Confused between the terms tax exemption, tax deduction and tax rebate? Let’s simplify

Taxpayers are always looking for ways to reduce their taxable income. And knowing the difference between tax rebates, tax exemptions and tax deductions can be a powerful tool. That said, these terms are often mistakenly used interchangeably by people. 

Without further ado, let’s break these terms down:  

Tax deductions

Federal tax law allows taxpayers to deduct a number of different personal expenses from their taxable income each year. However, according to the U.S. Internal Revenue Code, there are specific types of things that can be expensed and offer tax savings.

Standard deductions:

All taxpayers who do not itemize deductible expenses are eligible to claim the standard deduction, as per the IRS. The federal government sets the standard deduction amount every year for each filing status. For example, in 2020, it sanctioned a standard deduction of $12,400 for single taxpayers, $18,650 for those filing as head of household and $24,800 for married couples filing a joint tax return. For instance, for a single taxpayer earning $90,000 during the year, the income would come to $77,600 after the standard deduction. Note that this amount is subject to further reduction by claiming other allowable deductions.

For the year 2020, by availing the standard deduction, one can deduct up to $300 per tax return of qualified cash contributions. And for 2021, this amount is up to $600 per tax return for married couples filing joint returns and $300 for other filing statuses.

Above the line deductions:

Before arriving at the final taxable income amount, one needs to calculate the adjusted gross income for personal income tax returns. In order to arrive at AGI, the deductions are typically less restrictive than below the line deductions (explained next) since their limitations have no effect on the AGI.

For instance, the student loan interest deduction allows one to deduct the interest paid on qualified student loans provided the deduction-specific requirements are met. Similarly, the qualified self-employed health insurance payments are fully deductible irrespective of the AGI.

Below the line deductions:

Deductions taken below the line reduce the AGI. Several of these deductions have different limitations that directly correlate with the amount of AGI one reports. Most of these deductions are related to the expenses an individual itemizes on the Schedule A attachment to their personal income tax return. Medical and dental expenses as well as charitable contributions are some common itemized deductions. Note: The deductible medical expenses only include the portion that exceeds 7.5% of the AGI for the year 2020.

Taxpayers who choose to itemize deductions cannot claim the standard deduction either.

Small business deductions:

 A sole proprietor running a small business must incorporate business earnings into their personal tax return by preparing a Schedule C, which is a separate calculation of the total net profit or loss that requires them to report all business-related incomes and deductions.

A small business owner can avail any business deduction that is available to all other types of businesses on the Schedule C. Examples of such deductions are staff salaries, office rent, advertising and marketing expenses, and other reasonable expenses that solely relate to the company.

Tax exemptions

Most taxpayers are entitled to some type of tax exemption on their tax returns that reduce their tax outgo. State and federal governments often exempt companies from paying income tax entirely when they serve the public, such as with religious organizations or charities.

Personal exemptions:

Before 2018, if an individual is not claimed as a dependent on another taxpayer’s return, then they can claim one personal tax exemption. This is a fixed amount that usually goes up every year. The exemption lowers their taxable income, but with fewer restrictions than a deduction. 

For married couples filing a joint return, both spouses each get an exemption.

Dependent exemptions:

Before 2018, the IRS allowed individuals to take additional exemptions for each dependent they claimed. The source of these exemptions are usually children who live with them for more than six months, are under the age of 19 (or under 24 if a full-time student) and who do not contribute more than half of their own financial support during the tax year. Other dependents may be relatives who live with the taxpayers or parents even if they don’t.

Tax-exempt businesses:

For a company to receive tax-exempt status, it must satisfy all IRS requirements. Usually, these are nonprofit organizations that provide valuable services to the community.

Once a firm receives tax-exempt status, it does not have to pay federal income tax, but it must maintain up-to-date and accurate records to keep its status. Donations made to these organizations may entitle individuals to claim a charitable contribution deduction if itemized.

State and local exemptions:

State, county and municipal governments also offer tax exemptions to companies in order to stimulate the local economy. For instance, an organization may be exempt from paying local property taxes if it moves its operations to a particular geographic area. Or, cities and states may offer sales tax holidays where customers are able to purchase goods without paying state or local sales taxes.

Tax rebates

Federal, state and local authorities often issue tax rebates to encourage taxpayers to stimulate a flagging economy quickly or to make certain types of purchases by getting cash into users’ hands. The eligibility requirements for tax rebates vary widely, but broadly, taxpayers do not have to wait until they file next year’s tax return to receive payment. In many cases, the tax rebate check is not directly related to deductions and credits one claims on a return.

Tax rebate measures are usually more immediate than tax refunds because governments can enact them at any time during the year. One example is the Recovery Rebate Credit of 2008, which the federal government passed to help jump-start the U.S. economy in the middle of a severe economic slowdown. The government anticipated that this would encourage taxpayers to immediately spend their checks, thereby stimulating the economy.

The 2001 federal tax rebate:

 Congress sought to stimulate consumer spending by issuing a midyear tax rebate when the economy was reeling from the collapse of the dot-com bubble in the year 2001. Even then the government hoped that issuing checks would have an immediate positive effect on the economy, instead of reducing tax rates (which happened the following year). The tax rebate helped counteract the recession by increasing aggregate consumption by 2.9% in the third quarter of 2001 and 2% in the fourth quarter, as per the National Bureau of Economic Research.

Alternative energy tax rebates:

Some state and local governments also provide incentives in the form of rebates for the purchase of alternative energy systems such as solar. A large part of the funding for such programs comes from the federal government, although the refunds are administered by individual states and municipalities. 

Hybrid car tax rebates:

Protecting and preserving the environment is a major concern in many areas. In order to encourage the purchase of hybrid cars that reduce gasoline consumption, some state and local governments also offer a number of rebates.