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.

Key Takeaways

  • 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 29 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 — a payroll tax credit created by the government in 2020 to help businesses during the coronavirus pandemic — saw significant changes in 2021.

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.

Why Are Tax Credits Important?

Tax credits are considered important for several reasons. Because tax credits are used to incentivize desired behavior and actions, they can be valuable tools in achieving a desired outcome. For instance, if a government wants to convince taxpayers to go green for the environment, they might provide tax credits for energy efficient products like alternative fuels. Want to promote higher education? Place tax credits around continued learning. Tax credits become extremely important when it comes to stimulating economic performance, inclusion and stability. For small businesses in particular, available tax credits can give them an edge over larger firms, promoting market competitiveness.

How Tax Credits Work & How to Claim Them

How does the payroll tax work? Put simply, a tax credit is a dollar-per-dollar reduction in the income tax owed. Depending on the amount owed versus the credit, it will either reduce the amount of tax owed or increase the amount of the refund.

The IRS offers guides for both individuals and businesses that list all possible credits and deductions. Guides include detailed documentation or tools around each credit to help determine eligibility.

Once eligibility is determined, each individual tax credit requires its own form. If eligible for more than one credit, a business will also have to file a Form 3800, General Business Credit. On Form 3800, each of the credits will be added up to calculate the total value of all tax credits.

Small-Business Tax Credits Vs. Tax Deductions: What’s The Difference?

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.

  1. General Business Credit. It currently includes 29 credits for the current year as well as any unused portions of nonrefundable credits carried forward from prior years.
  2. 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 on your payroll tax returns for which you were previously ineligible.

    Here’s a short list of some General Business Credits your business may want to explore.

  3. Credit for small employer pension plan startup costs: Helps businesses with the cost of setting up qualified plans.
  4. Credit for employer-provided childcare facilities and services: Offsets the cost of providing childcare facilities for employees.
  5. Energy efficient home credit: Contractors can claim this credit for selling or leasing energy-efficient residences.
  6. Low-income housing credit: Provides credits to owners of rental buildings in low-income housing projects.
  7. Work opportunity tax credit (WOTC): 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. This credit is claimed by filing Form 5884.
  8. 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.
  9. 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.

    Any unused R&D credits that aren't elected to offset payroll taxes may be carried forward for up to 20 years and used when the business becomes profitable.

  10. 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.
  11. Credit for small employer health insurance premiums: 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 $56,000 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.

  12. Employer credit for paid family and medical leave: 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 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.

    Status of 2020 Tax Credits for Small Businesses

    The federal government’s response to the coronavirus pandemic in 2020 included new small business tax credits, which continued to be active in 2021.

  13. Employee retention credit: The employee retention credit (ERC) was a part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which aimed to help businesses remain solvent during the pandemic. The ERC provided a refundable payroll tax credit for qualified wages paid to retained full-time employees. It was then initially extended through December 31, 2021 by the American Rescue Plan Act (ARPA). However, The Infrastructure Investment and Jobs Act eliminated the ERC earlier than anticipated.  The credit is now repealed for wages paid in the fourth quarter of 2021, except for recovery startup business.
  14. Families First Coronavirus Response Act (FFCRA): The Families First Coronavirus Response Act (FFCRA) expanded tax credits related to family and sick pay for COVID-19 related illness, covering some situations that were not traditionally covered by federal FMLA. While the FFRCA initially required employers with fewer than 500 employees to provide short-term paid sick leave in exchange for tax credits, it became voluntary starting in 2021. The FFCRA tax credit was extended by ARPA from April 1 to September 30 and amended to include vaccine-related reasons. It expired on September 30, 2021.

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7 Things You Need to Know About the Employee Retention Credit for 2021 Taxes

Here are seven important points about the updated employee retention credit.

  1. 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 employment taxes.
  2. The Consolidated Appropriation Act (CAA) released enacted at the beginning of 2021 permitted employers to seek the employee retention tax credit, even if they had received a PPP loan. However, taxpayers cannot claim the ERC on PPP wages used for PPP loan forgiveness.
  3. Who qualifies for the payroll tax credit? To be eligible, businesses must have experienced a partial or total government-ordered shutdown, or a “significant” decline in gross receipts.
    • In 2020, a significant decline is a 50% decrease in gross receipts compared to the same calendar quarter in 2019.
    • In 2021, a significant decline is a 20% decrease in gross receipts compared to the same quarter in 2019. 
  4. For 2020, the credit can reduce your tax bill by 50% of up to $10,000 of each employee’s qualified wages (including healthcare premium costs) each quarter through Dec. 31, 2020. For 2021, the credit is 70% of all qualified wages from January 1, 2021 to September 30, 2021 (This excludes recovery startup businesses, which can continue taking advantage of the credit until December 31, 2021). It’s limited to $10,000 in wages per employee for any quarter, meaning you can claim $7,000 for each employee in every quarter. The maximum credit is $21,000 per employee.
  5. To be considered a “recovery startup business” and continue your ERC credit into the fourth quarter of 2021, businesses must meet the following criteria:
    • Began operations on or after February 15, 2020.
    • Maintains average annual gross receipts that do not exceed $1 million.
    • Employs one or more employees (other than 50% owners)
    • Does not otherwise qualify for the credit (i.e. did not experience a partial or total government-ordered shutdown, or a “significant” decline in gross receipts.

    Recovery startup businesses are still qualified to request advance payment of employee retention credit through IRS Form 7200 for the fourth quarter of 2021 — deadline is January 31, 2022.

  6. 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.
  7. 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.

Payroll Tax Credit FAQs

What is the difference between payroll taxes and employment taxes?

Both are taxes that employers pay directly to the IRS. While there is overlap between these tax terms, employment taxes refer to the taxes paid to the IRS directly from the employer. They include income, Social Security, Medicare and Federal Unemployment Tax Act (FUTA) taxes. Payroll taxes refers to the taxes deducted to fund Medicare and Social Security programs in the U.S.

Do owners qualify for the employee retention credit?

Wages paid to those with more than 50% ownership in a business do not qualify for the ERC. Wages paid to an individual related to a majority shareholder are also not considered eligible.

How does the small business tax credit work?

The ERC credit can be claimed by reporting total qualified wages for each calendar quarter on Form 941, Employer’s Quarterly Federal Tax Return. The FFRC credit can also be claimed via Form 941, where employers will report any qualified sick or family leave.

What should employers do if they received an advance payment of the employee retention credit or reduced their employment tax deposits in anticipation of receiving the ERC for the fourth calendar quarter of 2021?

Because the ERC was unexpectedly terminated a quarter early due to the enactment of the Infrastructure Investment and Jobs Act, employers must repay any erroneous advanced payments or adjust any reduced deposits. Employers must repay any advanced payments by the due date of their employment tax return that includes the fourth quarter of 2021 to avoid any penalties. Similarly, employers that reduced their deposit in regards to wages paid on or after October 1, 2021 in anticipation of the ERC they expected to claim must deposit those taxes by December 20, 2021.

How long does it take to get an ERC return?

Generally, you will receive your refund within 3 weeks if you file electronically or 8 weeks if you mail your return.