15 Tax Deductions and Benefits for the Self-Employed - Investopedia

Summary

Over the years, legislators have written numerous lines into the tax code to soften the blow of the extra costs that self-employed taxpayers must shoulder as they do business. The Tax Cuts and Jobs Act (TCJA), effective as of the 2018 tax year, made several changes to self-employed tax deductions. Many of these changes are temporary and set to expire in 2025, but others are permanent.

The law affects small businesses in many ways, particularly via a qualified business income (QBI) deduction for pass-through businesses—those that pay taxes as an individual taxpayer(s) rather than through a corporation.

For owners of sole proprietorships, partnerships, S corporations, and certain trusts, estates, and limited liability companies (LLCs), this deduction provides a great benefit. Eligible taxpayers can deduct up to 20% of their QBI. A pass-through’s QBI is the net amount of qualified items of income, gain, deduction, and loss from a qualified trade or business.

Over the years, legislators have written numerous lines into the tax code to soften the blow of the extra costs that self-employed taxpayers must shoulder as they do business. The Tax Cuts and Jobs Act (TCJA), effective as of the 2018 tax year, made several changes to self-employed tax deductions. Many of these changes are temporary and set to expire in 2025, but others are permanent.

The law affects small businesses in many ways, particularly via a qualified business income (QBI) deduction for pass-through businesses—those that pay taxes as an individual taxpayer(s) rather than through a corporation.

For owners of sole proprietorships, partnerships, S corporations, and certain trusts, estates, and limited liability companies (LLCs), this deduction provides a great benefit. Eligible taxpayers can deduct up to 20% of their QBI. A pass-through’s QBI is the net amount of qualified items of income, gain, deduction, and loss from a qualified trade or business.

Key Takeaways The Tax Cuts and Jobs Act (TCJA), which went into effect in 2018, included a number of changes to tax deductions for the self-employed.

If you’re self-employed, it’s important to review what you are allowed to deduct each year to make your business as profitable as possible.

There are two ways of calculating a deduction for a home office and a vehicle used for business purposes. It pays to do calculations for both methods to see which is more financially beneficial.

Meals with clients and business travel are deductible, but meals that are included with entertainment may not be, according to the TCJA.

Premiums for insurance that you buy to protect your business and for health insurance are legitimate deductions. And don’t forget startup, advertising, and retirement plan costs.

Eliminated or Changed Deductions

Some deductions that have been eliminated or changed post-TCJA include:

Entertainment and fringe benefit deduction

Employees’ parking, mass transit, or commuting expenses deduction

Domestic production activities deduction

Local lobbying expenses deduction

State and local tax (SALT) deduction is now limited to $10,000 ($5,000 in the case of married filing separately)

Deduction of settlement or legal fees in a sexual harassment case, when the settlement is subject to a nondisclosure

Key provisions that are set to expire in 2025 include:

QBI deduction

SALT deduction cap

Standard deduction will return to pre-TCJA levels

Income tax rates will return to pre-TCJA levels

It is important to note that tax laws are constantly changing, and these provisions may be modified or extended at any point prior to 2025. A review of the most common self-employed taxes and deductions is necessary to keep you up to date on any necessary changes to your quarterly estimated tax payments.

1:52 WATCH: 8 Tax Benefits For The Self-Employed

1. Self-Employment Tax Deduction

The self-employment tax refers to the Medicare and Social Security taxes that self-employed people must pay. This includes freelancers, independent contractors, and small-business owners. The self-employment tax rate is 15.3%: 12.4% for Social Security and 2.9% for Medicare.

