Are you Self-Employed? Here’s what you can deduct.
Almost every day, one of my clients will ask whether a certain expense is deductible for their business. In general, most expenses that are reasonable and necessary to the operation of your business will be deductible. Let’s take a look at some common expense categories that all self-employed taxpayers should consider.
Operating expenses are costs that are incidental and necessary for the daily operation of your business. With a few exceptions, these expenses are always fully tax deductible. Common operating expenses are:
- Office Rent
- Advertising and Marketing Expenses
- Salaries and Wages paid to employees (W-2)
- Amounts paid to contractors (1099)
- State and Local taxes paid (e.g. tangible property tax)
- Office supplies and expenses
- Software subscriptions
Many businesses carry inventory that is sold at retail. The IRS has special rules for inventory. Inventory can only be deducted when it is sold to the customer, not when it is purchased. There are two methods for tracking inventory—the perpetual method and the periodic method. The perpetual method expenses each inventory item the moment that it is sold, whereas the period method tracks the total amount of inventory at the end of each period (usually at the end of the year). The actual expense related to sold inventory is then calculated at the end of the period. Either method will result in the same deduction. We recommend that most of our clients use the periodic method, which only requires you to track your inventory purchases throughout the year and then provide a count of inventory at year end.
Major Asset Purchases
Many businesses require the use of major assets like furniture, tools, machines, and equipment. Expensive assets are not allowed to be expensed all at once. Their costs must be allocated throughout its useful life through the process of depreciation. The IRS has published various methods of depreciation that must be used by taxpayers. I advise my clients to track each major asset purchase separately from other expenses. Your tax professional can determine the most advantageous allowable method of depreciation upon preparing your tax return.
Meals & Entertainment
Business related meals and entertainment expenses are one of the most controversial deductions among small business owners. Beginning in 2018 because of the Tax Cuts and Jobs Act, entertainment such as sporting events, club memberships, and cocktail hours are no longer allowable deductions—even if they fit the description to be considered business-related.
Business meals are deductible, although some of the rules shifted with the TCJA. With some exceptions, business meals are limited to 50% of the total amount. We advise our clients to provide us with the total amount of meals expense and allow us to determine tax deductibility.
For businesses that require significant driving, auto expenses are typically one of the most significant deductions. The IRS allows taxpayers to either deduct actual automobile expenses or to use a simplified calculation based on mileage. In most instances, the simplified method is easier for record keeping, and often provides a larger deduction than the actual expense method.
Actual Expense Method
The actual expense method for auto expense requires you to track all automobile related expenses for your vehicle(s). This means fuel, repairs, lease payments, interest on loans, depreciation, and auto insurance. You must then separately track business mileage, commuting mileage, and personal mileage to determine the percentage of the actual expenses to deduct.
Simplified Method (Mileage only)
The IRS allows a simplified method of deducting auto expense by tracking your vehicle’s mileage. Throughout the year, you must track your vehicle’s business mileage, commuting mileage, and personal mileage. You may then deduct a dollar amount based on your business mileage. For example, if you are a real estate agent that drove 8,000 miles for business purposes in 2019, you can deduct 58 cents per mile for a total deduction of $4,640. The actual dollar-per-mile deduction changes on an annual basis (for 2020, the deduction will be 57.5 cents per mile).
Home Office Expenses
Similar to automobile expenses, home office expenses have two methods to calculate your deduction. As long as your home office fits the IRS’s published eligibility requirements, you can take this deduction.
Actual Expense Method
For home office expenses, you may add the costs related to your entire home such as rent, mortgage interest, depreciation on your home, insurance, maintenance, and HOA dues. You may then take a deduction based on the square footage of your dedicated home office compared to the entire square footage of your home office. For example, if your home office is 120SF and your home is 1,200SF, you may take a deduction equaling 10% of your total home expenses. You may also add 100% of any home office expenses that are directly related to the home office such as office furniture and equipment.
The simplified method for home office expense still requires you to calculate the square footage of both your home office as well as your entire home. Instead of calculating the expenses related to your home and home office, the IRS allows you to deduct $5 per square foot of your home office. Using the example above, your deduction would be $5 x 120SF = $600.
Charitable contributions are not deductible to your business. Instead, you may include your business’s charitable contributions on Schedule A of your 1040 (Itemized Deductions). Although donations are not deductible, non-profit organizations often offer sponsorship opportunities to business owners that provide advertising and marketing for your business. In this case, you may deduct the amount of your donation that is directly related to the marketing benefits you are receiving from the charitable organization.
The IRS provides a special deduction for business owners who pay for their own major medical health insurance premiums. The method of this deduction changes based on how your business is organized, but it is generally not directly deductible by the business. This is not always the case, so speak with your tax advisor about how to appropriately account for health insurance premiums.