What is Self-Employment?
Let’s start with the basics: Who is self-employed? The federal government has three definitions of self-employment:
- You are the sole proprietor or an independent contractor in business for yourself.
- You are a partner in a business.
- You are otherwise in business for yourself (including a part-time business).
These are fairly self-explanatory. Basically, if you own a business, are a private contractor, or are in some other way in business for yourself, you are self-employed and are subject to self-employment tax requirements.
Is That a Self-employed Business Expense?
One of the major points of confusion in determining tax obligation is expenses: What are they?
To put it plainly, expenses are products or services on which a business spends money. Tax-deductible business expenses can help shave off some of the money you may owe in taxes at the end of the year. To be deductible, a business expense must occur regularly and must be necessary for the operation of the business. These are called ordinary and necessary expenses. The goods and services associated with these expenses are commonly accepted items in your trade or business that are helpful and appropriate for your business. There are many forms of expenses, and the two major expense categories are capital and non-capital.
Types of Expenses
A capital expense occurs when a business buys a new asset or adds value to an existing asset. Typically, capital expenses are characterized by a significant initial investment and are focused on maintaining current operational levels or on future growth. As such, capital expenses are reflected as assets on the financial statements, and there may be corresponding liabilities associated with the assets.
Capital expenses can be tangible or intangible. An example of a tangible capital expense would be a baker remodeling a customer seating area; the expenses associated with the remodel would be considered capital expenses, and any furniture or equipment purchased for the product would be considered capital assets. An example of an intangible capital expense would be costs associated with or the value of a patent, license, or trademark.
Capital expenses are not necessarily immediately deductible, either. In some cases, small capital expenditures may be eligible for immediate deduction using the Section 179 provision; however, most will be amortized for deduction. Self-employed taxpayers should seek professional advice regarding which is most appropriate.
As you might expect, non-capital expenses are purchases that are typically less expensive than capital expenses and have a shorter useful life expectancy. Non-capital expenses are broken down into two other categories: discretionary and non-discretionary.
Discretionary expenses are fully optional purchases such as entertainment, memberships, or events, and only some of them are tax-deductible. These can be a bit difficult to pin down. In the corporate world, these are usually expenses that are meant to improve client or employee relationships. But discretionary expenses vary depending on the business or person. They are always a good thing to keep track of for future reference. Many businesses limit discretionary expenses to save money when cash flow has slowed.
A non-discretionary expense is more easily defined. These are expenses that are required to maintain the business, including fixed expenses that are continuous and uniform over time, such as rent, education materials, interest fees, pension contributions, or benefit payments. Non-discretionary expenses can also include unpredictable but essential expenses, including out-of-pocket medical costs, child support, and even advertising. If you are wondering what kind of non-discretionary expenses can be deducted, it is important to remember that unless a portion of the expense is used for the business, it cannot be deducted.
Fixed and Variable Expenses
To further complicate matters, it’s generally recommended that self-employed individuals break down capital and non-capital expenses into two categories: fixed and variable expenses. Some examples of fixed expenses include rent, contract payments such as an internet bill, or even payroll. Some variable expenses can include things such as marketing, taxes, or travel expenses. While fixed expenses are just that—fixed—and can’t be changed from period to period, understanding where your variable expenses are may allow you to see where savings might be achieved in slower earning periods.
Specific Deductions to Consider
The expenses noted here are listed in the order they appear on IRS Form 1040 Schedule C. In some cases, self-employed individuals may be required to file a different tax return, such as a Form 1065. In addition, the deductions noted here are not an exhaustive list. Please consult a tax professional to determine the deductions for which you are eligible.
Advertising & Promotion
No matter what type of business you’re conducting, eventually you will need to advertise and promote it. Generally, you can deduct any form of advertising or promotion cost as long as it is for the sole benefit of your business. The IRS sees any form of promotion as a regular and necessary expense to conduct business. For example, a small catering service owner who participates in a food festival could deduct the booth rental fee and the costs associated with the foods served at the festival. Self-employed individuals who sponsor nonprofit organizations or events can deduct these costs as advertising and promotional expenses, as well.
Car & Truck Expenses
Self-employed individuals have two methods for deducting car and truck expenses: standard mileage rate or actual expenses.
