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In addition to claiming all of the tax deductions that you can, you can further minimize your income tax bill by claiming all of the tax credits available to you.
When they're available, tax credits are generally better for you than deductions would be, because credits are subtracted directly from your tax bill. Deductions, in contrast, are subtracted from the income on which your tax bill is based.
So, a dollar's worth of tax credit reduces your tax bill by a dollar, but a dollar's worth of deductions lowers your tax bill by 35 cents if you're in the 35 percent bracket, by 33 cents if you're in a 33 percent bracket, etc. In cases where you have a choice between claiming a credit or a deduction for a particular expense, you're generally better off claiming the credit.
As wonderful as tax credits can be, with the IRS (as you've probably figured out by now) there's almost always a catch. In this case, the catch is that tax credits are only available for certain very limited situations. Many of them apply only to certain industries (like restaurants and bars, or energy producers). And credits come with a set of very complicated rules, which you (or, more likely, your tax pro) must follow in order to claim them.
- Types of credit available - most federal income tax credits currently available to small business owners are very narrowly targeted to encourage you to take certain actions that lawmakers have deemed desirable (generally, to benefit disadvantaged/low-income individuals or the environment). There are also a few credits designed to prevent double taxation, and a few designed to encourage certain types of investments that are considered socially beneficial.
- Claiming credits - the forms and procedures used to calculate and claim business tax credits are quite complicated. In fact, we recommend that you leave the technical details to your tax pro. However, we do provide an outline of the basic rules, including the dollar limits, carryback and carryforward rules, and recapture rules, so you can decide whether to pursue arranging your business affairs to take advantage of a credit.