One of the questions I get asked the most is, “if I buy ‘such and such’, can I deduct it?”. Most often, the question is asked to justify the purchase of a toy or otherwise desired item–typically to a spouse–by being able to say, “yeah, it cost a lot, but it’s tax deductible”. I will say however, that the question is also asked because of an individual’s legitimate attempt to reduce taxes owed (i.e., “should I go ahead and buy the computer I need now at the end of the year, or should I wait until next year?”). But in either case, there seems to be a perception on the part of the inquirer that the purchase will be a “credit” rather than a “deduction”, and there is a difference between the two.
The difference between a “deduction” and a “credit” can be simply stated; however, whether you’re using a purchase as a deduction or as a credit on your tax return can affect the outcome of your taxes greatly. A “deduction” is an item that is “deducted” (of course) from your taxable income. A “credit” is a reduction of your actual tax liability (that is the result of your taxable income). By way of a very simple example–
Let’s say your taxable income is $1,000 and you are in the 10% bracket. Your income tax is $100 ($1,000 x 10%).
Now, let’s say you want to purchase a $100 laptop for your business (I know, very unlikely to find one for this price–unless it’s actually a calculator, which may be the case). As a business expense, you would “deduct” this from your aforementioned $1,000 taxable income. This reduces your taxable income to $900, thus resulting in income tax due of $90 ($900 x 10%–because remember, you’re in the 10% bracket). So in effect, you’ve spent $100 on your laptop, and it has saved you $10 in income tax ($100 originally owed less the new amount owed of $90). Cash outflow $100, cash saved $10.
Now, let’s say it wasn’t $100 you spent on a laptop, but instead it was $100 spent on child care expenses. It so happens that child care expenses are taken as a “credit” rather than a “deduction”. Therefore, in this scenario, you have incurred $100 in income tax (again, this is the $1,000 x 10%). Credits reduce income tax so $100 in child care expenses is subtracted from income tax of $100 resulting in $0 tax due ($100 income tax less $100 credit). Cash outflow $100, cash saved $100.
Obviously it’s better to save $100 rather than $10, but we don’t always have control over this. These examples are merely to explain the large difference between two words (deduction and credit) as they are most often used in tax terms. Does this mean you shouldn’t buy a laptop? Not necessarily. If you’re a small business, then it’s highly likely you need a computer of some sort. What it DOES mean is that rarely will a small business’ tax savings on a purchase justify the purchase itself (i.e., don’t spend money on a toy if you don’t need to since it may not be yielding the benefit you think it will–it’s better to have $100 cash in your pocket rather have saved $10 in tax).
If you’re unsure of the effect of a purchase on your income taxes (if any effect at all), please feel free to contact me at dmiller@edanielmillercpa.com.
E. Daniel Miller, CPA, PC
Photo Stuart Miles / FreeDigitalPhotos.net