Standard Mileage Rate
The standard mileage rate is $0.575 per mile for 2020, but the IRS stipulates how it can be used. If you own your vehicle, you are eligible to use the standard mileage rate only if you have always used the standard mileage rate since the vehicle has been placed into service. If you lease your vehicle, then you can use the standard mileage rate only if you do so for the entire lease term. If you use the standard mileage rate, you can also add the costs of tolls and parking to the total amount, so be sure to track these carefully—along with your actual mileage—in your accounting software.
Actual Expenses Method
There are three components for tracking actual expenses for a car or truck that you use for business. The first includes actual expenses that are incurred throughout the year, such as maintenance and repairs, fuel and other auto fluids, insurance, state-required license plates, and similar. The second is depreciation, and the third is lease payments, both of which are covered later in this article.
Commissions & Fees
Commissions and fees are those payments made to others, not what you received. Self-employed individuals who paid others commissions, such as for the sale of art or other works, or fees, such as for the sale of real estate owned by the business, must also file the new Form 1099-NEC to report payments of $600 or greater. In general, however, all of the commissions and fees you paid are deductible expenses.
If you had independent contractors working for you during the year, you can typically deduct the cost of their labor. As with commissions and fees, self-employed individuals who paid an independent contractor $600 or more must file Form 1099-NEC to report the payments. In addition, keep in mind that contract labor is not the same as wages paid to employees, labor costs associated with repairs and maintenance, or the cost of seeking legal advice. All of those expenses are reported elsewhere.
Depletion occurs for certain self-employed individuals whose businesses involve natural resources, such as mining and timber harvesting. As the natural resources are used as part of the business operation, the value of the depletion can be deducted. The depletion deduction can be calculated using two methods: cost and percentage. However, the method you use is dependent on the type of natural resource you’re working with, so it’s a good idea to seek professional advice before taking this deduction.
Depreciation is a method to calculate the cost of a physical asset over its useful life or the object’s life expectancy. Basically, it is used to represent the amount of asset value that has been used within the tax year.
In some cases, depreciation is spread out over multiple years, and there are several methods to calculate depreciation. Straight-line depreciation is the simplest way to report depreciation—reporting equal depreciation each year throughout the entire asset’s life expectancy or until the asset has reached its salvage value. Declining balance depreciation is an accelerated form of depreciation, in which the straight-line rate for the asset is multiplied by an accelerator, thus increasing the amount of depreciation deducted in earlier years of useful life. Double declining balance is a variation of the declining balance method.
In other cases, full depreciation can be taken in the year the asset was purchased through a Section 179 deduction. The IRS does limit how much of a deduction may be taken in a certain year. For 2020, the limit is $1,040,000, and the deduction applies only to assets or software that is used for business purposes at least 50% of the time.
Employee Benefit Programs
Self-employed individuals who pay for employee benefits on behalf of their employees can deduct the cost of the benefits. Benefit programs included in this deduction are generally grouped into two categories: insurance and dependent care. If, for example, you paid for health insurance for your employees, or if you contributed to their child care costs, you can deduct those expenses. Keep in mind, however, that your own personal health and life insurance contributions may not be eligible for deduction here. This deduction only applies to programs for your employees.
Businesses generally need to carry insurance to protect themselves. The two types of insurance that are deductible in this category are liability coverage and errors and omissions coverage. All other insurance expenses—such as employee health or life coverage, worker’s compensation insurance, or car/truck insurance—are deducted elsewhere.
Interest expenses can be complicated, and whether they’re deductible depends on the type of interest that the self-employed individual paid. For example, mortgage loan interest can be deductible, but the real estate for which the mortgage exists must be used in the business. Similarly, credit card interest can sometimes be deductible, but the credit card must be used for business purposes. In some cases, deductibility must be allocated. For example, if a self-employed person has a credit card that is used for both business and personal reasons, only the business portion of the interest could be considered deductible.
Legal and Professional Services
You may deduct fees paid to any professional services, including those who are independent contractors themselves. The IRS lists accountants and attorneys exclusively for legal professional fee deductions. It is important to remember that you must keep business professional fees separate from your personal fees; only business fees can be deductible. If you have a professional such as a tax preparer for both your business and personal taxes, you must separate the costs.
When you begin your business, the costs associated with any professional you use to help set up your business are also tax-deductible. These expenses—also called organizational costs—are incurred from start-up activities, such as hiring an attorney to write a partnership agreement, an IT professional to set up your business computers, or an accountant to set up your business accounting system, and all fall into the legal and professional services category.
