Part I · Compliance — How the System Operates · pp. 49–62

Chapter 4: Credits — Direct Offsets to Tax

Credits reduce tax liability dollar-for-dollar, and understanding which credits apply, whether they are refundable, and the rules that govern their interaction is essential to both maximizing benefits and managing compliance risk.

Overview

This chapter explains how tax credits work as direct reductions of tax liability, distinct from deductions, which only reduce taxable income. Because a credit's value is fixed regardless of a taxpayer's marginal rate, credits are Congress's preferred tool for delivering targeted relief to lower- and middle-income taxpayers. The chapter covers the major individual credits—including the Child Tax Credit, Child and Dependent Care Credit, education credits, Earned Income Tax Credit, Saver's Credit, energy credits, and Foreign Tax Credit—as well as business credits and the rules governing how multiple credits combine.

Credits are classified as nonrefundable, refundable, or partially refundable, and that classification determines whether a taxpayer can receive money back beyond wiping out their tax liability. Refundable credits function as cash transfers and carry heightened compliance scrutiny, including due diligence requirements for paid preparers and elevated audit risk. The chapter also addresses the OBBBA changes that made the Child Tax Credit permanent at $2,200 per child and terminated the individual energy credits on accelerated 2025 deadlines.

In this chapter

• 4.1 The Fundamental Distinction Between Deductions and Credits — Credits reduce tax dollar-for-dollar; deductions only reduce taxable income at the taxpayer's marginal rate.
• 4.2 Refundable vs. Nonrefundable Credits — Nonrefundable credits can only reduce tax to zero; refundable credits can generate a refund beyond zero liability.
• 4.3 The Child Tax Credit (Section 24) — A $2,200 per-child credit under OBBBA, partially refundable through the Additional Child Tax Credit, phasing out at higher income levels.
• 4.3.1 Credit Amount — $2,200 per qualifying child under age 17, indexed for inflation.
• 4.3.2 Refundable Portion — Additional Child Tax Credit — Up to $1,700 per child refundable, computed as 15 percent of earned income above $2,500.
• 4.3.3 Phase-Out — Credit begins reducing at $200,000 AGI (single) and $400,000 (married filing jointly).
• 4.3.4 Qualifying Child — Must meet age, relationship, residency, support, citizenship, and Social Security number requirements.
• 4.3.5 Worked Example — CTC and ACTC — Illustrates how the nonrefundable and refundable portions interact at different income levels.
• 4.4 Child and Dependent Care Credit (Section 21) — A nonrefundable credit for care expenses that enable the taxpayer to work, with rates from 20 to 35 percent based on AGI.
• 4.4.1 Qualifying Individuals — Includes dependents under 13 and incapable-of-self-care persons living with the taxpayer.
• 4.4.2 Expenses and Credit Rate — Expenses capped at $3,000 (one individual) or $6,000 (two or more); rate ranges from 20 to 35 percent; OBBBA enhances the credit beginning in 2026.
• 4.4.3 Worked Example — CDCC — Demonstrates the credit calculation for a couple with daycare expenses.
• 4.5 Education Credits — Two credits for higher education expenses: the AOTC and the LLC.
• 4.5.1 American Opportunity Tax Credit (Section 25A) — Partially refundable credit of up to $2,500 per student for the first four years of post-secondary education.
• 4.5.2 Lifetime Learning Credit (Section 25A) — Nonrefundable credit of up to $2,000 per return, available for any level of post-secondary education.
• 4.5.3 Choosing Between AOTC and LLC — Taxpayers cannot claim both for the same student; the AOTC is generally better for eligible students.
• 4.5.4 Worked Example — Education Credits — Illustrates the AOTC calculation for a family below the phase-out range.
• 4.6 Earned Income Tax Credit (Section 32) — Fully refundable, means-tested credit that is the largest cash transfer program administered through the tax code.
• 4.6.1 Structure — Credit phases in, plateaus, then phases out based on earned income, filing status, and number of qualifying children.
