Taxes are a fact of life for business owners, but you can reduce what you owe by maximizing your tax deductions and tax credits. Both strategies reduce your tax burden but in different ways. A credit reduces your bill dollar-for-dollar, while a deduction lowers your taxable income for the year. Between the two, a tax credit may have a larger impact because it directly reduces your tax bill. But it’s worth learning about both types of tax breaks so you can write off as many as you qualify for and pay less at tax time.
What’s a tax credit?
A tax credit provides you with a dollar amount to subtract from the taxes you owe. For instance, if you qualify for a $2,000 tax credit and you owe $3,000, the credit lowers your liability down to $1,000. There are two main types of credits:
- Refundable tax credits: A refundable tax credit allows you to get money back if the credit amount exceeds the amount you owe in taxes. So if you qualify for a $500 refundable tax credit and you owe $400 in taxes for the year, the government will send you a check for the difference: $100.
- Nonrefundable tax credits: A nonrefundable tax credit still directly reduces your tax bill, but you won’t get money back if you owe less than the credit amount. For example, if you receive a $500 nonrefundable tax credit and you owe $100 for the year, the credit only wipes out your $100 tax bill. You won’t get the remaining $400 from the credit amount.
What’s a tax deduction?
A tax deduction reduces the amount of your income subject to tax. For instance, say your online business earned $100,000 for the year. You plan to take the $14,600 standard deduction for single filers on your personal income taxes. The deduction lowers your taxable income, so you’d only owe tax on $85,400.
- Below-the-line tax deductions These are subtracted from your adjusted gross income (AGI) to lower your taxable income and reduce your tax liability. You itemize these deductions on your tax return, which can vary based on your business entity. It’s beneficial to claim below-the-line deductions if the dollar amount you can claim exceeds your standard deduction.
- Above-the-line tax deductions: This type of deduction is subtracted from your gross income to arrive at AGI without itemizing. For example, self-employment expenses can help reduce your net business income.
How your business structure can impact your tax return
The business structure you choose affects how your business is taxed and how you’ll file your business tax return each year. Each state has its own forms and guidelines, so check with your accountant on your state tax obligations.
Here are the rules for federal income taxes by business type:
Sole proprietorship
When you run a sole proprietorship, you’ll report business income directly on your personal federal income tax return. You’ll fill out Schedule C on top of Form 1040, which is also where you’ll list any applicable business credits and deductions. Your tax bracket will be based on your combined personal and business income.
Partnership
In a business partnership, the taxable income from the business flows through to each partner’s individual income tax return using Schedule K-1 (Form 1065). All partnership types complete this form.
As a partner, you’ll calculate taxable income and claim your share of credits and deductions based on the percentage of the business you own. If you and another person split revenue evenly, for example, you each pay taxes on 50% of the taxable income. Check with a CPA on how to split your eligible tax credits and deductions.
S corporation
An S corporation passes through its corporate income, losses, deductions, and credits to its shareholders for federal tax purposes. If you run a single-owner S corp, for instance, then you’ll file a personal tax return using Form 1040, plus a Form 1120-S. For S corps with more than one shareholder, fill out Schedule K-1 (Form 1120-S)
Example: Tax deduction vs. tax credit
Here’s a simplified example of how a tax credit and a tax deduction can impact your tax bill:
| $15,000 tax deduction | $15,000 tax credit | |
| Your adjusted gross income | $115,000 | $115,000 |
| Tax deduction | -$15,000 | |
| Taxable income | $100,000 | $115,000 |
| Tax rate | 24% | 24% |
| Calculated tax | $24,000 | $27,600 |
| Tax credit | $15,000 | |
| Your tax bill | $24,000 | $12,600 |
Keep your records on hand
Credits and deductions both decrease your tax obligation, but they do so in different ways. A tax credit directly lowers your bill dollar-for-dollar, while a tax deduction reduces your taxable income.
You typically won’t need to provide proof your business qualifies for these tax breaks—unless you get audited. So it’s important to keep business records where they’re organized and in a safe place. (For instance, keep copies of sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks related to your credits and deductions.)
The IRS recommends keeping documents that support a deduction or credit “until the period of limitations for that tax return runs out.” That’s usually three years, though employment tax records should be kept on file for an extra year.
