Tax Credit: What It Means for Employers

What it means in practice

Payroll teams meet tax credits from two directions. Several employer credits are tied to wages, tips, leave or health premiums the business pays, and the credits an employee expects to claim can lower the income tax withheld from each paycheck. This entry maps those credits; it does not decide whether anyone qualifies.

Credit versus deduction. The IRS puts the difference in one line each: a credit "is an amount you subtract from the tax you owe," while a deduction "is an amount you subtract from your income when you file so you don't pay tax on it." A deduction lowers tax only indirectly, by lowering the income the tax rate applies to. A credit lowers the tax itself. That is why a $1,000 credit is generally worth more than a $1,000 deduction.

Refundable and nonrefundable credits. The IRS says some credits "are refundable - they can give you money back even if you don't owe any tax," and names the earned income tax credit as one (see earned income credit). A nonrefundable credit, in the IRS's description of one such credit, "can reduce a taxpayer's federal tax bill but will not result in a refund if the credit is larger than what the taxpayer owes." Many business credits fall in between: they are general business credits that, according to the IRS WOTC page, taxable employers can generally carry back one year and then forward 20 years if they cannot use them all in the current year.

Income tax credits versus payroll tax credits. Most employer credits are claimed with the business income tax return through Form 3800, General Business Credit. A few offset employer payroll taxes instead, such as the research payroll tax credit claimed on Form 941.

1. Work Opportunity Tax Credit (Form 5884). The WOTC is a general business credit under section 51 for wages paid to members of 10 targeted groups, such as qualified veterans and SNAP recipients, once a state workforce agency (SWA) certifies the worker. The IRS says the credit is generally 40% of up to $6,000 of first-year wages for an employee who works at least 400 hours, so the maximum is generally $2,400; a 25% rate applies at 120 to 399 hours, and wages for an employee who works under 120 hours count as zero. Higher wage caps apply to some groups: up to $24,000 for certain qualified veterans, $10,000 per year in each of two years for long-term family assistance recipients, and $3,000 for summer youth employees (Instructions for Form 5884). Rehired employees, dependents and related individuals do not qualify. Taxable employers claim it on Form 5884 and Form 3800 and must reduce their wage deduction by the credit.

WOTC status and the Form 8850 window. Under the IRS rules, the employer and applicant complete Form 8850 on or before the day a job offer is made, and the employer submits it to the SWA no later than 28 days after the employee starts work. That process now applies only to past hires. The IRS says the WOTC is available for individuals who "begin work on or before December 31, 2025," and its March 2026 notice states: "Form 8850 is no longer in use. The work opportunity credit does not apply to employees who begin work for the employer after December 31, 2025." The Department of Labor's WOTC page likewise says WOTC "is authorized until December 31, 2025." The Form 5884 instructions note that when the credit has expired and is later extended retroactively, the IRS may allow more time to submit Form 8850.

2. Employer credit for paid family and medical leave (section 45S, Form 8994). Originally limited to tax years beginning before 2026, the credit was made permanent and expanded by the Working Families Tax Cuts, the IRS announced in August 2026 (IR-2026-86, Notice 2026-28). It now covers employees with six months of service and part-time employees customarily working 20 hours or more a week, and from 2026 it can be based on paid leave insurance premiums as well as leave wages. It ranges from 12.5% to 25% of leave wages for up to 12 weeks per tax year; the IRS FAQ says the 12.5% rises by 0.25% for each percentage point that leave pay exceeds 50% of normal wages, and the written policy must give at least two weeks at no less than 50%. The FAQ and Form 8994 instructions (12/2024) predate the new law. Leave rules themselves are covered under FMLA.

3. FICA tip credit (section 45B, Form 8846). Food and beverage employers where tipping is customary can claim a credit for the employer Social Security and Medicare tax paid on employees' tips. The 2025 Form 8846 says that for tax years beginning after 2024 the credit extends to certain beauty services, such as hair and nail care. Tips used to bring an employee up to a minimum wage do not count: $5.15 an hour (the rate in effect on January 1, 2007) for food and beverage employers and $7.25 an hour for beauty service employers. Creditable tips are multiplied by 7.65%, with an adjustment for tips above the Social Security wage base, and the employer reduces its deduction for employer Social Security and Medicare taxes by the credit.

4. Small business health care tax credit (section 45R, Form 8941). For tax year 2025, the Form 8941 instructions require fewer than 25 full-time equivalent employees, average annual wages of less than $67,000 per FTE, and premiums paid under a qualifying arrangement, generally a uniform percentage of not less than 50% of the premium. The maximum credit is 50% of premiums paid (35% for tax-exempt employers, claimed as a refundable credit on Form 990-T). The IRS says the plan generally must be offered through a SHOP Marketplace and the credit is available for only two consecutive tax years.