• 4.6.2 2025 Credit Amounts — Maximum credits range from $649 (no children) to $8,046 (three or more children).
• 4.6.3 Qualifying Children — Age, relationship, residency, and support requirements differ from other credits' definitions.
• 4.6.4 Compliance Considerations — EITC has high improper-claim rates and elevated audit risk; preparers face due diligence requirements.
• 4.7 Saver's Credit (Section 25B) — Nonrefundable credit of 10 to 50 percent of retirement contributions for lower-income taxpayers.
• 4.8 Energy Credits — IRA-created credits that OBBBA terminated on accelerated 2025 deadlines.
• 4.8.1 Energy Efficient Home Improvement Credit (Section 25C) — 30 percent credit for qualifying improvements, terminated after December 31, 2025.
• 4.8.2 Residential Clean Energy Credit (Section 25D) — 30 percent credit for solar, geothermal, and similar property, terminated after December 31, 2025.
• 4.8.3 Clean Vehicle Credits (Sections 30D and 25E) — Credits up to $7,500 (new) and $4,000 (used) for clean vehicles, terminated after September 30, 2025.
• 4.8.4 OBBBA Termination of the Energy Credits — Practitioner's key 2025 task is verifying acquisition and placed-in-service dates.
• 4.9 Foreign Tax Credit (Section 901) — Prevents double taxation of foreign-source income by crediting foreign income taxes against U.S. liability.
• 4.9.1 Direct vs. Indirect Credit — Credit is limited to U.S. tax attributable to foreign-source income by category.
• 4.9.2 Election to Deduct — Taxpayers may elect to deduct foreign taxes instead of claiming the credit, year by year.
• 4.9.3 Carryovers — Excess credits can be carried back one year and forward ten years.
• 4.10 How Credits Combine — The Strip Mall Phenomenon — Refundable credits can produce refunds exceeding total tax liability, which explains the concentration of tax-preparation businesses in lower-income areas.
• 4.11 Business Credits and the General Business Credit — Numerous business credits are aggregated under Section 38, with carryforward rules and liability-based limits.
• 4.12 Credit Ordering and Compliance Considerations — Credits must be applied in the order the Code and forms prescribe; refundable credits carry heightened due diligence and audit risk.
• 4.12.1 Due Diligence Requirements — Paid preparers face per-failure penalties for certain credits and filing statuses.
• 4.12.2 Examination Risk — The IRS targets refundable credit claims with automated filters and correspondence audits.
• 4.12.3 Penalty Exposure — Errors can trigger accuracy-related, fraud, due diligence, and erroneous refund penalties.
• 4.13 Conclusion — Credit compliance requires confirming eligibility, satisfying due diligence, applying correct ordering, and staying current with OBBBA changes.

Key terms

• Nonrefundable credit — A credit that can reduce tax liability to zero but cannot generate a refund.
• Refundable credit — A credit that can reduce tax liability below zero and produce a refund payment.
• Additional Child Tax Credit (ACTC) — The refundable portion of the Child Tax Credit, capped at $1,700 per child.
• Earned Income Tax Credit (EITC) — A fully refundable, means-tested credit for working taxpayers that phases in and out with earned income.
• General Business Credit (Section 38) — A framework that aggregates multiple business credits, limits them by tax liability, and provides carryforward rules.
• Due diligence requirements — Obligations on paid preparers to verify eligibility and complete Form 8867 for certain refundable credits and filing statuses.
• Limitation by category — The rule that the Foreign Tax Credit cannot exceed U.S. tax attributable to foreign-source income in each separate category.
• Strip mall phenomenon — The tendency for refundable credits to produce refunds exceeding total tax liability, driving tax-preparation businesses in lower-income neighborhoods.

Who needs this chapter

Taxpayers and practitioners who need to understand, calculate, or claim any federal tax credit—including families, students, workers, investors in energy property, and businesses claiming research, hiring, or energy credits.