Tax deductions vs. tax credits for small business

Deduction and credit get used interchangeably in casual talk about taxes, and the confusion costs business owners money. They are not the same thing, and the difference is not academic: a dollar of tax credit is worth far more than a dollar of tax deduction. Understanding why — and knowing which credits a small business might qualify for — is one of the highest-return pieces of tax literacy an owner can have. This is general education; whether you qualify for a specific credit is a question for a tax professional.

A deduction reduces taxable income

A deduction lowers the amount of income that gets taxed. If you are in a 24% bracket and take a $1,000 deduction, your taxable income drops by $1,000 and your tax drops by roughly $240 — the deduction's value is the amount times your tax rate. Deductions are valuable and plentiful for businesses, but each dollar of deduction saves you only cents on the dollar.

A credit reduces your tax directly

A credit subtracts from your tax bill dollar for dollar. A $1,000 tax credit cuts your tax by the full $1,000, regardless of your bracket. That is why credits are so much more powerful: a $1,000 credit is worth roughly four times a $1,000 deduction for someone in a 24% bracket. Credits are rarer and often tied to specific activities the government wants to encourage.

Credits a small business might explore

• Retirement plan startup credits: small employers that set up a qualified retirement plan may claim credits toward the cost of starting and administering it — a direct reward for offering a plan.
• Work opportunity and hiring-related credits: hiring from certain targeted groups can qualify for credits.
• Research and development credit: businesses doing qualifying development work — broader than many owners assume — may claim an R&D credit.
• Health care and energy-related credits: providing employee health coverage or making certain energy investments can carry credits under current rules.

The bottom line

A deduction lowers taxable income and saves you your tax rate times the amount; a credit lowers your tax bill dollar for dollar and is worth far more per dollar. Chase your legitimate deductions, but pay special attention to credits — especially the retirement-plan startup credits that reward the very move that also builds your future. Because credits change constantly and eligibility is specific, use any list as a starting point for a conversation with a tax professional, who can tell you which ones you actually qualify to claim.