment credit, can be carried backward into the past year, and then forward for 20 years - if these carrybacks and carryforwards are insufficient to use up the credit, the remainder can be deducted in the 21st year.

Step Five: Compute and Subtract Refundable Credits

Refundable credits include the earned income credit, portions of the additional child credit and the  education credit, the credit for any income taxes withheld on your paycheck, and the credit for gasoline and special fuels taxes. If subtracting these credits leaves you with a tax liability below zero, the IRS will send you a check for the difference.

Watch Dollar Limits on Tax Credits

Your total general business credit for the year can't exceed your net income tax, minus the greater of (1) your tentative minimum tax, or (2) 25 percent of your net regular tax liability that is more than $25,000 ($12,500 for marrieds filing separately). Your net income tax is your net regular tax liability plus your alternative minimum tax.

Example

Sally's general business credit for the year is $30,000. Her net income tax is $27,500. Her tentative minimum tax, figured on Form 6251, is $18,487. The amount of general business credit she can take for the year is $9,013. This is the net income tax of $27,500 minus the larger of her tentative minimum tax, $18,487, or 25 percent of her net regular tax liability that is more than $25,000 (25% of $2,500 = $625). Since $18,487 is larger than $625, she subtracts $18,487 from $27,500 to arrive at $9,013.

Carrybacks and Carryforwards Prevent Wasting Credits

If the dollar limitations on the general business credit prevent you from claiming all of it in the year that it was earned (the "credit year"), you can generally carry it back to the year preceding the credit year, and forward to the following 20 years.

To claim a carryback, first, try to carry the credit back to the earliest allowable year preceding the credit year, observing your remaining dollar limit on credits for that year. If you can't use it up in that year, move on to the following year.

This process is repeated until the credit is used up, or until the end of the carryover period - if any credit is still left, it can be deducted in the year following the last carryover year.

Some credits have special rules under which they can't be carried back to a year before that particular credit was enacted into law - and this is one reason why it's important to claim credits in the correct order.

If you have any carrybacks or carryforwards from other credit years, figure your general business credit for this year in the following order:

  1. any carryforwards to this year, the earliest ones first;
  2. the business credits for this year; and
  3. any carrybacks to this year, the earliest ones first.

As a result of this rule, in each year the oldest credits (and the ones closest to expiring) will always be used up first, and the newest credits become carryovers if the business credit limit is exceeded.

To claim a carryback, you must generally file an amended return (Form 1040X, Amended U.S. Individual Income Tax Return, or 1120X, Amended U.S. Corporation Income Tax Return) for the tax year to which you're carrying the credit.

Tools to Use

Among the Business Tools are Form 1040 and Form 1040X. They are in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.

You can also apply for a quick refund of taxes for a prior year by filing Form 1045, Application for Tentative Refund, or Form 1139, Corporation Application for Tentative Refund. Either of these two forms is used to claim a tentative adjustment of tax from a general business credit carryback.

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