How valuable is the Work Opportunity Credit to a small business? It be quite valuable, though the calculation is not as straightforward as it seems.

What is the Work Opportunity Credit?

The WOTC is a tax credit that is intended to serve as an incentive for employers to hire workers from certain backgrounds. For example, the WOTC can be taken for hiring veterans, or for hiring ex-convicts.

I’m going to give a modified real-life example of a WOTC case I’ve dealt with involving the hiring of an ex-convict.

The WOTC for hiring an ex-convict is 40% of the first \$6,000 of wages paid (so \$2,400 maximum credit).

This is how it’s advertised — a \$2,400 tax credit. But that’s a little misleading. The tax savings are large, but not quite \$2,400. And the calculation to get to the ending tax liability involves some adjustments.

Setup

John is a sole proprietor. His proprietorship brings in \$100,000 of revenue during the year. His expenses were:

• \$20,000 paid to an employee who qualifies for the WOTC. Assume that the employee was hired during the year, and otherwise meets all the qualifications for the “40% of the first \$6,000 in wages” WOTC.

• Other business expenses were \$40,000.

• John’s itemized deductions total \$15,000.

• John is single and has no dependents

Tax Liability if No WOTC

For the sake of comparison, let’s calculate John’s tax liability if he doesn’t take the WOTC.

(For the entirety of this example, we’ll be using 2013 information. Meaning, self-employment tax rate of 15.3%, and 2013 tax brackets and exemption amounts.)

1. Business net income: \$100,000 revenue – \$20,000 paid to employee – \$40,000 of other expenses = \$40,000 net income.

2. Self-employment tax: \$40,000 net income x .9235 = \$36,940 SE tax base. \$36,940 x .153 = \$5,652 SE tax.

3. Self-employment tax deduction: 1/2 of \$5,652, which equals \$2,826.

4. Adjusted Gross Income: \$40,000 net income minus \$2,826 SE tax deduction = \$37,174.

5. Taxable income is \$37,174 – \$15,000 itemized deductions – \$3,900 personal exemption = \$18,274.

6. Income tax on \$18,274 = \$2,295.

7. Total tax liability: \$2,295 income tax + \$5,652 SE tax = \$7,947.

With WOTC

Now let’s look at what the WOTC does to the calculation.

We know that the WOTC is supposed to be 40% of the first \$6,000 of wages paid to a qualifying employee, or up to \$2,400. And John’s employee qualifies John for the full \$2,400 credit. But John’s tax liability doesn’t actually decrease by \$2,400.

Why?

Because John must reduce his deduction for wages paid by the amount of WOTC claimed. So here’s how the calculation looks:

1. Adjusted deduction for wages paid: \$20,000 paid to employee – \$2,400 WOTC credit claimed = \$17,600.

2. Business net income: \$100,000 – \$17,600 paid to employee – \$40,000 other expenses = \$42,400.

3. SE tax: \$42,400 x .9235 = \$39,156 x .153 = \$5,991 SE tax.

4. SE tax deduction: \$5,992 x .5 = \$2,996.

5. AGI: \$42,400 – \$2,996 = \$39,404.

6. Taxable income: \$39,404 – \$15,000 itemized deductions – \$3,900 exemption = \$20,504.

7. Tax on \$20,504 = \$2,629

8. Total tax liability: \$2,629 taxable income – \$2,400 WOTC + \$5,991 SE tax = \$6,220.

9. Net difference: \$7,947 tax liability without WOTC – \$6,220 tax liability with WOTC = \$1,727.

So in the end, John claims a \$2,400 WOTC credit and actually saves \$1,727 on his taxes.

Image courtesy of MR LIGHTMAN / FreeDigitalPhotos.net