Employers and employees share the self-employment tax. Each pays 7.65%. People who are fully self-employed pay both parts themselves. An additional 0.9% Medicare tax rate applies if income is above a certain threshold amount. The threshold figures are as follows:

Married filing jointly: $250,000

Married filing separate: $125,000

Single: $200,000

Head of household: (with qualifying person): $200,000

Qualifying widow(er) with dependent child: $200,000

The income thresholds for additional Medicare tax apply not only to self-employment income but also to your combined wages, compensation, and self-employment income. So, if you have $100,000 in self-employment income and your spouse has $160,000 in employee wages, you’ll have to pay the additional Medicare tax of 0.9% on the $10,000 by which your joint income exceeds the $250,000 threshold.

Paying extra taxes to be your own boss is no fun. The good news is that the self-employment tax will cost you less than you might think because you get to deduct half of your self-employment tax from your net income when calculating your income tax. The Internal Revenue Service (IRS) treats the employer portion of the self-employment tax as a business expense and allows you to deduct it accordingly.

Social Security and Medicare Taxes

It is important to note that the self-employment tax refers to Social Security and Medicare taxes, similar to Federal Insurance Contributions Act (FICA) tax paid by an employer. When a taxpayer takes a deduction of one-half of the self-employment tax, it is only a deduction for the calculation of that taxpayer’s income tax. It does not reduce the net earnings from self-employment or reduce the self-employment tax itself.

Remember, you’re paying the first 7.65% whether you are self-employed or work for someone else. And when you work for someone else, you’re indirectly paying the employer portion because that’s money that your employer can’t afford to add to your salary.

Self-employed individuals determine their net income from self-employment and deductions based on their method of accounting. Most self-employed individuals use the cash method of accounting and will therefore include all income actually or constructively received during the period and all deductions actually paid during the period when determining their net income from self-employment.

2. Home Office Deduction

The home office deduction is one of the more complex deductions. In short, the cost of any workspace that you use regularly and exclusively for your business, whether you rent or own it, can be deducted as a home office expense.

You are basically on the honor system, but you should be prepared to defend your deduction in the event of an IRS audit. One way to do this is to prepare a diagram of your workspace, with accurate measurements, if you are required to submit this information to substantiate your deduction, which uses the square footage of your workspace in its calculation.

In addition to the office space itself, the expenses that you can deduct for your home office include the business percentage of deductible mortgage interest, home depreciation, utilities, homeowners insurance, and repairs that you pay during the year.

If your home office occupies 15% of your home, for example, then 15% of your annual electricity bill becomes tax-deductible. Some of these deductions, such as mortgage interest and home depreciation, apply only to those who own rather than rent their home office space.

How to Calculate the Home Office Deduction

You have two choices for calculating your home office deduction—the standard method or the simplified option—and you don’t have to use the same method every year. The standard method requires you to calculate your actual home office expenses and keep detailed records in the event of an audit.

The simplified option lets you multiply an IRS-determined rate by your home office square footage. To use the simplified option, your home office must not be larger than 300 square feet, and you cannot deduct depreciation or home-related itemized deductions.

The simplified option is a clear choice if you’re pressed for time or can’t pull together good records of your deductible home office expenses. However, because the simplified option is calculated as $5 per square foot, with a maximum of 300 square feet, the most that you’ll be able to deduct is $1,500.

If you want to maximize your home office deduction, you’ll want to calculate the deduction using both the regular and simplified methods to find out which one will give you the greater benefit. If you choose the regular method, calculate the deduction using IRS Form 8829, Expenses for Business Use of Your Home.

3. Internet and Phone Bills Deduction

Regardless of whether you claim the home office deduction, you can deduct the business portion of your phone, fax, and Internet expenses. The key is to deduct only the expenses directly related to your business. For example, you could deduct the Internet-related costs of running a website for your business.

If you have just one phone line, you shouldn’t deduct your entire monthly bill, including personal and business use. According to the IRS, “You can’t deduct the cost of basic local telephone service (including any taxes) for the first telephone line you have in your home, even if you have an office in your home.” However, you can deduct 100% of the additional cost of long-distance business calls or the cost of a second phone line dedicated solely to your business.

