Tax credits for small businesses can help them stay afloat, particularly during an economic downturn. For example, in the midst of the COVID-19 pandemic, the 2020 employee retention credit provided a $5,000 credit per employee for qualifying companies. Tax credits help businesses get off the ground, keep their doors open and invest in strategic areas. Payroll tax credits reduce a business’s liability for payroll taxes such as Social Security and Medicare taxes.
What Are Payroll Tax Credits?
Payroll tax credits decrease the amount of payroll taxes a business owes. Payroll taxes are imposed on employers and employees and include income tax, Social Security and Medicare taxes (or Federal Insurance Contributions Act (FICA)), and federal unemployment tax. Small business payroll tax credits reduce the amount that employers contribute to these taxes.
For example, employers and employees normally split responsibility equally for social security taxes, which total 12.4% on employee earnings (up to $137,700 in 2020). Some payroll tax credits reduce or even eliminate the employer’s share of those taxes.
- Tax credits are a dollar-for-dollar offset of federal income tax liability.
- By keeping up to date on current tax credits and eligibility requirements, small businesses can reduce their tax obligations. That extra cash can be invested to grow your business.
- The General Business Credit currently includes 26 different credits toward the cost of creating pension plans, providing childcare facilities, buying or using non-gasoline vehicles and other activities.
- The employee retention credit is a 2020 payroll tax credit that’s part of the government’s efforts to help businesses during the coronavirus pandemic.
Why Do Tax Credits Exist?
Tax credits help reduce a company’s tax bill as an incentive to engage in practices that benefit individuals and communities. And by holding onto cash that would have normally been paid in taxes, businesses invest in strategic areas to become more profitable.
What’s the Difference Between a Tax Credit and a Tax Deduction?
Tax credits are applied directly to your tax bill. If you owe $100,000 in tax but are eligible for a $40,000 credit, your tax liability—the amount you must pay the Internal Revenue Service (IRS)—is $60,000. There are two types of tax credits:
- Nonrefundable tax credits: Businesses reduce their tax bills up to the amount they owe.
- Refundable tax credits: Businesses receive refunds if credits exceed the amount they owe.
On the other hand, tax deductions, such as business expenses itemized on IRS Schedule C, are subtracted from your gross income before calculating the amount of tax due. So, if your income is $200,000 and you have $20,000 in deductions, you’ll pay tax on $180,000.
13 Tax Credits You Should Know About
These payroll tax credits decrease the amount of payroll taxes your business owes.
- General Business Credit. It currently includes 26 credits for the current year as well as any unused portions of nonrefundable credits carried forward from prior years.
When the amount of the credit is higher than allowed in the current year, the excess can be applied to increase your General Business Credit on tax returns filed in previous years. You must file IRS Form 3800 to claim any of the General Business Credits; in addition, there are specific forms for estimating and claiming each credit.
It’s important to review availability and eligibility each tax year because new credits are offered, and as your business changes you may be able to claim tax credits for which you were previously ineligible.
Here’s a short list of some General Business Credits your business may want to explore.
- Credit for small employer pension plan startup costs: Helps businesses with the cost of setting up qualified plans.
- Credit for employer-provided childcare facilities and services: Offsets the cost of providing childcare facilities for employees.
- Energy efficient home credit: Contractors can claim this credit for selling or leasing energy-efficient residences.
- Low-income housing credit: Provides credits to owners of rental buildings in low-income housing projects.
- Work opportunity credit (WOC): This credit benefits employers that hire people in specific categories—including long-term unemployment recipients, some veterans, recipients of various kinds of public assistance and those who face significant barriers to employment. The amount of the credit varies depending on the category, up to $9,600 per employee.
- Alternative fuel/motor vehicle tax credits. Several General Business Credits and other tax credits are available to help encourage the use of environmentally friendly vehicles. They include credits for electric vehicles, hydrogen fuel cell vehicles and using or selling biodiesel or other biofuels.
