Employment Tax Credits

Tax credits are even better than tax deductions. A tax deduction is worth only as much as the tax bracket you are in. For example, if you are in the top federal income tax bracket for individuals, 35% in 2012, a $100 deduction saves $35 in taxes. Tax credits reduce your taxes dollar-for-dollar. A $100 tax credit saves $100 in taxes.

Employer’s Employment-Related Tax Credits

There are a number of tax credits related to the employment of workers. These tax credits reduce your deduction for compensation dollar-for-dollar. For example, if your deduction for compensation is $40,000 and you are entitled to claim a $2,000 employment tax credit, you may deduct only $38,000.

Employment-related tax credits reduce your deduction for wages paid to your employees.

WORK OPPORTUNITY CREDIT

To encourage employers to hire certain individuals from specially targeted groups, there is a tax credit called the work opportunity credit. The credit of up to $9,600 for 2012 applies to certain veterans.

Prior to 2012, there was a much broader credit, which may be extended retroactively for 2012. If extended, then the following information applies for 2012: The credit applies to such targeted groups as Aid to Families with Dependent Children (AFDC) recipients, food stamp recipients, ex-felons, high-risk youth, and those in areas that suffered certain population decline. The credit is 25% of the first $6,000 of wages ($3,000 of wages for summer youth) for those who work between 120 and 400 hours. The top credit is $2,400 ($1,200 for summer youth). The credit is 40% of the first $6,000 of wages ($3,000 of wages for summer youth) for those who work at least 400 hours. The top credit is $2,100 ($1,050 for summer youth). For veterans with service-connected disabilities who have been unemployed for any 6 months or more during a 1-year period ending on the date of hire, qualified wages taken into account in figuring the credit are $12,000.

If you employ an eligible worker, be sure to obtain the necessary certification from your state employment security agency. This is done by having the employee sign IRS Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, on the first day of work and submitting it to your state workforce agency within 28 days of the new employee’s starting work (or until June 19, 2012, for qualified veterans hired before May 22, 2012). Without having submitted this form, you cannot claim the credit, but if you make a timely submission you claim the credit even if the state agency fails to respond to you.

EMPLOYER CREDIT FOR FICA ON TIPS

Owners of restaurants and beverage establishments can claim a credit for the employer portion of FICA paid on tips related to the furnishing of food and beverages on or off the premises. This is 7.65% of tips in excess of those treated as wages for purposes of satisfying the minimum wage provisions of the Fair Labor Standards Act (FLSA).

EMPOWERMENT ZONE EMPLOYMENT CREDIT

The empowerment zone employment credit expired at the end of 2011, but could be extended retroactively for 2012. If extended, then the following information applies for 2012. The Departments of Housing and Urban Development and Agriculture initially named 6 cities and 3 rural economically distressed areas across the country as empowerment zones (Round I zones) and in 1998 named 22 more (Round II). In addition, the District of Columbia is an enterprise zone—another type of economically distressed area—and employers in the zone are eligible for the empowerment zone employment credit. Eight additional employment zones have been designated (Round III). If you do business in 1 of these economically depressed zones and hire part-time or full-time employees who perform substantially all of their employment services within the zone, you may claim a credit based on their wages. The credit is 20% of the first $15,000 of qualified wages. The top credit is $3,000 per employee per year. There is no limit on the number of employees for which you may claim the credit. Wages for purposes of calculating the credit include not only salary and wages but also training and educational benefits. To determine whether a particular area has received designation, go to www.hud.gov/crlocator.

INDIAN EMPLOYMENT CREDIT

The Indian employment credit expired at the end of 2011, but could be extended retroactively for 2012. If extended, then the following information applies for 2012. You can claim a credit if you employ part-time or full-time workers who receive more than 50% of their wages from services performed on an Indian reservation. The employee must be an enrolled member of an Indian tribe or a spouse of an enrolled member. The employee must also live on or near the reservation on which the services are performed. The credit is 20% of the first $20,000 of excess wages and the cost of health insurance. Excess wages and health insurance costs are such costs over amounts paid or incurred during 1993. However, wages paid to any employee earning more than $30,000 are not taken into account; such employee is not a qualified employee.