Categorizing office expenses can be a point of confusion for many business owners. Many people assume that this category refers to traditional items like paper clips and copier paper, but it actually refers to things like janitorial supplies, storage cabinets, beverage services provided for employees, and services that a self-employed person would purchase to maintain the office area, such as cleaning services. Software is also included in this category, as are computers and printers, phones, and cloud hosting services.
Pension & Profit Sharing Plans
One of the best tax write-offs a self-employed individual can have is a retirement plan. Options included in this category include a traditional IRA, an individual 401(k), a company-specific profit sharing plan, or an annuity plan, such as a SEP, SARSEP, or SIMPLE IRA plan. The type of plan you choose determines the amount you can contribute and, therefore, deduct. For example, a self-employed person can contribute up to 25% of their income to a SEP, up to $57,000 total (for 2020); if you choose a SIMPLE IRA, you can invest your entire net self-employment earnings up to $13,000 (for 2020), and there’s an additional investment opportunity for taxpayers who are at least 50 years old. It is important to note that all contributions to a traditional IRA are deductible in the year they are made.
Rent and lease payments normally cannot be deducted, but self-employed individuals can deduct these expenses. Rent and lease payments are only deductible for property (that is, buildings, structures, machinery, vehicles, and other equipment) that is being used for business purposes. Much like when you have an in-home office, you can deduct a portion of your rent according to the portion of the property being used for business. If the property you are using is completely used for business, you can deduct the full amount of rent payments. You must be able to prove that the portion you are deducting is actually for business.
In addition, rent and lease payments that are made in advance, such as pre-paying several years of rent for office space, are limited. Only the current year’s expenses can be deducted, and the expenses for future years are held over and can be deducted in their corresponding years. The held over amount is capitalized, meaning that it is noted as an asset on the balance sheet until the time when it can be deducted.
Repairs & Maintenance
In many cases, self-employed workers can deduct costs associated with repairs and maintenance of their property, equipment, and office space. The IRS definition of routine maintenance is fairly broad in that it allows any maintenance that ensures property remains in normal operating condition. Keep in mind, however, that the cost of your time in making those repairs or conducting maintenance is not included in this deduction.
The easiest way to determine whether a repair or maintenance effort is deductible is the “betterment, restoration, adaptation” (or BRA) test. If the repair or maintenance work being done betters, restores or adapts the equipment or property specifically for use within the self-employed person’s business, the cost of the repair is generally deductible. There are some restrictions regarding deductions for repairs and maintenance, but the IRS also has some “safe harbor” rules that, if met, mean that the repairs and maintenance can be written off easily. In general, the key to meeting the safe harbor standards is that the repairs and maintenance activities should be small (under $2,500 per invoice, or under $10,000 or 2% of the adjusted basis for a single project) or routine (meaning recurring tasks related to wear and tear). Anything outside of those parameters must be justified clearly.
The cost of any supplies or materials that are required to do business is included in the Supplies category. Typical examples of supplies include pencils, paper, toner, folders, and similar objects, as well as packaging items and postage. Other items are included in this category, as well, including equipment and instrumentation for which the useful life is less than a year.
If you are ever having trouble making the distinction between what is considered deductible and what isn’t, remember that most things are deductible if they are regular and necessary. The IRS has three rules when it comes to allowing deductions for office supplies. You can generally deduct 100% of the cost if:
- You do not keep specific records of the use of office supplies.
- You do not track inventory for office supplies.
- The value of the deduction doesn’t reduce your income to a level significantly lower than it should be.
Taxes & Licenses
Any business must adhere to many different regulations—local, state, or federal—and to obtain the licenses and permits for these regulatory purposes almost always incurs a fee. Complying with these regulations not only keeps your business safe from litigation, but also portrays to your customers that your business is legitimate. Examples of licenses and permits you may need to obtain include local and state business licenses, incorporation fees, building permits, and similar. In addition, renewal fees for professional licenses and purchase and renewal fees for software licenses fall into this category, as do fees associated with copyright, trademark, domain name, and business name searches. In addition, self-employed individuals may be subject to a variety of taxes, including:
- State, local, and municipal taxes
- Real estate taxes
- Personal property taxes
- Social Security and Medicare taxes
- Federal and State Unemployment tax
- Federal Highway Use tax
Travel & Meals
Traveling can be an essential part of growing your business. If the trip is considered business-related, self-employed individuals may be able to deduct the costs. For a trip to qualify for travel deductions, the IRS stipulates that you must be conducting business away from your tax home, which is the city or general vicinity of your place of business. There are several exceptions and conditions for deducting travel expenses.