4. Health Insurance Premiums Deduction

If you are self-employed, pay for your health insurance premiums, and are not eligible to participate in a plan through your spouse’s employer, then you can deduct all of your health, dental, and qualified long-term care (LTC) insurance premiums.

You can also deduct premiums that you paid to provide coverage for your spouse, your dependents, and your children who were younger than 27 at year’s end, even if they aren’t dependents on your taxes. Calculate the deduction using the Self-Employed Health Insurance Deduction Worksheet in IRS Publication 535.

5. Meals Deduction

A meal is a tax-deductible business expense when you are traveling for business, at a business conference, or entertaining a client. The meal cannot be extravagant under the circumstances, and in the past, you could only deduct 50% of the meal’s actual cost if you keep your receipts, or 50% of the standard meal allowance if you keep records of the time, place, and business purpose of your travel but not your actual meal receipts. Unfortunately, this means that the desk lunch is not tax deductible.

However, the deduction has been amended, according to the Consolidated Appropriations Act (CAA), 2021, H.R. 133, Temporary allowance of a full deduction for business meals. The bill temporarily allows a 100% business expense deduction for meals (rather than the current 50%) as long as the expense is for food or beverages provided by a restaurant. This provision is effective for costs incurred after Dec. 31, 2020, and expires at the end of 2022.

The standard meal allowance is the federal Meals & Incidental Expenses (M&IE) rate, updated every fiscal year, effective Oct. 1. The current rate and M&IE breakdown can be found on the U.S. General Services Administration (GSA) website. The lunch that you eat alone at your desk is not tax-deductible.

Additionally, before the TCJA, meals, and entertainment expenses were considered together. For tax years 2018 and later, according to the IRS, “if food or beverages are provided during or at an entertainment event, and the food and beverages were purchased separately from the entertainment, or the cost of the food and beverages was stated separately from the cost of the entertainment on one or more bills, invoices, or receipts, you may be able to deduct the separately stated costs as a meal expense.”

However, if the meals are not separately identified on the receipt, then they cannot be deducted at all.

6. Travel Deduction

To qualify as a tax deduction, business travel must last longer than an ordinary workday, require you to get sleep or rest, and take place away from the general area of your tax home (usually, outside the city where your business is located). Further, to be considered a business trip, you should have a specific business purpose planned before you leave home and you must actually engage in business activity—such as finding new customers, meeting with clients, or learning new skills directly related to your business—while you are on the road.

Handing out business cards during your friend’s bachelor party in Las Vegas does not make your trip tax-deductible.

Keep complete and accurate records and receipts for your business travel expenses and activities, as this deduction often draws scrutiny from the IRS. Deductible travel expenses include the cost of transportation to and from your destination (such as plane fare), the cost of transportation at your destination (such as car rental, Uber fare, or subway tickets), lodging, and meals.

You can’t deduct lavish or extravagant expenses, but you also don’t have to choose the cheapest options available. But remember: You, not your fellow taxpayers, will still be paying the bulk of your business travel costs, so it’s in your interest to keep them reasonable. Your travel expenses for business are 100% deductible, except for meals, which are limited to 50%. If your trip combines business with pleasure, then things get a lot more complicated; in a nutshell, you can only deduct the expenses related to the business portion of your trip.

For example, if your spouse (who does not work for you as an employee) joins you on a business trip, then you can only deduct the portion of lodging and transportation costs that would have been incurred if you had traveled alone. Don’t forget that the business part of your trip needs to be planned ahead.

7. Vehicle Use Deduction

When you use your car for business, your expenses for those drives are tax-deductible. Make sure to keep excellent records of the date, mileage, and purpose for each trip, and don’t try to claim personal car trips as business car trips.

You can calculate your deduction using either the standard mileage rate determined annually by the IRS or your actual expenses. The standard mileage rates are 56 cents per mile in 2021 and 58.5 per mile in 2022. Using the standard mileage rate is easiest because it requires minimal record-keeping and calculation. Just write down the business miles that you drive and the dates when you drive them. Then, multiply your total annual business miles by the standard mileage rate. This amount is your deductible expense.

