Guide to Self-Employment Tax Deductions
As an entrepreneur joining the 32.5 million small businesses in the United States, you should be reveling in the self-employed lifestyle you've created for yourself. However, one thing you might not be looking forward to is tax time. Whether you became a small business owner for the first time this year or have been in business for 10 years, the unique challenges of ever-changing tax laws and tax liability can be daunting.
Because the process is not the same as when you were an employee — where you filled out a W-4 and had withholding tax deducted from your salary — your tax filing procedure will be a little bit complex as a self-employed professional. One of the most critical aspects of calculating your tax bill is keeping track of your expenses to take advantage of self-employment deductions. Deductions are important for any small business owner because they reduce your taxes and, subsequently, your cost of doing business — potentially making your business more profitable.
This article will walk you through why you have to pay self-employment tax and how it works. We'll also list the various deductions available to you as a small business owner.
Who Pays Self-Employment Tax?
Self-employment tax applies to individuals who work for themselves as freelancers, independent contractors, consultants, or small business owners. The self-employment tax rate is currently 15.3%, where 12.4% is allocated to Social Security contributions, and 2.9% goes to Medicare. Employees who earn wages also contribute to these programs, except the amount is withheld from their pay.
You must pay this tax if you had a profit from self-employment of $400 or more. Your net income or profits is calculated by subtracting business expenses from your total business earnings for the year. You'll have to pay self-employment tax no matter how old you are and even if you're already receiving Social Security or Medicare.
You are subject to self-employment taxes if you're a small business owner operating as:
- A sole proprietor
- A partner in a partnership
- A single-member limited liability company (LLC) aka disregarded entity
- A member of a multi-member LLC that elected to be treated as a partnership for federal tax purpose
- A member of an LLC that elected to be taxed as an S corporation
- A member of a qualified joint venture
How Self-Employment Tax Works
Here are a few things to note about federal income tax and self-employment tax specifically:
- Since you are your own boss, you're responsible for both the employee and employer portion of the self-employment tax bill. Hence, you have to pay the full 15.3%. When you were an employee, your employer covered half of it as payroll taxes.
- For your 2020 tax return, up to $137,700 of your net earnings is subject to the Social Security portion of 12.4%. All of your net earnings are subject to the 2.9% Medicare tax. However, if you earned more than $200,000 as a single filer, you'll have to pay an additional 0.9% in Medicare taxes.
- Regarding which forms you'll need to file, visit this link. For example, if you're a sole proprietor, you'll want to use the IRS Schedule C form to calculate your net earnings from self-employment. You can calculate your self-employment tax on Schedule SE.
Keep in mind that there is a lot more you'll want to research when calculating taxes, including which income tax bracket you fall under. You'll also want to think about the various business expenses you're eligible to claim as tax write-offs for the year. Follow along as we discuss the most common deductions allowed to self-employed individuals like you.
Types of Self-Employment Tax Deductions
Tax deductions or write-offs are expenses you incur during a tax year that the IRS allows you to subtract from your total earnings to lower your taxable income. Under the U.S. tax laws, as a taxpayer, you have the choice to apply the standard deduction or itemized deductions to your personal tax return:
- Standard deduction : This is a flat-rate amount set by the IRS and can change from year to year. The amount you can claim is based on your filing status, age, and whether you're disabled or if someone is claiming you as a dependent on their tax return.
- Itemized deductions : These are expenses you incurred on eligible products, services, or contributions that can be subtracted from your adjusted gross income (AGI) to reduce your tax liability. There are numerous qualifying deductions you can claim as a small business owner. Just remember to keep your receipts and other documentation for proof.
Below, we'll look at some specific tax deductions you'll likely encounter when running your small business.
Home Office Deductions
If you work from home, you can claim a percentage of your mortgage or rent; property taxes; the cost of utilities, repairs, and maintenance; and other similar expenses as a home office deduction. You only qualify for the area or square footage of your home that you use exclusively and regularly for business-related activities, though.
Even if you don't do all your work in your home office, it can still be considered your principal place of business if you use it for billing customers, setting up appointments, and keeping books and records.
You can choose between two ways to claim this deduction:
- Simplified method: With this option, you're not claiming actual expenses. You'll multiply the square footage you use as your home office by the prescribed rate of $5 per square foot, up to 300 square feet. If you're using the simplified option, your deduction can't exceed $1,500.
- Regular method: For this option, you'll have to establish the percentage of your home that you use for business purposes and divide that by the total amount of your actual mortgage/rent, utility costs, insurance premiums, and other eligible expenses. Use the IRS Form 8829 ("Expenses for Business Use of Your Home") to calculate your home office deduction.
Internet and Phone Bills
For this deduction, you can deduct part or all of your phone and internet service expenses. You can deduct all of your phone bills if you have a dedicated business phone line. If you don't have an exclusive line and internet service for your business, you can claim a percentage of your internet and mobile phone bills.
Health Insurance Premiums
If you pay for your own health insurance premiums, you can also claim them as a business expense. You're allowed to deduct all of your health, dental, and qualified long-term care insurance premiums. This applies to premiums you paid for your own coverage and for the coverage of your spouse, dependents, and children who are under the age of 27 by the end of the year.
This deduction is more an adjustment to income than an actual deduction, which means you can claim it even if you choose to use the standard deduction. However, if you're eligible to enroll in your spouse's employer health plan but decided not to, you won't be eligible to claim this deduction.