Transportation and lodging expenses are generally deductible for overnight trips except when the length of the trip exceeds one year. In addition, only the expenses for the self-employed individual are deductible, not costs for spouses, dependents, and others unless the co-travelers are also employed by the business and traveling for business purposes. Travel by a self-employed individual or their employees for the purposes of a conference or seminar outside of the United States is typically not deductible unless the meeting they’re attending is directly related to their business.
Incidental expenses, such as tips, don’t have to be itemized on days when no meals were purchased; however, incidental expenses are limited in scope and don’t include common costs like laundry services. Entertainment expenses are also precluded from deductibility in this category.
Meals can be deducted in one of two ways. The easiest way to deduct meal costs while traveling is to use the standard meal allowance method. The IRS specifies the amount that can be deducted for meals and incidentals in a given day. For 2020, the rate is $55 per day. The more complicated method is to note actual expenses. For most people, only 50% of actual cost is deductible; one exception to this rule is anyone who is subject to the Department of Transportation hours of service limits, and those travelers can deduct 80% of actual expenses. Irrespective of the method, you must keep receipts for all meal expenses to prove that the meals were consumed during your trip and for business purposes.
All utility expenses that are directly related to the trade or business are deductible—with one exception. If you are using a home phone service as your business phone service, only any extra costs (above and beyond your basic home phone billing amount) are deductible. Self-employed people who use the simplified home office cost deduction method should deduct utilities as part of that calculation.
Any salaries and wages paid to employees are included in this category. Any wages you paid to yourself are excluded from this amount. In addition, if you received any credits, such as Work Opportunity, Empowerment Zone, or Paid Family and Medical Leave, the total for this category would be reduced accordingly. If this deduction applies to you, keep in mind that you will likely also be required to file IRS Form W-2, Wage and Tax Statement, for each employee you paid, regardless of the amount you paid them.
Business Use of Home
Further expenses can be deducted if you are working from home. If you own a home and are making mortgage payments or paying rent, a portion of the total cost can be deducted. This portion that can be deducted is dependent on the amount of space in the home you are using as a dedicated home office. As with meals, there are two methods for calculating the business use of home deduction: simplified and actual.
The simplified method for claiming the business use of home deduction is to calculate the square footage of the home that is used exclusively for business (limited to 300 square feet) and multiply that number by $5. If there are multiple self-employed individuals in the home, and both qualify for the business use of home deduction, each person may deduct up to $1,500 using the simplified method.
The actual method requires that you itemize all the expenses directly related to the home office using IRS Form 8829. Some expenses can be itemized in multiple places on Form 1040. If you have questions regarding where deductions should be taken (for example, Schedule A or Schedule C), please consult a tax professional.
Cost of Goods Sold
Cost of Goods Sold (COGS) is another aspect of business taxes. If your business manufactures products or purchases them for resale, your inventory must be valued at the beginning and end of each tax year; however, small businesses aren’t always required to keep an inventory to qualify for a COGS deduction. Essentially, any costs the self-employed individual incurs related to manufacturing a product or service is part of COGS except the cost of their own labor.
COGS is calculated by subtracting the end of year inventory value from the sum of the beginning of year inventory value, the value of sold goods, and the costs of labor, materials and other expenses. Inventory value can be calculated using the cost, the lower of cost or market value, or another method approved by the IRS, but it must be calculated the same way year over year.
In addition to the expenses outlined elsewhere in this article, there are additional expenses that may be deductible by self-employed individuals.
Paycheck Protection Program Loan
During the COVID-19 pandemic, the U.S. Federal government has rolled out a number of stimulus programs, including the Paycheck Protection Program. Taxpayers who have already received loan forgiveness may not deduct any expenses that were paid as a result of the forgiven loan, including healthcare benefits, rent, utilities, mortgage interest, payroll, and loan interest.
Education Expenses/Professional Development
Continued education is important for self and business growth and typically qualifies as a business expense. If the education is needed to maintain or improve skills required for a business, it is considered an expense, but this does not include the federal or state minimum education requirements. The price of education can only be deductible if the minimum requirement has already been met for the specific job and further education is required or wanted. Educational opportunities such as a salesperson taking a negotiation seminar or a bookkeeper purchasing financial law textbooks are examples of business expenses for professional development. In addition, if you have employees, and they are required to complete continuing education, you can pay for the classes or materials and deduct it as an expense for your business.
