What Is the Work Opportunity Tax Credit?
The work opportunity tax credit offers a tax credit to employers who hire employees from certain target groups that have historically faced barriers to employment, including ex-felons, veterans, and people on long-term unemployment. The credit is based on qualified wages paid to these employees during their first year of employment. To claim the work opportunity tax credit, you will complete Form 5884 and include it with Form 3800 when you file your business taxes.
Hiring employees is an expensive undertaking for any business. But if you hire certain employees, the government wants to make it less expensive for you by offering a work opportunity tax credit (WOTC) to lower your overall business tax bill.
This valuable tax credit can help small business owners reduce how much they owe in taxes by a percentage of the wages that they pay to an employee of an eligible targeted group. How can you claim this credit and lower your tax bill? This guide will walk you through the work opportunity tax credit details you need to know.
What Is the Work Opportunity Tax Credit?
The federal government wants to help incentivize businesses to hire employees from certain target groups that have historically faced barriers to employment, including ex-felons, veterans, and people on long-term unemployment. The way they do that is through the work opportunity tax credit.
The work opportunity tax credit offers a tax credit to employers for qualified wages paid to these employees during their first year of employment. For long-term temporary assistance for needy families (TANF) recipients, the credit is extended to their second year of employment as well.
How Much Is the Work Opportunity Tax Credit?
The work opportunity tax credit can be a sizeable credit, but varies, depending on these factors:
- What target group the employees are a part of
- How much they are paid during their first year of employment
- How many hours they work during their first year of employment
Depending on what targeted group an employee is a part of, the work opportunity tax credit will be subject to different qualified wage maximums (which are covered in more detail below). For example, an ex-felon can have $6,000 of allowable wages included in the credit calculation. A long-term TANF recipient can have $10,000 of allowable wages included in the credit calculation.
The credit you can claim will be either 25% or 40% of the qualified wages. If an employee works at least 400 hours during their first year of employment, you can claim 40% of allowable qualified wages. If they work between 120 hours and 400 hours, you can claim 25% of the allowable wages. If they work fewer than 120 hours, though, and you won’t be able to take the credit.
For example, if you hire an ex-felon for more than 400 hours per year and paid them at least $6,000 in qualified wages, your credit will be $2,400 ($6,000 x 40%). For a long-term TANF recipient who works more than 400 hours per year and is paid at least $10,000 in qualifying wages, the maximum credit is $4,000.
How Do You Claim the Work Opportunity Tax Credit?
While the work opportunity tax credit is valuable, there are a number of forms to file and steps to go through before you can get the benefit of the tax credit.
Step 1: Determine Whether an Employee Is Qualified
The first step in qualifying for the work opportunity tax credit is to determine whether an employee falls into one of the target groups. These groups are:
- IV-A Recipient under the Temporary Assistance for Needy Families (TANF) program: A member of a family receiving assistance under a title IV-A program
- Qualified Veteran: Someone who served in the U.S. Armed Forces for at least 180 days and meets additional criteria
- Ex-Felon: Someone who has been released from prison or convicted within the last year
- Designated Community Resident: Someone aged 18 to 39 living within an empowerment zone, an enterprise community, or a renewal zone
- Vocational Rehabilitation Referral: A person with physical or mental disabilities
- Summer Youth Employee: Someone age 16 or 17 living within an empowerment zone, an enterprise community, or a renewal zone
- Supplemental Assistance Nutrition Program (SNAP) Recipient: A member of a family receiving SNAP benefits who is between 18 and 39 years old
- Supplemental Security Income Recipient: Someone receiving supplemental social security income under title XVI of the Social Security Act
- Long-Term Family Assistance Recipient: A member of a family that receives TANF benefits or has exhausted all of their TANF benefits
- Qualified Long-Term Unemployment Recipient: Someone who has been unemployed for at least 27 weeks and has received unemployment benefits
You can find a more detailed description for each of these target groups in the IRS instructions for Form 8550.
Step 2: Pre-Qualification
If you plan on hiring an employee from a targeted group, the next step is to get a certification from the state workforce agency (SWA) in your state. This certification will be your proof that you’ve hired an employee that qualifies you for the tax credit. You’ll need this certification before you can claim the credit.
There are a few steps you’ll need to take in order to certify that they are a qualified employee:
- Ask the job applicant to fill out Form 8850 on the day of or before a job offer is made
- Complete the remainder of the form by the date that the job offer is made
- Complete the conditional certification Form 9061 (or ask them for Form 9062 if they’ve already applied for it)
Once you have both forms completed, you’ll need to submit them to the SWA within 28 calendar days of the start of their employment. It’s important to note that you don’t send these forms to the IRS—certification comes from the SWA.
After you submit these forms, you’ll receive a letter from your SWA approving or denying the employee’s eligibility.
Step 3: Calculate Qualified Wages
Once you know your employee qualifies, it’s time to calculate just how much of their wages can count toward the tax credit. These are your qualified wages.
Qualified wages are wages on which you’ve paid FUTA tax in the employee’s first year of work (and for long-term TANF recipients, in their second year of work as well). However, these wages don’t include wages you paid while you also received payment from a federal on-the-job training program for the employee. You’ll also need to reduce the wages you paid by any Social Security Act payments you received for the employee.
Once you know the qualified wages, you’ll need to determine the limit for the maximum allowable wages for the employee that you can use in the calculation. Most employees have a maximum allowable qualified wage limit of $6,000, but there are some exceptions. For example, depending on the category of veteran, the maximum allowable wages can go up to $24,000. Summer youth employees have a maximum allowable wage of $3,000.
You can find the various limits for the current year included in the IRS instructions for Form 5884.
Step 4: Claiming the Work Opportunity Tax Credit
To claim the work opportunity tax credit, most employers will use Form 5884 to calculate their allowable credit. However, if your business is a tax-exempt organization that hired a qualified veteran, you should use Form 5884-C to calculate the tax credit.
You’ll use the maximum wage from Step 3 in the calculation and include it on Form 5884, Line 1 A for employees who worked between 120 and 400 hours in their first year or Line 2 for employees who worked more than 400 hours in their first year.
Once you have the total credit calculated on Form 5884, you’ll include it on Form 3800, General Business Credit. These forms get submitted with your business tax returns.
Work Opportunity Tax Credit Limitation
The work opportunity tax credit isn’t refundable, meaning it’s limited by the total tax liability that you have. However, you can carry it forward or backward using the normal rules.
The Bottom Line
The work opportunity tax credit is a valuable credit that you can receive from hiring certain employees. Plus, you get the added benefit of knowing that you’re hiring someone from a group that often has a more challenging time finding employment.
But there are a number of steps you need to get right during and just after the hiring process to ensure you qualify. Make sure you understand the forms and deadlines before you begin the hiring process. And if you have any doubts about the forms required or whether you’re calculating your credit correctly, working with a small business tax advisor can help ensure you’re getting all of the tax benefits available to you.