This refers to meals you take when you're traveling for business or when you're meeting and entertaining clients. If you keep your receipts, you can claim up to 50% of the actual meal's cost as a tax-deductible expense. Otherwise, if you only keep records of your business travels, your deductible will be equal to 50% of the standard meal allowance. Your records must also include the time, place, and purpose of the trip.
These are the new stipulations for eligible meal deductions from the Tax Cuts and Jobs Act:
- The meal must take place between you and a current or prospective client.
- The expense is incurred at a restaurant and not an entertainment venue, such as a nightclub, cocktail lounge, or sports arena.
- The meal is not lavish or extravagant under the circumstances.
- There's a reasonable expectation of deriving income or other business benefits from the meeting.
For your trip to qualify as a business travel expense, the IRS has the following requirements:
- The trip must last longer than a regular workday where you would need to sleep at a place away from home, which generally means outside the city where your business is located.
- The business trip should be planned for specific business activities.
- You must engage in a business activity like meeting with clients, attending a seminar, or learning new skills related to your business or trade while you're away.
- The expense can't be lavish or extravagant under the circumstances.
Business travel expenses are 100% deductible. You can claim the cost of transportation to and from your destination (e.g., plane ticket), transportation costs at your destination (e.g., car rental, Uber, or train tickets), and the cost of lodging. If your trip is a combination of business and sightseeing, you can only deduct the percentage of the costs associated with you doing business. Remember that the business activity and purpose must be planned for it to qualify as a business trip.
This deduction is a high-touch area for audit, so make sure you keep your records and receipts if the IRS asks to see them.
If you use your car to conduct business, the expenses you incur for those drives are eligible deductions. You can calculate the amount by using the standard mileage rate or deducting your actual expenses. To use the standard mileage rate, multiply the total miles you've driven for the year to the standard rate, which is 57.5 cents per mile for 2020. Make sure you keep accurate records of the dates, mileage, and purpose of each trip.
To claim the deduction using car expenses, add:
- Gas expenses
- Insurance premiums
- Lease payments
- Registration fees
- Parking expenses
- Repairs and maintenance expenses
The interest you pay for business loans or business credit cards is a qualifying deduction. But make sure you're not charging any personal purchases on your business credit card. If you borrowed money and used the proceeds for more than one type of expense, you must allocate the interest based on the use of the loan's proceeds.
For example, if you use 80% of the loan for your business capital and use the remaining 20% to buy a new appliance for your house, you can only deduct the interest paid for 80% of the loan.
Retirement Plan Contributions
One way to save on your taxes as a self-employed individual is to contribute to retirement plans, such as a SEP-IRA, SIMPLE IRA, and individual 401(k). Since you work for yourself, you can contribute as an employee and employer.
For example, you can contribute as much as $19,500 in 2020 in salary deferrals. You're also allowed an additional $6,500 catch-up contribution if you're 50 years or older. You can deduct contributions to an individual 401(k) plan of up to $57,000 in 2020. If you're 50 or older, you can deduct up to $64,500 or 100% of earned income, whichever is less.
Publications and Subscriptions
You can also claim fees you pay for a membership to professional organizations and boards, such as business leagues, chambers of commerce, civic or public service organizations, professional organizations like bar associations and medical associations, real estate boards, and trade associations.
For this deduction, you can also deduct the cost of any subscriptions to specialized magazines, journals, and books related to running your business.
During a tax year, if you attend classes or seminars to learn new skills to run your business better, you can claim the expenses as deductions. This includes expenses like tuition, books, lab fees, and transportation costs to and from classes. You may not deduct expenses you incur to change careers.
Use the dedicated area of Schedule C for this deduction. You can include business insurance premiums and employee accidents and health insurance premiums. Review IRS Publication 535 if you need clarifications for this deduction.
You can generally claim the rent you pay for office space as deductions, including fees to cancel a business lease. You can also claim expenses for equipment rentals. However, you can't take rent deductions on any property that you own, even partially.
The IRS allows you to deduct up to $5,000 in business startup costs. These expenses may include market research, travel costs related to starting your business or canvassing business locations, and lawyer fees. For example, if you registered your business as an LLC, you could claim up to $5,000 of your organizational expenses, such as filing fees or accountant fees.
As a business owner, you can generally claim expenses you incur in marketing your services or products. These could include the cost of Facebook ads, mail flyers, newspaper announcements, or the cost of setting up your website. Exceptions are lobbying expenses or advertising costs you incur in a convention program of a political party.
Qualified Business Income Deduction
As a small business owner who has pass-through income, you may be eligible for the qualified business income deduction. You have pass-through income if your business structure is a sole proprietorship, partnership, an S corporation, or an LLC.
You may qualify for a 20% deduction on your taxable business income if your total taxable income in 2020 is $163,300 or below for single filers or $326,600 or below for joint filers. Keep in mind that your total taxable income includes all of your earnings for the tax year, not just your business income.
Manage Your Tax Forms and Accounting with Skynova
There are numerous tax deductions available for self-employed individuals and small business owners. The ones mentioned above are the most common, but you may qualify to deduct other business expenses, such as office supplies and tax preparation fees.
Remember to only take deductions for ordinary and necessary expenses in your trade or line of work. Keep your receipts and make sure to have accurate records of expenses you claim as deductions. If you're unsure how to proceed, it might be best to seek professional help from an accountant.
Save time doing administrative duties. Try Skynova's all-in-one invoicing and accounting software, a platform specially made for small businesses. Simply upload your receipts to keep track of your expenses. Your receipts will be organized, backed up, and available at your fingertips.