To use the actual expense method, you must calculate the percentage of driving that you did for business all year as well as the total cost of operating your car, including depreciation, gas, oil changes, registration fees, repairs, and car insurance. If you spent $3,000 on car operating expenses and used your car for business 10% of the time, then your deduction would be $300.

If you want to use the standard mileage rate on a car you own, you need to use that method in the first year when the vehicle is available for use in your business. In later years, you can choose to use either the standard mileage rate or switch to actual expenses. If you are leasing a vehicle and wish to use the standard mileage rate, you must use the standard mileage rate in each year of the lease period. As with the home office deduction, it may be worth calculating your deduction both ways so that you can claim whichever is the larger amount.

8. Interest Deduction

Interest on a business loan from a bank is a tax-deductible business expense. If a loan is used for both business and personal purposes, then the business portion of the loan’s interest expense is allocated based on the allocation of the loan’s proceeds.

You will need to track the disbursement of funds for various uses if the entire loan is not used for business-related activities. Credit card interest is not tax-deductible when you incur the interest for personal purchases, but when the interest applies to business purchases, it is tax-deductible.

That said, it’s always cheaper to spend only the money that you already have and not incur any interest expenses at all. A tax deduction only gives you back some of your money, not all of it, so try to avoid borrowing money. For some businesses, though, borrowing may be the only way to get up and running, to sustain the business through slow periods, or to ramp up for busy periods.

9. Publications and Subscriptions Deduction

The cost of specialized magazines, journals, and books directly related to your business is tax deductible as supplies and materials.

A daily newspaper, for example, would not be specific enough to be considered a business expense. A subscription to Nation’s Restaurant News would be tax deductible if you are a restaurant owner, and Nathan Myhrvold’s several-hundred-dollar Modernist Cuisine boxed set would be a legitimate book purchase for a self-employed, high-end personal chef.

10. Education Deduction

Any education expenses you want to deduct must be related to maintaining or improving your skills for your existing business. The cost of classes to prepare for a new line of work isn’t deductible.

If you’re a real estate consultant, taking a course called Real Estate Investment Analysis to brush up on your skills would be tax deductible, but a class on how to teach yoga would not be.

11. Business Insurance Deduction

Do you pay premiums for any type of insurance to protect your business, such as fire insurance, credit insurance, car insurance on a business vehicle, or business liability insurance? If so, you can deduct your premiums.

Some people don’t like paying insurance premiums because they perceive them as a waste of money if they never have to file a claim. The business insurance tax deduction can help ease that dislike.

12. Rent Deduction

If you rent out an office space, you can deduct the amount that you pay for rent. You can also deduct amounts paid for any equipment that you rent. And if you have to pay a fee to cancel a business lease, that expense is deductible, too.

But you can’t deduct rent expenses on any property that you own, even partially. Also, rent must be reasonable in amount. The need for a reasonableness test typically arises when you and the owner are related, but rent is considered valid if it is the same amount that you would pay to a stranger.

13. Startup Costs Deduction

The IRS usually requires you to deduct major expenses over time, rather than all at once, as capital expenses. However, you can deduct up to $5,000 in business startup costs in the first year of active trade or business.

Examples of tax-deductible startup costs include market research and travel-related expenses for starting your business, scoping out potential business locations, advertising, attorney fees, and accountant fees. The $5,000 deduction is reduced by the amount that your total startup cost exceeds $50,000. If you set up a corporation or LLC for your business, you can deduct up to $5,000 more in organizational costs, such as state filing fees and legal fees.

Professional fees to consultants, attorneys, accountants, and the like are also deductible at any time, even if they aren’t startup costs.

Business expenses such as buying equipment or vehicles aren’t considered startup costs, but they can be depreciated or amortized as capital expenditures.