Qualified small business R&D payroll tax credit. The R&D payroll tax credit is an incentive aimed specifically at startups. It can be used to offset payroll and income tax liability. Qualified companies:
- Have less than $5 million in revenue over five years with qualifying research activities and expenditures.
- Have less than five years of revenue.
- May claim R&D tax credits against the employer portion of Social Security payroll tax, which is 6.2 percent of wages paid, up to $8,239.80 per year per employee.
- Can apply up to $250,000 of the research credit against payroll tax liability.
- New markets tax credit: This credit is intended to spur development in low-income communities. The U.S. Treasury Department's Community Development Financial Institutions Fund administers the program, which offers tax incentives to encourage private investors to invest in projects. The credit (39% of the total investment) is distributed over seven years.
Health insurance premiums credit. This credit helps cover premiums for health insurance purchased through the Small Business Health Options Program (SHOP). It can be worth up to 50% of your premium contributions (for tax-exempt employers, that figure is up to 35%). To claim the credit, you must:
- Have fewer than 25 full-time equivalent (FTE) employees.
- Pay employees an average salary of $55,000 per year or less, adjusted annually for inflation.
- Contribute at least 50% of premium costs for employees (though not dependents).
- Enroll in coverage through SHOP.
Businesses can benefit from the credit in the current tax year or in previous years by filing an amended return; however, refund limitations may apply.
Family Medical Leave Act (FMLA) credit: This credit is for employers that provide paid family and medical leave to employees. To qualify for the credit, employers must have a written policy that provides:
- At least two weeks of paid family and medical leave annually to all qualifying FTE employees.
- At least 50% of wages normally paid to the employee.
The credit is equal to a percentage of wages paid to qualified employees during family and medical leave.
August 2020 Tax Credits You Can Use for Your Small Business
The federal government’s response to the coronavirus pandemic in 2020 included new tax credits.
- Employee retention credit: This payroll tax credit is part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which aims to help businesses remain solvent during the pandemic. For eligible employers, the CARES Act provides a refundable employment tax credit of 50% for up to $10,000 per employee per quarter for wages paid from March 13 to Dec. 31, 2020.
Eligible small businesses must have employees and have suffered one of the following negative impacts:
- Suspended operation due to orders from a government authority that limited commerce, travel or group meetings due to COVID-19.
- Sustained a notable decline in gross receipts during a calendar quarter as compared to the same quarter in 2019.
- Families First Coronavirus Response Act (FFCRA). The Families First Coronavirus Response Act (FFCRA) expands tax credits related to family and sick pay for COVID-19 related illness, covering some situations that were not traditionally covered by federal FMLA. For example, the FFCRA applies to small businesses with fewer than 50 employees, whereas traditional FMLA did not.
6 Things You Need to Know About the 2020 Payroll Tax Credit
Here are six important points about the employee retention credit.
- The employee retention credit helps businesses impacted by the coronavirus pandemic keep employees on the payroll for as long as possible by offering a credit toward the employer’s share of Social Security taxes—6.2% of wages.
- Businesses can only take the credit if they haven't received funds from the Paycheck Protection Program.
- You must demonstrate that your business has undergone significant harm due to the pandemic—closure by order of a governmental body or loss of revenue during a quarter compared to 2019.
- The credit can reduce your tax bill by 50% of up to $10,000 of each employee’s wages (including healthcare premium costs) each quarter through Dec. 31, 2020.
- Because it’s a refundable credit, the portion of the credit you don’t need is considered an over-payment of payroll taxes and will be returned when you file your federal taxes.
- The IRS also allows you to reduce your quarterly employment tax deposits, increasing your cash on hand and boosting your business’s odds of survival.
As your business grows and new tax policy is released, it’s vital to stay up to date on the latest payroll calculations, deductions and credits. Even for small businesses and startups, one of the best and most efficient ways to not leave money on the table is to invest in a business accounting software platform. With NetSuite Finance, Accounting and Payroll in addition to the other reporting and tracking features, you have access to current tax management features in one simple, easy-to-use system. Additionally, it integrates seamlessly with other powerful software, like Human Capital Management that help make payroll processing easier and scalable as your business grows and changes.