What Are Tax Deductions and Credits? A Guide for Small Business Owners and Freelancers

Taxes are an unavoidable reality for small business owners, freelancers, and individual taxpayers. Understanding the difference between tax deductions and tax credits is vital for effective financial planning and reducing your tax burden. These two concepts can save you money, but they work in distinct ways.

This guide provides clarity on these important financial tools.

What Are Tax Deductions and How Do They Work?

A tax deduction reduces your taxable income. This means the portion of your earnings subject to taxation becomes smaller. By lowering this amount, deductions also lower the total taxes you owe. Here’s an example:

• If your annual income is $70,000 and you claim $10,000 in deductions, your taxable income will be reduced to $60,000. So, for simplicity, assuming all of your income is taxed at 20 percent, the $10,000 reduction decreases your tax liability $2,000—from $14,000 ($70,000 x .2) to $12,000 ($60,000 x .2).

Tax deductions are generally based on expenses you incurred during the year, and they must meet certain IRS eligibility criteria. To claim deductions, you must be able to document the expense with documentation, such as receipts and financial statements.

Standard Deduction vs. Itemized Deductions

When it comes to deductions on individual tax returns, you have two main options:

#1 – Standard Deduction: This is a fixed dollar amount that the IRS allows taxpayers to subtract from their income. Most taxpayers opt for this straightforward method because it requires minimal paperwork. For example, in the 2024 tax year, the standard deduction amounts are:

• $14,600 for single filers or married individuals filing separately
• $29,200 for married couples filing jointly or qualifying surviving spouses
• $21,900 for those filing as the head of household

#2 – Itemized Deductions: If you have significant deductible expenses, itemizing might help you save more money. This method allows you to separately list qualifying expenses, but it requires more effort and documentation. Common itemizable deductions include:

• Medical and dental expenses (over 7.5% of your adjusted gross income)
• Home mortgage interest
• Charitable donations
• State and local taxes

For instance, if you are not married and have deductible expenses of $25,000, opting to itemize instead of taking the standard deduction could lower your taxable income by a greater amount.

Deductions That Can Be Claimed in Both Cases

Regardless of whether you take the standard deduction or itemize, some expenses are always deductible. These include:

• Retirement contributions (IRA)
• Student loan interest
• Health savings account contributions
• Business-related expenses (e.g., home office, vehicle use)

Meticulously tracking and documenting these expenses throughout the year can make claiming them at tax time much easier.

What Are Tax Credits and What Makes Them Unique?

Unlike deductions, a tax credit is a dollar-for-dollar reduction in your tax liability. For example, a $1,000 tax credit directly reduces the taxes you owe by $1,000. This makes tax credits generally more powerful at saving money than deductions.

Tax credits also come in two forms:

1. Refundable Tax Credits: Refundable credits allow you to receive the full credit amount, even if it reduces your tax liability to below $0. For example, if you owe $500 in taxes but qualify for a $1,000 refundable tax credit, you’ll receive a $500 refund.
2. Nonrefundable Tax Credits: Nonrefundable credits can reduce your taxes to zero, but they won’t provide a refund for any remaining amount. For example, if you owe $500 in taxes and qualify for a $1,000 nonrefundable credit, you’ll only reduce your tax liability to $0 but won’t receive the extra $500.

Key Tax Credits to Be Aware Of

There are numerous tax credits available depending on your financial and personal circumstances. Here are some of the most notable ones:

• Earned Income Tax Credit (EITC): This refundable credit assists low- to moderate-income workers. Workers with children typically receive more significant benefits, but even those without qualifying children may qualify. This is one of the most underutilized tax credits, so ensure you don’t miss out.
• Child Tax Credit: This nonrefundable credit helps families with qualifying children. Eligible families can reduce their tax liability by a significant amount.
• Child and Dependent Care Tax Credit: Taxpayers who paid for childcare or dependent care to work, go to school, or search for work may qualify for this credit.
• Clean Energy Credits: If you have bought certain cars or made home improvements that are energy efficient, such as installing new windows, doors, or solar panels, then you can claim a credit that will cover a portion of the costs.

Navigating Tax Laws and Regulations

Tax regulations are continually evolving, and filing your taxes accurately requires staying up-to-date on the latest changes. Tax laws can vary widely based on your state, business type, and whether or not you have international considerations.

Small business owners and freelancers especially benefit from professional support to minimize errors and identify potential savings. Tools like tax software provide user-friendly interfaces to simplify tax compliance. Additionally, working with an accountant or tax consultant may be wise for more complex situations.

For businesses and individuals dealing with international income or foreign investments, professional guidance can be invaluable. International tax regulations often involve added layers of reporting requirements, so it’s important to avoid costly oversights.

Take Charge of Your Tax Savings

If you applied tax credits or deductions to your 2024 tax reports and are now facing questions or disputes from the IRS, state, or local tax authorities, our experienced tax attorney, James A. Kraehenbuehl of Mid-Atlantic Law & Tax, PLLC, is here to help. We have the experience and insight needed to review and defend your case. Contact us today to schedule a consultation.

James A. Kraehenbuehl

James A. Kraehenbuehl, founder of Mid-Atlantic Law and Tax, is an experienced business attorney, tax lawyer, and executive who has represented hundreds of clients, from individuals with simple tax preparation to global companies with complex legal issues.

Linkedin