14. Advertising Deduction

Do you pay for Facebook or Google ads, a billboard, a TV commercial, or mailed fliers? The costs that you incur to advertise your business are tax deductible.

You can even deduct the cost of an ad that encourages people to donate to charity while also putting the name of your business before the public in the hope of gaining customers. For example, a sign advertising “Holiday Toy Drive sponsored by Robert’s Hot Dogs” would be tax deductible.

15. Retirement Plan Contributions Deduction

One deduction that you can take going into business for yourself that is especially worthwhile is the deduction for self-employed retirement plan contributions. Contributions to Simplified Employee Pension-individual retirement accounts (SEP-IRAs), Savings Incentive Match Plan for Employees (SIMPLE) IRAs, and solo 401(k)s reduce your tax bill now and help you rack up tax-deferred investment gains for later.

For the 2021 tax year, for example, you could feasibly contribute as much as $19,500 in deferred salary (or $26,000, with the $6,500 catch-up contribution, if you’re 50 or older). In 2022, that amount goes up to $20,500, with the $6,500 catch-up contribution. Plus, you can contribute another 25% of your net self-employment earnings after deducting one-half of self-employment tax and contributions for yourself.

With a self-employed 401(k), the total maximum contributions cannot exceed $58,000 for 2021 and $61,000 for 2022 (not counting catch-up contributions of $6,500, if eligible) for both employee and employer contribution categories. Contribution limits vary by plan type, and the IRS adjusts the maximums annually. Of course, you can’t contribute more than you earn, and this benefit will only help you if you have enough profits to take advantage of it.

1:06 SEP Account: Jessica Perez

I Rent My Home. Do I Qualify for the Home Office Expense Deduction? Yes, you can qualify for the home office expense deduction if you meet all of the business use requirements. A renter can use the simplified method or actual expense method based on the percentage of the home that is dedicated to business use.

Is a C Corporation Eligible for the Qualified Business Income (QBI) Deduction? No. According to the Internal Revenue Service (IRS), “income earned through a C corporation or by providing services as an employee is not eligible for the deduction.” A C corporation files a Form 1120: U.S. Corporation Income Tax Return, and it is not eligible for the deduction. You also cannot deduct any portion of wages paid to you by an employer and reported on a Form W-2: Wage and Tax Statement. Independent contractors and pass-through businesses are eligible for the deduction. They report their percentage of business income on a Schedule C: Profit or Loss from Business that accompanies the Form 1040: U.S. Individual Tax Return.

Which Method is Better for My Business Vehicle: Standard Mileage or Actual Expense? It depends on the vehicle-related expenses that you have incurred during the year. If you’ve spent significant money on maintenance (oil changes, brake pad replacements, new tires, etc.), car inspections, and registration, then it may be more beneficial for you to use the actual expense method. On the other hand, if you’ve paid minimal expenses in the year or driven many miles for business, then the 56 cents per mile in 2021 may provide a larger expense deduction. It’s also simpler because you don’t need to keep detailed records of all your expenses. If you have kept all of your expense records, it is always beneficial to check your total expense deduction under both methods.

The Bottom Line

Most small business tax deductions are more complicated than this brief overview describes—it is the U.S. Tax Code, after all—but now you have a good introduction to the basics.

There are more deductions available than those listed here, but these are some of the biggest ones. Office supplies, credit card processing fees, tax preparation fees, and repairs and maintenance for business property and equipment are also deductible. Still, other business expenses can be depreciated or amortized, meaning that you can deduct a small amount of the cost each year over several years.

Remember, anytime when you’re not sure whether a cost is a legitimate business expense, ask yourself, “Is this an ordinary and necessary expense in my line of work?” This is the same question that the IRS will ask when examining your deductions if you are audited. If the answer is no, then don’t take the deduction. And if you’re not sure, seek professional help with your business tax return from a certified public accountant (CPA) or other credentialed tax preparer.

15 Tax Deductions and Benefits for the Self-Employed - Investopedia
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