Tax Deductions and Tax Credits
The U.S. tax code offers two main vehicles for reducing taxes: tax deductions and tax credits. Here’s an overview of the differences, and examples of each.
Tax Deductions Versus Tax Credits
In other words, if your small business earned $500,000 in taxable profit last year, and you had $25,000 in tax deductions, the tax deductions alone reduce your taxable income to $475,000. Tax credits, on the other hand, are amounts subtracted from the taxes you owe, not from your income. If your business owes $100,000 in tax, for example, and are eligible for a $5,000 dollar-for-dollar tax credit, the credit reduces your tax liability to $95,000.
Tax credits are available for a wide number of activities, often related to specific actions deemed worth encouraging by governmental agencies, such as the purchase of electric or alternative fuel vehicles.
Examples of Tax Deductions
Depreciation and Section 179
If your business requires a fixed asset that will be used for more than one year – property such as equipment, machinery, vehicles, or real estate that is specifically used to create business income – you may be able to use the price as a tax deduction. The method is known as “depreciation,” and it takes place over a fixed number of years. The years vary by asset type.
Depreciation can be used for a wide number of business assets, including real estate. But if your business requires significant purchases of equipment or machinery that you will buy and then place into service in a given year, a Section 179 deduction makes it possible to take the full purchase price as a deduction in that year, which can be highly advantageous for a small business. The IRS sets the deductible amount for most purchases every year. In 2024, it is $1.22 million.
Note that a Section 179 deduction must be for equipment eligible per the IRS. (A wide range of assets are eligible, including office equipment and computers.) Purchases must be used for business purposes at least 50 percent of the time.
Charitable Donations
Charitable donations can be a great way for your business to give back to the community and to build relationships within the community and with your employees. In addition, many charitable donations are tax deductible.
To be deductible, charitable donations must be given to a qualified 501(c) (3) organization.
Businesses can donate cash or gift the charitable organization with equipment or property.
Small businesses donations for corporations are generally limited to no more than 10 percent of the business’s taxable income in a given year. Amounts over that amount, however, can sometimes be carried over to the subsequent five years.
But the amount you can deduct depends on your business structure, as well. If you are a sole proprietor or in a structure whose income is passed through and reported on your personal tax returns (partnership or S Corp), you can use the charitable contribution tax deductions open to individuals, which is significantly higher than those open to corporations. Individuals can generally donate up to 60 percent of their adjusted gross income (AGI) in cash to a qualified charity if they itemize deductions. (You can use these on your personal tax returns as the owner or shareholder of a C Corp as well, of course.)
Individuals can also make non-cash charitable contributions. Any donation totaling more than $500 requires filing Form 8283 with the IRS at the time annual tax returns are filed. If a non-cash contribution is over $5,000, you will also need a letter attesting to the donation from the recipient organization.
Individuals who personally travel to do charitable work can also take allowable travel mileage as a tax deduction from their personal tax returns.
Meals & Entertainment
Deducting business-related meals and entertainment can be very beneficial to your bottom line, especially if you work in an industry that requires extensive business travel.
It’s also, though, one of the most complicated of deductions, as the percentage deductibility and whether a given expense is deductible or not varies widely, according to the purpose and the business use. The deductions allowable also change frequently from year to year.
For 2024, you can deduct 50 percent of the following expenses:
• A business meal with clients to discuss work
• Employee meals while traveling
• Employee meals while at a conference
• Employee dinners for working late
• Food provided for a Board meeting
• Food provided to workers in an office
Some larger deductions exist; for example, a companywide party is 100 percent deductible.
Note that some deductions have been phased out. At one point, you could deduct client entertainment, such as baseball game tickets, from your taxes as long as business was discussed. That is no longer allowable.
Start Up Expenses
If your business incurs startup expenses, you can deduct as much as $5,000 in its first year. If you have more than $5,000 in expenses, the excess can be amortized over 15 years. Startup expenses can include payments for legal and accounting services, market research costs, employee training, and organizational setup expenses.
Examples of Tax Credits
Research and Development Tax Credit
If your business engages in qualified research that results in product development or enhancement, you may be eligible for a tax credit. Note that the research must be carried on before the product is on the market for sale; research after it’s commercially available is not eligible for the credit.
To be eligible, your business’s work must include experimentation, must be based on hard sciences (computer science, engineering, physics, chemistry or biology) and must be aimed specifically to develop a new process or product, or to improve one.
If you qualify, a number of research expenses are deductible, including wages, supplies, research expenses you paid a third party and selected computer expenses.
Retirement Plans Startup Cost
The Setting Every Community Up for Retirement Enhancement 2.0 Act of 2022 (SECURE 2.0) contains multiple potential credits for employers who set up and administer retirement plans, such as 401(k)s. The deductible expenses are both for administering the plan and educating employees about it, and can be as much as $5,000 over three tax years.
To be eligible, your company must have no more than 100 employees who were paid a minimum of $5,000 in the preceding tax year and have at least one employee in the plan who is a non-highly compensated employee (NHCE) as defined by the IRS. In addition, the employees served by the pension plan can’t have been receiving contributions or benefits from another retirement plan sponsored by you or a group related to you over the last three tax years.
Employee Retention Credit
The Employee Retention Credit (ERC) was enacted by the Federal government in the midst of the COVID-19 pandemic. It was intended to assist small businesses whose businesses were negatively affected the pandemic, by enabling them to keep workers employed.
Note that even though ERC was discontinued in 2021, employers who were affected during the period but didn’t file for the ERC can file for it retroactively until 2025.
It should also be noted, though, that the ERC was unfortunately subject to many fraudulent claims during the pandemic, which the IRS has announced it is still sorting through. This shouldn’t discourage you from filing an application for a valid ERC, but it means that the application process is likely to be slow.
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