Throughout the years, legislators have written numerous lines into the tax code to soften the blow of the extra costs that self-employed persons must shoulder as the do business. However, the 2017 Tax Cuts and Jobs Act (JCJA) eliminated several 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 complex 20% business income deduction for pass-through businesses—those who pay taxes through the individuals rather than through the corporation.
Some deductions that have been eliminated include:
- Entertainment deduction
- Domestic production activities deduction
- Local lobbying expenses deduction
- Employees’ parking, mass transit or commuting expenses deduction
A review of the most common self-employed taxes and deductions is necessary to help inform you of necessary changes to your business withholdings and income changes
1. Self-Employment Tax
The self-employment tax refers to the employer portion of Medicare and Social Security taxes that self-employed people must pay. Everyone who works must pay these taxes, which for 2018 are 7.65% for employees and 15.30% for the self-employed. Here’s how the rates break down:
- 6.2% Social Security tax each for employee and employer on the first $128,700 in wages
- 1.45% Medicare tax each for employee and employer with no wage limit
You will owe an additional Medicare tax of 0.9% in the following situations:
Married filing jointly
Married filing separately
The income thresholds for additional Medicare tax apply not just to self-employment income, but 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 wage income, 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. The IRS treats the “employer” portion of the self-employment tax as a business expense and allows you to deduct it accordingly. What’s more, you only pay self-employment tax on 92.35% of your net, not gross, business income.
Remember, you're paying the first 7.65% no matter whom you work for. And when you work for someone else, you’re indirectly paying the employer portion because that’s money your employer can’t afford to add to your salary.
2. Home Office
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, regardless of 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, in case you are required to submit this information to substantiate your deduction, which uses the square feet of your workspace in its calculation.
In addition to the office space itself, the expenses you can deduct for your home office include the business percentage of deductible mortgage interest, home depreciation, property taxes, utilities, homeowners insurance and home maintenance 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.
You have two choices for calculating your home office deduction: the standard method and 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. 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 might be 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 you’ll be able to deduct is $1,500. If you want to make sure you’re claiming the largest home office deduction you’re entitled to, you’ll want to calculate the deduction using both the regular and simplified methods. If you choose the standard method, calculate the deduction using IRS form 8829, Expenses for Business Use of Your Home.
3. Internet and Phone Bills
Regardless of whether you claim the home office deduction, you can deduct your business phone, fax, and internet expenses. The key is to deduct only the expenses directly related to your business. If you have just one phone, you shouldn't deduct your entire monthly bill, which includes both personal and business use. You should only deduct costs that specifically relate to your business. If you have a second phone line that you use exclusively for business, however, you can deduct 100% of that cost. By the same token, you would only deduct your monthly internet expenses in proportion to how much of your time online is related to business – perhaps 25% to 50%.
4. Health Insurance Premiums
If you are self-employed, pay for your own health insurance premiums and were not eligible to participate in a plan through your spouse's employer, you can deduct all of your health, dental and qualified long-term care 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-end, even if they aren’t dependents. Calculate the deduction using the Self-Employed Health Insurance Deduction Worksheet in IRS publication 535.
A meal is a tax-deductible business expense when you are traveling for business or entertaining a client. The meal cannot be lavish or extravagant under the circumstances and you can 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. The lunch you eat alone at your desk is not tax deductible.
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 at a bar during your friend’s bachelor party won’t make your trip to Vegas 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 don’t have to choose the cheapest options available, either. You, not your fellow taxpayers, will be paying the bulk of your 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, things get a lot more complicated; in a nutshell, you can only deduct the expenses related to the business portion of your trip – and don’t forget that the business part needs to be planned ahead.
7. Vehicle Use
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; it’s 54.5 cents per mile in 2018) or your actual expenses.
The standard mileage rate is the easiest because it requires minimal record keeping and calculation. Just write down the business miles you drive and the dates 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 you did for business all year as well as the total cost of operating your car, including 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, your deduction would be $300. As with the home office deduction, it may be worth calculating the deduction both ways so you can claim the larger amount.
Interest on a business loan from a bank is a tax-deductible business expense. 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 you already have and not incur any interest expenses at all. A tax deduction only gives you some of your money back, 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
The cost of specialized magazines, journals, and books directly related to your business is tax deductible. A daily newspaper, for example, would not be specific enough to be considered a business expense, but 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” box set is a legitimate book purchase for a self-employed, high-end personal chef.
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
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.
If you rent out an office space, you can deduct the amount you pay for rent. You can also deduct amounts paid for the equipment 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.
13. Start-Up Costs
The IRS usually requires you to deduct major expenses over time as capital expenses rather than all at once. However, you can deduct up to $5,000 in business start-up costs. Examples of tax-deductible start-up costs include market research and travel related to starting your business, scoping out potential business locations, advertising, attorney fees, and accountant fees. 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 any time, even if they aren’t start-up costs. Business expenses such as buying equipment or vehicles aren’t considered start-up costs, but they can be depreciated or amortized as capital expenditures.
SEP Account: Jessica Perez
Do you pay for Facebook ads, Google ads, a website, a billboard, a TV commercial, or mailed flyers? The costs you incur to advertise your business are tax deductible. You can even deduct the cost of advertising that encourages people to donate to charity while also putting your business’s name before the public in the hope of gaining customers. A sign advertising “Holiday Toy Drive sponsored by Robert’s Hotdogs,” for example, would be tax deductible.
15. Retirement Plan Contributions
One deduction you can take going into business for yourself that is especially worthwhile: the deduction for self-employed retirement plan contributions. Contributions to SEP-IRAs, 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 2018 tax year, for example, you could feasibly contribute as much as $18,500 in deferred salary ($24,500 if you’re 50 or older) plus another 25% of your net self-employment earnings after deducting one-half of self-employment tax and contributions for yourself, up to a maximum of $55,000 (not counting catch-up contributions) for both contribution categories, with a self-employed 401(k). 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.
The Bottom Line
Most small business tax deductions are more complicated than this brief overview describes – we are talking about the tax code, after all – but now you have a good introduction to the basics. There are also 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 and still, other business expenses can be depreciated or amortized, meaning you can deduct a small amount of the cost each year for several years.
Remember, any time 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 the IRS will ask when examining your deductions if you get audited. If the answer is no, don't take the deduction. And if you're not sure, seek professional help with your business tax return from a certified public accountant.