EMPLOYER WAGE CREDIT FOR ACTIVATED RESERVISTS

The employer wage credit for activated reservists expired at the end of 2011, but could be extended retroactively for 2012. If extended, then the following information applies for 2012. If you continue some or all of the wages of employees called to active duty (called a differential wage payment), you can take a tax credit of 20% of the differential that does not exceed $20,000 (a top credit of $4,000).

This credit applies only to small employers (on average fewer than 50 employees) that have a written plan to provide the wage differential. No deduction for compensation can be claimed if the compensation is a differential wage payment used to determine this credit.

GENERAL BUSINESS CREDIT

Some employment tax credits are part of the general business credit. As such, they not only reduce your deduction for wages but are also subject to special limitations. The general business credit is the sum of employment tax credits and certain other business-related credits. The general business credit cannot exceed your net tax liability (tax liability reduced by certain personal and other credits), reduced by the greater of:

  • Tentative minimum tax (the alternative minimum tax before the foreign tax credit), or
  • 25% of regular tax liability (without regard to personal credits) over $25,000.

The amount of the general business credit in excess of this limit can be carried back for 1 year. Any additional excess amount can then be carried forward for up to 20 years. You cannot elect to forgo the carryback. (For credits arising in tax years before 1998, the carryback period was 3 years and the carryforward period was 15 years. For credits arising in 2010 of small businesses with average annual gross receipts not exceeding $50 million, there was a 5-year carryback and a 20-year carryforward.)

Example
Your 2012 tax liability (without regard to personal credits) is $15,000 and you have no alternative minimum tax liability. Your general business credit from eligible small business credits is $17,000. In 2012, you can claim a general business credit of $15,000 (your net tax liability reduced by your tentative minimum tax liability of zero). The $2,000 unused credit can be carried back 1 year. If it cannot be fully used on amended returns, it can be carried forward for up to 20 years starting on your 2013 return.

Employee’s Employment-Related Tax Credits

An employee may be entitled to claim certain credits by virtue of working. These include the earned income credit and the dependent care credit. They are personal tax credits, not business credits. They are in addition to any child tax credit to which a person may be entitled ($1,000 in 2012 for each child under age 17 if income is below a threshold amount).

EARNED INCOME CREDIT

If you employ an individual whose income is below threshold amounts, the employee may be eligible to claim an earned income credit. This is a special type of credit because it can exceed tax liability. It is called a refundable credit, since it can be paid to a worker even though it more than offsets tax liability.

DEPENDENT CARE CREDIT

Whether you are an employee or a business owner, if you hire someone to look after your children under age 13 or a disabled spouse or child of any age so that you can go to work, you may claim a tax credit. This is a personal tax credit, not a business tax credit. You claim the credit on your individual tax return.

The credit is a sliding percentage based on your adjusted gross income (AGI). The top percentage is 35%; it scales back to 20% for AGI over $43,000. This is the AGI on a joint return if you are married and do not live apart from your spouse for the entire year.

The percentage is applied to certain employment-related expenses up to $3,000 per year for 1 dependent, or $6,000 per year if you have 2 or more qualifying dependents. Employment-related expenses include household expenses to care for your dependent—housekeeper, babysitter, or nanny—and out-of-the- house expenses for the care of dependents, such as day-care centers, preschools, and day camps. Not treated as qualifying expenses are the costs of food; travel to and from day care, preschool, or day camp; education; and clothing. Also, the cost of sleep-away camp does not qualify as an eligible expense.

If you are eligible for a credit, be sure to get the tax identification number of anyone who works for you and the day-care center or other organization to which you pay qualified expenses. The tax identification number of an individual is his or her Social Security number. You must include this information if you want to claim the credit.

