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Understanding Federal Tax Credits

Over the years, Congress has populated the tax code with a plethora of tax credits. Most states have followed suit with their own credits. Some of these credits are available only temporarily, to encourage certain activities to take place before the credit expires. Other credits have become permanent fixtures of the tax law. Whether targeted toward businesses or individuals, most tax credits have a common theme: they are awarded to taxpayers who take certain actions that the government has decided to encourage and reward.

Credit vs. deduction

A credit is usually, but not always, more valuable than a deduction. A credit represents a dollar-for-dollar reduction in the tax bill. The amount of tax savings associated with a deduction depends on the taxpayer’s marginal tax rate for the year. For example, a $1,000 credit reduces the tax bill by $1,000. A $1,000 deduction for someone in the 35 percent marginal tax bracket saves $350 in tax.

Double-dipping

The potential for double-dipping arises when the same expenditure qualifies for a tax credit and as a tax deduction. Sometimes the law allows double-dipping and sometimes it does not. The rules vary from credit to credit. When double-dipping is not allowed, the tax must be calculated using the deduction and recalculated using the credit in order to see which produces the better result.

Refundable vs. nonrefundable

When a credit is refundable, if the credit exceeds the tax liability for the year, the government issues a refund check. Not surprisingly, most credits are nonrefundable. When a nonrefundable credit exceeds the tax liability for the year, two possibilities come into play:

  • With some credits, the excess credit amount is simply “lost.”
  • With other credits, the excess amount can be carried to prior and/or future tax returns to reduce the tax liability in other years.

Recordkeeping

Most tax credits require the capture of information not easily identified in traditional financial reports. Businesses and individuals must be aware of whether their activities qualify for tax credits and then gather the appropriate information. Remember, if a credit is not overtly claimed on a tax return, the IRS is not going to issue a refund check.

 
State tax credits

Many states base their income tax on Federal taxable income or Federal adjusted gross income. As such, a deduction allowed on the Federal return may automatically flow to the state return. Not so with credits. Federal credits do not flow to state returns. States often offer their own list of tax credits, available only to those who file returns in those states.

 
Unclaimed credits

By some estimates less than 2 percent of eligible taxpayers claim tax credits. As a result, many overpay their taxes because they are unaware a credit exists, they fail to recognize their eligibility, or they conclude that the recordkeeping requirements are too onerous.

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