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Tax credits reduce the amount of tax you owe, but they don’t always result in a refund. Learn how tax credits work and when they apply.
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Tax credits can reduce the amount of tax you owe, but how they work — and how they differ from tax deductions — isn’t always obvious.
This guide explains what tax credits are, how refundable and nonrefundable credits work, and how they affect your tax bill.
Table of Contents
A tax credit is an amount applied directly against taxes owed. Some credits reduce your tax liability, while others may result in a refund.
Many tax credits are available to businesses, often tied to specific activities such as investing in clean energy, supporting low-income communities, hiring from targeted groups, or offering employee benefits.
Review common business tax credits to see which ones may apply to your business.
Tax credits reduce the amount of tax owed, but how they apply depends on the specific credit.
Some tax credits are nonrefundable and can only reduce your tax bill to zero. Others are refundable, meaning they may result in a refund if the credit exceeds the amount owed. Some credits are partially refundable and may include limits, caps, or percentage-based calculations.
Because each credit has its own rules and calculation method, determining eligibility and credit amounts isn’t always straightforward. The IRS provides guidance for each credit, and accountants or certified tax preparers can help ensure credits are applied correctly.
Tax credits may be offered at both the federal and state levels. Federal tax credits are established by the IRS and include a limited number of credits available specifically to businesses, often tied to areas like energy efficiency, hiring incentives, and community investment.
State tax credits vary by location and may provide additional incentives for businesses operating within the state. These credits can differ widely in eligibility, value, and filing requirements, so businesses should consult their state tax authority or a tax professional to determine what credits may apply.
A tax credit can sometimes result in a refund, but not all tax credits work that way. Whether a credit leads to a refund depends on whether it’s refundable, nonrefundable, or partially refundable.
The sections below explain these differences and how each type of credit affects your tax bill.
Tax credits fall into two main categories: refundable and nonrefundable.
All tax credits reduce the amount of tax you owe dollar for dollar. However, only some credits can result in a refund if the credit exceeds your tax liability.
Some credits are also partially refundable, meaning a portion of the credit may be refunded under specific conditions.
| Credit Type | What It Does |
|---|---|
| Refundable | Can reduce your tax bill below zero and result in a refund |
| Nonrefundable | Can reduce your tax bill to zero but won’t generate a refund |
| Partially refundable | May provide a limited refund based on IRS rules |
While both tax credits and tax deductions can reduce how much you owe in taxes, they work in very different ways.
Tax deductions reduce your taxable income, while tax credits reduce the actual amount of tax you owe — and in some cases, can increase your refund.
Here’s a simple example:
If Sarah earns $110,000 and qualifies for $20,000 in tax deductions, her taxable income drops to $90,000. That means less of her income is subject to tax, lowering her overall tax bill.
Now, if Sarah still owes $5,000 in taxes after deductions and qualifies for $2,000 in tax credits, her tax bill drops dollar for dollar — from $5,000 to $3,000.
Using eligible deductions and tax credits together can significantly reduce what you owe and help maximize overall tax savings.
Learn more about how tax deductions work or explore common business tax deductions to see how businesses can reduce taxable income.
To claim a tax credit, you must meet the credit’s specific eligibility requirements. A certified public accountant (CPA) or qualified tax preparer can help identify which credits apply to your situation and ensure they’re calculated correctly.
Most tax credits require completing a dedicated IRS form to calculate the credit amount. That amount is then applied to your tax return according to IRS instructions. While the process can involve additional paperwork, properly claimed credits can significantly reduce your tax liability.
For business owners, staying organized is key. Use our free small business tax prep checklist or review our complete guide to small business taxes to help ensure you don’t miss available credits.
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