If you hire someone to work in your home, be sure to pay the nanny tax. This is the employment taxes (Social Security, Medicare, and FUTA taxes) on compensation you pay to your housekeeper, babysitter, or other in-home worker. You must pay Social Security and Medicare taxes if annual payments to a household worker in 2012 exceed $1,800. If you paid cash wages of $1,000 or more in any calendar quarter to a household employee during the current tax year or the previous year, you also must pay federal unemployment tax (FUTA) on the first $7,000 of wages. You do not pay these taxes separately but instead can report them on Schedule H and include them on your Form 1040. You should increase your withholding or estimated tax to cover your liability for them to avoid estimated tax penalties. You cannot deduct employment taxes on household workers as a business expense. However, the tax itself is treated as a qualifying expense for the dependent care credit.

Where to Deduct Compensation Costs
Self-Employed (Including Independent Contractors and Statutory Employees)
Compensation paid to employees and employee benefits paid or provided to/for them are deductible on the appropriate lines of Schedule C. The deduction for wages must be reduced by any employment credits paid. Self-employed farmers deduct compensation costs on Schedule F. If you maintain a cafeteria plan for employees, you must file an information return, Form 5500, annually. If you personally incur dependent care costs for which a credit can be claimed, you must file Form 2441, Child and Dependent Care Expenses. The credit is then entered on Form 1040.
Partnerships and LLCs
Compensation paid to employees and employee benefits paid or provided to them are a trade or business expense taken into account in determining the profit or loss of the partnership or LLC on Form 1065, U.S. Return of Partnership Income. Report these items on the specific lines provided on Form 1065. Be sure to offset them by employment tax credits. Salaries and wages paid to employees and employee benefits are not separately stated items passed through to partners and members. Partners and members in LLCs report their net income or loss from the business on Schedule E; they do not deduct compensation and employee benefit costs on their individual tax returns.
Guaranteed payments to partners are also taken into account in determining trade or business profit or loss. There is a specific line on Form 1065 for reporting guaranteed payments to partners. They are also reported on Schedule K-1 as a separately stated item passed through to partners and LLC members as net earnings from self-employment. This will allow the partners and LLC members to calculate their self-employment tax on the guaranteed payments. If the partnership or LLC maintains a cafeteria plan for employees, the business must file an information return, Form 5500, annually. Partners and LLC members who personally incur dependent care costs for which a credit can be claimed must file Form 2441 with their Form 1040.
S Corporations
Compensation paid to employees and employee benefits paid or provided to them are trade or business expenses that are taken into account in determining the profit or loss of the S corporation on Form 1120S, U.S. Income Tax Return for an S Corporation. They are not separately stated items passed through to shareholders. This applies as well to compensation paid to owners employed by the corporation. Note that compensation to officers is reported on a separate line on the return from salary and wages paid to nonofficers. Be sure to reduce salary and wages by employment tax credits.
Shareholders report their net income or loss from the business on Schedule E; they do not deduct compensation and employee benefit costs on their individual tax returns. If the corporation maintains a cafeteria plan for employees, it must file an information return, Form 5500, annually. Shareholders who personally incur dependent care costs for which a credit can be claimed must file Form 2441 with their Form 1040.
C Corporations
Compensation and employee benefits paid to employees are trade or business expenses taken into account in determining the profit or loss of the C corporation on Form 1120, U.S. Corporation Income Tax Return. Compensation paid to officers is segregated from salaries and wages paid to employees. Be sure to reduce salary and wages by employment tax credits. Total compensation exceeding $500,000 paid to officers of the corporation is explained in greater detail on Form 1025-E, which accompanies Form 1120. Remember that the corporation then pays tax on its net profit or loss. Shareholders do not report any income (or loss) from the corporation. If the corporation maintains a cafeteria plan for employees, it must file an information return, Form 5500, annually.
Employment Tax Credits for All Businesses
Employment taxes are figured on separate forms, with the results in most cases entered on Form 3800, General Business Credit. Form 3800 need not be completed if you are claiming only 1 business credit, you have no carryback or carryover, and the credit is not from a passive activity.
The separate forms for employment taxes are the following (assuming expired credits have been extended):
  • Employer wage credit for activated reservists: Form 8932
  • Empowerment zone credit: Form 8844
  • Indian employment credit: Form 8845
  • Social Security tax credit on certain tips: Form 8846
  • Work opportunity credit: Form 5884
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