5. Qualified small business payroll tax credit for research (Form 8974). The IRS says this election "is designed to benefit an eligible startup that has little or no income tax liability." A qualified small business elects on Form 6765 with a timely filed (not amended) income tax return to apply up to $500,000 of its research credit against payroll tax, starting in the first calendar quarter after that return is filed. The credit reduces the employer share of Social Security tax, up to $250,000 per quarter, then the employer share of Medicare tax, and any balance carries forward. The Form 941 instructions (03/2026) put it on line 11 with Form 8974 attached; see Form 941.

6. The expired Employee Retention Credit. The IRS describes the ERC as a refundable tax credit for eligible employers that paid qualified wages "after March 12, 2020, and before Jan. 1, 2022." No new wages qualify. The IRS is closely reviewing claims and offers a withdrawal program for ineligible ones. See Employee Retention Tax Credit (ERTC).

Employee credits and withholding. Employees claim personal credits on their own returns, but Step 3 of the 2026 Form W-4 lets an employee whose income will be $200,000 or less ($400,000 if married filing jointly) enter $2,200 for each qualifying child under 17 and $500 for each other dependent, plus an estimate of other credits. Publication 15-T (2026) tells employers to use the Step 3 total "as an annual reduction in the amount of withholding," dividing it by the number of pay periods in the percentage method worksheet. Step 3 affects federal income tax withholding only, not Social Security or Medicare tax.

The earned income credit notice. Publication 15 (2026) requires employers to notify employees who had no federal income tax withheld that they may be able to claim a refund because of the EIC. The employer can do this through the statement on the back of Form W-2 Copy B, Notice 797, or its own statement with the same wording.

How it works for an employer, step by step. (1) Keep the paperwork each credit requires, such as SWA certifications for past WOTC hires and a written leave policy for 45S. (2) Track the wages, tips or premiums each credit is figured on, without counting the same wages twice. (3) Claim income tax credits on the specific form and Form 3800, reducing the related deduction where the instructions say so. (4) Claim the research payroll tax credit on Form 941 with Form 8974. (5) Apply each employee's Form W-4 Step 3 amount in every payroll.

Example 1: credit versus deduction (illustration). A business owes $10,000 of tax before credits. A $1,000 credit cuts the bill to $9,000. A $1,000 deduction at a hypothetical 20% tax rate reduces taxable income by $1,000 and the tax by only $200, to $9,800.

Example 2: WOTC for a 2025 hire (illustration). A certified employee in a $6,000 wage group began work on November 3, 2025, and earns $9,000 over more than 400 hours in the first year. The credit is 40% x $6,000 = $2,400, and the wage deduction drops by $2,400. At 300 hours it would be 25% x $6,000 = $1,500. A January 2026 start would produce no credit under current IRS guidance.

Example 3: FICA tip credit, using the IRS figures (illustration). The 2025 Form 8846 example describes a food and beverage employee with $450 of October tips and $375 of wages for 100 hours ($3.75 an hour). At $5.15 an hour the wages would have been $515, so $140 of tips are not creditable and $310 are. At 7.65%, the credit for that month is about $23.72.

Example 4: 45S and Form W-4 (illustration). An employee normally paid $1,000 a week takes four weeks of qualifying leave paid at 100%, or $4,000. Pay is 50 percentage points above 50%, so the rate is 12.5% + (50 x 0.25%) = 25%, a $1,000 credit, subject to any additional limit. Separately, an employee paid biweekly enters $4,400 in Step 3 for two qualifying children; the employer reduces withholding by $4,400 / 26 = $169.23 per payroll.

Where states differ: two examples. Examples only. State workforce agencies handle WOTC certification, and their 2026 notices differ in detail. California: the Employment Development Department says federal authorization "expired on December 31, 2025," and that applications with start dates of January 1, 2026 and later "will be accepted and retained pending federal reauthorization." Wisconsin: the Department of Workforce Development says it will fully process timely requests for start dates on or before December 31, 2025, and that applications for people who begin work on or after January 1, 2026 "will reflect a pending status subject to program reauthorization." For 45S, the IRS says employers can count leave required by state or local mandates toward eligibility "but not toward the credit calculation."

Recordkeeping. Keep credit forms, SWA certifications, leave policies and tip records with your employment tax records, which Publication 15 (2026) says to keep for at least 4 years.

Question: Can the same wages count for two credits? Generally no. The IRS says wages used for the WOTC cannot be used for other wage-based credits, though an employer may claim more than one credit for the same employee on different wages. The 45S FAQ says the same.

Question: Should we keep sending Form 8850 for 2026 hires? The IRS says the form is no longer in use because the credit does not apply to employees who start after December 31, 2025, while some SWAs, such as California and Wisconsin, say they are holding 2026 applications pending reauthorization. Check your SWA and IRS.gov/Form8850 for current instructions.

Question: Does a credit an employee claims on Form W-4 cost the employer anything? No. Step 3 only lowers the income tax withheld from the employee. The employer's own Social Security and Medicare taxes are figured on wages and do not change.

This entry summarizes federal rules and two state examples as of November 2026; confirm current status on the IRS pages linked below.

Why it matters and common mistakes

How Remindax helps

Related terms

See all terms in Payroll Tax & Withholding or browse the full HR Glossary.