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Tax Alert: 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.

For more information on Federal tax credits, please contact Joseph Tighe, CPA, a J.H. Cohn partner, at jtighe@jhcohn.com or 973-618-6243.

Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and J.H. Cohn LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

Published date: 8/1/2012

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