“Don’t leave money on the table.” That could be an axiom for taxpayers everywhere. Yet every year countless taxpayers overlook money-saving opportunities in the form of tax credits.
Claiming tax credits is a surprisingly underutilized strategy. Currently, there are over 1200 different tax credits available, and unlike tax deductions, these credits provide a dollar-for-dollar reduction to your tax bill. In some cases, taxpayers may even be able to go back and file an amended tax return if they learn that they qualified for a tax credit after filing season.
This article aims to provide a “Tax Credits 101” overview of what tax credits are, how these credits can differ, and how to claim them. For a more nuanced look at which tax credits you might qualify for, reach out to a Certified Tax Planner to start building a customized tax plan.
The Origins of Tax Credits
Why exactly do tax credits exist? Does the government simply have money burning a hole in its pocket that needs to be given away every April? Tax credits are actually strategic—they are created to incentivize specific behavior, especially among corporations. For instance, the IRS offers a federal research and development (R&D) tax credit to encourage companies to invest in innovation, expansion, and job creation. Companies can receive a dollar-for-dollar reduction to their tax liability for certain expenditures. Qualifying expenses can include the design, development, or improvement of products, processes, techniques, formulas, or software. As you can imagine, this credit has the potential to apply to many different types of companies!
Tax credits don’t just appear on a federal level. Many states have their own version of an R&D credit and other business-related credits that the federal government may not offer. Other tax credits may focus on influencing individual behavior, in addition to corporate behavior. For example, some credits available today incentivize employees to save for retirement while also incentivizing employers to provide retirement benefits.
Refundable vs. Nonrefundable Tax Credits
Throughout the COVID-19 era, you may have noticed a lot of talk about refundable vs. nonrefundable tax credits. With refundable credits, the benefit that a taxpayer can receive is not limited to the taxes they owe. So if you qualify for a refundable credit of $2,500 but your tax liability that year is only $2,000, you are entitled to a $500 check to make up the difference. This is the reason that, per the highly-circulated news story, Amazon had a negative tax liability of $129 million in 2019. Major “credit” goes to refundable tax credits in making that happen.
Even if a tax credit is nonrefundable, it may have a “carryforward” provision. This means that if a business is not able to use the full amount they qualify for—say, because the IRS limits how much can be claimed in a single year or because their tax liability happens to be lower that year—they can apply the remainder of that amount to a future tax year.
If a tax credit is nonrefundable but there is no carryforward provision, that doesn’t necessarily mean you lose out on the “unused” portion of a tax credit. With the help of a proactive tax plan, you may be able to strategically increase your taxable income, since you have that tax credit to cover the higher tax bill. One strategy would be to do a Roth IRA conversion: shift your retirement funds to a Roth IRA, which means paying taxes on those funds upfront, but then use the tax credit to cover the tax bill. During retirement, you’ll be able to enjoy tax-free withdrawals.
Statutory vs. Discretionary Tax Credits
Tax credits can also be categorized as statutory or discretionary (or non-statutory). Statutory means that the tax credit is defined by the law and is available to all qualifying businesses. As long as a business meets certain criteria, they can claim this benefit. These credits come into existence when a new law is passed, but if that law changes or expires, that credit can disappear completely.
Discretionary credits, on the other hand, are evaluated on a facts and circumstances basis. Rather than checking the boxes on a list of qualifications and submitting your claim, for a discretionary tax credit you will typically need to go through an application process and build a narrative to explain how your business fits the requirements. Compare this to a grant that a nonprofit might apply for or a scholarship that a student might seek out. The proposal narrative of a grant application or the personal essay for a scholarship tells a story that demonstrates why that organization or person should be awarded the funding. Discretionary tax credits often operate in a similar way. While statutory tax credits are government funded, discretionary credits may have other funders, such as community leadership, special divisions of large corporations, or other government agencies.
Claiming Tax Credits
The type of tax credit will determine how you go about claiming it, and so will the amount that’s available to you. Some credits offer a fixed amount of money, while others are calculated as a percentage or a certain dollar amount up to a limit. For example, an R&D credit might amount to a percentage of a company’s research-and-development-related expenditures, not to exceed $250,000.
Different tax credits will also require different levels of documentation. You may have to document certain processes or generate certain results to qualify. Other credits may include a “clawback” or “recapture” provision, which essentially means that the company must continue to meet certain requirements in the future or even deliver on a set of public benefits, otherwise they must pay back that money. If you claim a credit with this kind of clause and fail to meet the continuing requirements, you may also get hit with penalties.
Tax credits are like the hidden gems of the tax planning world. By familiarizing yourself with the available credits, what steps you may need to take to qualify, and what restrictions exist for claiming them, you may be able to reduce or eliminate your tax liability completely—and even gain some extra cash in the case of refundable tax credits.
To help you get started on a proactive tax plan that factors in tax credits and other money-saving strategies, get connected with a Certified Tax Planner today!
Read more about tax credits in part 2 of this article, “Tax Credits 102: Exploring Employer-Provided Retirement Plan And Childcare Credits.”