A tax credit is a dollar-for-dollar reduction of tax liability. During COVID-19, much attention has been focused on employment tax credits for paid sick leave, paid family leave, employee retention, and COBRA payments. But income tax credits for small businesses may fit well into today’s economy and business planning, and provide significant tax savings.
Work opportunity credit
Your business goal: Hiring new employees. The biggest challenge facing many small businesses today is finding qualified employees. According to BLS, as of July 7, 2021, there are 9.2 million job openings. Small businesses aren’t the only ones hiring; large companies are also on the hunt to fill positions.
The business action: You need to use every action possible to fill your openings. This includes seeking referrals from current employees, posting on your website and on job sites (e.g., Indeed), and signs in your window.
The tax credit: If you hire someone from a targeted group specified by the IRS, you may claim a tax credit. One of the groups is “long-term unemployment recipient,” which includes anyone collecting unemployment for not less than 27 consecutive weeks. The amount of the credit varies somewhat with their targeted group. For a long-term unemployed, the credit is 40% of first year wages up to $6,000, for a maximum credit of $2,400. Important: To qualify for a credit, you must submit IRS Form 8850 to your state workforce agency no later than 28 days after a new employee begins working for you.
Retirement plan credits
Your business goal: Attracting and retaining employees. In today’s tight job market, companies are competing for talent by offering a variety of fringe benefits. One of the most common of these benefits is access to a retirement plan.
The business action: If you do not yet have a qualified retirement plan, such as a 401(k) plan, profit-sharing plan, or SEP, you can set one up. Depending on the plan you select, some or all of the contributions are made employee contributions (i.e., no cost to employers). Or employers may or must make contributions, which are deductible. Additional costs (explained below) may generate a tax credit. If you choose to adopt a 401(k) plan, it may include automatic enrollment with a salary reduction feature in which employees automatically participate and contribute within the annual limit a set percentage of their compensation (though they may opt out or reduce their salary reduction contributions).
The tax credit: A small employer may take a tax credit of up to $5,000 per year for up to 3 years to cover the cost of administration as well as employee education. The plan must cover at least one employee who is not highly compensated (i.e., not an owner) and the company may not have had a plan within the prior 3 years. A small employer that chooses an automatic enrollment plan—whether new or changing an existing plan—may claim an additional credit of up to $500 per year for up to 3 years. These two credits are explained in the instructions to Form 8881.
Your business goal: Developing new products and/or processes. You may envision research as the domain of large pharmaceutical and technology companies. But many innovations come from small businesses…and even inventors in their basement labs.
The business action: Be sure you budget for your R&D activities. Carefully document expenditures related to determine the effectiveness of the research as well as to optimize the credit.
The tax credit: The research credit is up to 20% of increased research expenditures (there’s a 14% credit limit with different parameters). This research must be undertaken for discovering information that is technological in nature, and its application must be intended for use in developing a new or improved business component of your business. In addition, substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality. This doesn’t need to be a product or service; it may be an internal innovative process.
Note: Small businesses (gross receipts under $5 million) may apply up to $250,000 of their research credit as against employment tax liability rather than using the full credit as an income tax credit. This may be helpful for start-ups that don’t have sufficient revenue to create tax liability that an income tax credit could offset. More details about the credit may be found in an IRS Audit Technique Guide.
These are not the only credits for which a small business may be eligible. For example, there’s a tax credit for paying at least half of employees’ group health costs if they meet certain conditions.
Best strategy: Meet with your CPA or other tax advisor to review the tax credits to which you potentially may be eligible and how to nail them down.