Bank fees are a typical operating expense for most businesses. There can be many reasons that a bank would charge you fees, including account maintenance fees, minimum balance fees, overdraft fees, and many others. As with most deductions, fees can only be deducted for the current filing year.
Health Insurance Premiums
Health insurance costs, as well as costs for dental and long-term care insurance, are sometimes deductible for both the self-employed person and their spouse, dependents, and eligible adult children. If the self-employed person is eligible to participate in any other insurance plan, including one offered by their spouse’s employer, premiums are not deductible. There are other eligibility requirements and limitations, as well.
First, and most importantly, the self-employment business must actually make a profit. The amount of net profit determines the percentage of the premiums that can be deducted. Second, if you are purchasing long-term care insurance, you must also meet certain age requirements. Third, there are other exceptions that may allow deduction of health insurance premiums, but they can be complex, so it’s best to consult a tax professional to determine your eligibility.
Business start-up costs, outside of those that are deducted under legal and professional services, can be handled in two ways: deduction or capitalization. Start-up costs are defined as any costs incurred in the creation of a business. Some expenses can be immediately deducted, such as costs developing a business plan and those associated with funding the business. Other costs, such as those for equipment, must be capitalized, which means that not all costs can be deducted in a single year. For 2020, the maximum start-up cost deduction is $5,000.
Membership Dues & Subscriptions
If you own a business, the dues you pay to professional, business, or civic organizations are deductible expenses. Applicable organizations include bar, medical, and trade associations; local chambers of commerce, real estate boards, and business leagues; and service organizations, such as a Rotary Club or the American Legion. Similarly, subscriptions to publications from professional organizations, such as trade magazines, professional journals, and similar, are deductible expenses. Any dues or subscriptions paid to an organization with the main purpose of entertaining its members are not tax-deductible.
QBI, or the Qualified Business Income Deduction or Section 199A, applies to a variety of business types, including sole proprietors and comprises two components: QBI itself and real estate investment trust (REIT) dividends/qualified publicly traded partnership (PTP) income. This deduction allows eligible business owners to deduct up to 20% of their qualified business income. The QBI deduction can be taken whether or not the sole proprietor files Schedule A, but some limitations do apply. For example, for 2020, self-employed individuals filing using the Single status cannot make more than $163,300, and those filing using the Married Filing Jointly status cannot make more than $326,600; in some cases, partial deductions may be allowed. Other limitations may also apply, including excluded income, such as dividends and income earned outside the U.S.
Income from self-employment is still subject to federal taxes. Some of your tax obligations may be offset by deducting applicable expenses. Hopefully, this article can point you in the right direction. There’s a lot to learn about this topic for the self-employed, and if you’re not confident in your ability to navigate the various deductions, you might want to seek out a professional to keep you on track and compliant with the IRS, and to help ensure you’re not paying more in taxes than you need to.
What is the self-employment tax?
Everyone pays Social Security and Medicare taxes. If you are employed by someone else or another business, your employer typically pays part of these taxes. However, if you are a sole proprietor or independent contractor, you are both employer and employee, so you pay the full amount on what you earn via your business. This is the self-employment tax.
My business is just getting started. How do I know if I need to pay self-employment taxes?
The answer here is simple. Anyone who earns at least $400 through self-employment must pay self-employment taxes. The only exceptions are some individuals employed by churches. Also, if your business does not earn a profit, you will not need to pay taxes, either. The downside is that you will not earn any credit for Social Security or Medicare in that year.
How much should I expect to pay?
The self-employment tax rate is calculated at 15.3% of your net income. Social Security accounts for 12.4% (it is capped, though), and Medicare accounts for 2.9% generally, but can include an additional 0.9% at a higher income. If you have income from an employer as well as income from self-employment, both incomes are considered in determining your tax obligation.
What income is included in the self-employment tax?
You will pay Social Security tax on the first $127,200 of your earned income, which includes anything you earn as an employed plus earned income from your business. All of your self-employment income is subject to Medicare tax, though.
- What is Self-Employment?
- Is That a Self-employed Business Expense?
- Types of Expenses
- Specific Deductions to Consider
- Other Expenses
- What is the self-employment tax?
- My business is just getting started. How do I know if I need to pay self-employment taxes?
- How much should I expect to pay?
- What income is included in the self-employment tax?