By Jeffrey I. Kim, CPA
Whether you do contract work or have your own small business, tax deductions for the self-employed can add up to substantial tax savings. With self-employment comes freedom, responsibility, and a lot of expense. Here are six tax write-offs to which self-employed people are entitled so you can better plan and organize at tax time.
One of the biggest benefits of being self-employed is that there are more retirement plan options available to you than available to most taxpayers. Three main options are the Simplified Employee Pension (SEP IRA), the Savings Incentive Match Plans for Employees (SIMPLE IRA), and the individual 401(k). Contributions to these plans reduce your taxable income, and investments can grow tax-deferred until you start making withdrawals from the plan. However, contributions are above-the-line deductions rather than Schedule C deductions, which means they save money on income tax but not self-employment tax. In most cases, an individual 401(k) plan will allow for the largest contribution, but SEP IRAs and SIMPLE IRAs can be good choices because of their simplicity. This can be a very generous deduction by the IRS.
There are two ways a taxpayer may file for business-related auto expenses: actual expenses incurred or the standard mileage rate prescribed by the IRS (54.5 cents as of 2018). The IRS’s allowable mileage rates should be checked every year because it can change. Actual car expenses include car payments, depreciation, registration, insurance, garage rent, licenses, repairs and maintenance, and so on. Most people use this method in the year they purchase the car to take advantage of the depreciation deduction. Generally, when using the actual expense method, the deduction is only for the percentage of miles driven for business usage. To calculate the allocable business deduction, add all the expenses and multiply by business miles over total miles. If you decide to use the standard mileage rate, keep a log of the miles driven for work to distinguish personal use from business use. Parking fees and tolls are deducted at 100 percent as a part of auto expense.
To qualify for a home office deduction, the IRS has two basic requirements: regular and exclusive use and principal place of your business. If you have a home-based business or you are using your home for business purposes, you may deduct expenses for the business use of your home. It is very important that you keep track of expenses relating to your housing costs. A few years ago, the IRS introduced a new simplified home office deduction method. This method is for small home offices (up to 300 square feet). Taxpayers using the regular method, instead of the simplified method, must determine the actual expenses of their home office. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Generally, when using the regular method, deductions for a home office are based on the percentage of your home devoted to business use. To figure this proportion, measure the square footage devoted to your home office and find what percentage it is of the total area of your home. If the office measures 150 square feet, for example, and the total area of the house is 1,200 square feet, your business percentage would be 12.5 percent (150 ÷ 1,200).
Health Insurance Premiums*
If you pay for your own health insurance 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. Rather than claiming your health insurance expenses as a medical deduction on Schedule A, the self-employed can deduct this insurance expense as an above-the-line adjustment to income, which is more advantageous. It affects your adjusted gross income, a detail upon which several other tax breaks depend.
One of the major changes within the Tax Cuts and Jobs Act is Section 199A. This part of the tax law permits owners of sole proprietorships to deduct up to 20 percent of the income earned by the business. The calculation can be complicated since it’s subject to several limitations. (This is a good reason to seek a tax professional.)
Put Your Child to Work
You can hire your under-18 child, and his or her wages will be exempt from Social Security tax, Medicare tax, and federal unemployment tax. You can hire your child part-time, full-time, or whatever works for you and the child. You can use his or her standard tax deduction to shelter up to $12,000 of 2018 wages paid by your business from federal income tax.
*Amount of deduction is limited to business income
Jeffrey I. Kim, CPA, is with McCarthy & Company PC in Lafayette Hill, Pa. He serves on PICPA’s CPA Image Enhancement Committee.