Self-employed individuals report business income on their personal tax returns. Tax deductions are one of the best ways to reduce your tax bill.
When you are independent, you are the boss. Leader. The big fish. It also means you’re the one stuck with the tax bill.
10 interesting tax deductions for the self-employed:
- Ordinary and necessary business expenses
- Allowable Business Income Deduction (QBI)
- Self-employment tax
- health insurance premiums
- home office
- Travel and meals
- Use of personal vehicle
- start-up costs
1. Ordinary and Necessary Business Expenses
If there’s a phrase that tax professionals and accountants love to throw around, it’s “ordinary and necessary”. As long as you can prove a business expense to the IRS, it is deductible.
Keep a list of business expenses with receipts during the year. You will be grateful for your organization at tax time.
The most common expenses that fall into this category are rent, business insurance, advertising, employee payroll, office supplies, and cost of goods sold. See our guide to business expenses for a more comprehensive list.
There are restrictions on business tax deductions for meals, vehicles and depreciation. We explore business expenses with limitations below.
2. Allowable business income deduction
The qualifying business income deduction is a general deduction that reduces your tax bill. Owners of pass-through entities — anything but a C corporation — can get a 20% deduction on qualifying income just to exist.
Like most tax deductions, the QBI deduction comes with a host of limitations. The biggest problem is that the QBI deduction does not affect the 15.3% Self-Employment Contributions Act (SECA) tax, which includes Medicare and Social Security taxes.
The QBI deduction goes on line 10 of the individual income tax form 1040.
3. Self-employment tax
If you’re self-employed, you’re probably well aware that you pay a good portion of your earnings in self-employment taxes. You are responsible for paying the SECA, which is equal to the employer and employee shares of Federal Insurance Contributions Act (FICA) taxes.
You can deduct what would be half of the employer’s health and social security contributions. Let’s say you owe $15,000 in self-employment taxes on last year’s earnings. Your self-employment tax deduction would be $7,500 ($15,000 SECA tax x 50% deduction).
This is one of the few tax deductions above the line, reducing your adjusted gross income (AGI). AGI is the basis for many tax calculations, so you generally want your AGI to be low.
You calculate the self-employment tax deduction on Form 1040 Schedule SE.
4. Health insurance premiums
Self-employed people who cannot get subsidized health insurance through a spouse can deduct the premiums. The deduction applies to your premiums as well as those of your spouse and dependents.
Like the self-employment tax deduction, the self-employment health insurance deduction is above the line and reduces your AGI. Translation: The deduction drops the amount of income that determines your eligibility for certain deductions and credits. Take the deduction on Form 1040 Schedule 1, line 16.
The IRS rewards students for life. Costs associated with developing the skills needed in your business count as a small business tax deduction. Sole proprietors deduct tuition, supplies, and travel between a workplace and school on Form 1040 Schedule C. There is no dedicated line for this deduction, so it goes to line 27a , other expenses.
You cannot deduct the cost of courses to help you move into a new field. For example, a florist could deduct the cost of a flower arranging seminar, but not a knitting class.
6. Home office deduction
Perhaps better than having a daily commute of less than 30 seconds, you can get a deduction for running a home business.
You qualify for the home office deduction when you have a dedicated space in your home that is not used for purposes other than your business. This must also be your main place of work, so you are not eligible for a home office deduction when you work in an office four out of five days a week.
You can either deduct $5 for each square foot of your home office – up to 300 square feet – or the actual costs of your home office. Review our guide to the home office deduction before completing IRS Form 8829 to claim the deduction.
7. Travel and Meals
The IRS limits the deduction of travel and meal expenses. When preparing your business financial statements, you must report the total amount spent on travel and meals. This is not the case for your taxes.
You can only deduct 50% of your total meal expenses, including the cost of office snacks and business meals with clients.
Travel costs – hotel, plane ticket, train, etc. – are only deductible when you move away from your tax base, where your business is located. Unlike meals, you can deduct 100% of eligible travel expenses.
IRS Topic #511 points out that your tax base and domicile can be in two different areas. If your business office is located one flight away from where your family lives, your tax base is your business location, not your family’s location.
Sole proprietors report travel and meal expenses on the Self-Employed Income Tax Return, Form 1040, Schedule C.
8. Use of personal vehicle
You can deduct business use of your personal car in two ways. The simplest is to apply the IRS mileage rate — $0.575 in 2020 — to each mile driven for business purposes.
Suppose you own a construction company and use your personal car to visit customers’ homes. When you drive 14 miles to a customer’s home and back, you can deduct $8.05 from your taxes (14 miles x $0.575 IRS mileage rate).
Set up a spreadsheet or use software to track your business mileage. It might be beneficial for you to take photos of your car’s odometer before and after every business trip.
Your second option is to deduct a portion of the total amount you spent on the use of your car during the year. To deduct the actual costs, you must determine the percentage of kilometers driven for business purposes and multiply it by the total cost of insurance, registration, gas, oil, etc.
9. Start-up and organizational expenses
Before your business even opens its doors, you are already spending money. Between market research and registering your business, you’re probably racking up thousands of dollars in expenses. You can deduct some of these costs in the first year of operation.
The IRS calculates start-up and organization costs separately. Finding office space or conducting market research counts as start-up costs. Organization costs include business registration and legal fees.
You can deduct up to $5,000 for start-up costs and an additional $5,000 for organization costs. The deductible amount decreases when the total expenses for the class exceed $50,000. The rest of your start-up and organizational costs are expensed over the first 15 years of your business in a process called depreciation.
Although I tell you about these deductions, you might be better off ignoring them. Start-up and organizational cost deductions don’t make sense for businesses that don’t expect to be profitable in their first year. To maximize your tax savings, you should choose to amortize all of your start-up and organizational expenses over 15 years.
Like educational expenses, sole proprietors deduct start-up and organizational expenses in the “other expenses” section of Form 1040 Schedule C.
When your business purchases capital assets such as buildings, machinery, or furniture, you generally don’t spend the full amount in the year of purchase. Instead, you slowly spend the asset in a process called depreciation.
The IRS uses its proprietary Modified Accelerated Cost Recovery System (MACRS) to determine the annual depreciable amount of each capital asset. Your tax software can help you with the calculation.
If you prefer to deduct the full cost of your capital asset purchase, you have that option as well. In fact, you have two options: the Section 179 deduction and the depreciation allowance.
You can immediately deduct up to $1.04 million of qualifying capital purchases with the Section 179 deduction. This should cover the cost of your new computers.
Bonus depreciation is a similar tax deduction that allows you to deduct the full cost of qualifying assets, but there is no dollar amount limit. Check the respective guides for the restrictions of each deduction.
You report depreciation on Form 4562.
Don’t forget the tax credits
Tax deductions aren’t the only way to reduce your small business tax liability. Browse our list of the best small business tax credits to get dollar-for-dollar reductions on your tax bill.