Self-employed business owners have the advantage of being able to deduct most business expenses. Being able to take these deductions is important because they can reduce your business tax bill.
Although tax regulations can change, here are some of the most important tax deductions you can take right now.
How Business Tax Deductions Work
Most self-employed business owners report and pay their income taxes through their personal tax returns. They calculate their income and deductions on a separate form, usually Schedule C, and then add their total net income from their business to their other sources of income on their Form 1040/1040-SR.
In order to take business deductions, the Internal Revenue Service (IRS) says these expenses must be both ordinary (common and accepted in your type of business) and necessary (helpful and appropriate).
The more legitimate deductions your business can take, the less your business net income for taxes, including calculations for federal and state income taxes and self-employment tax.
Self-employment taxes are those paid by self-employed individuals and owners of businesses for Social Security and Medicare taxes. The rate is the same as that for employees and employers, 15.3%, up to a maximum amount for the Social Security part each year.
For 2020, the first $137,700 of your combined wages, tips, and net earnings is subject to any combination of the Social Security part of self-employment tax, Social Security tax, or railroad retirement (tier 1) tax. The amount increased to $142,800 for 2021. This tax also includes an additional Medicare tax for self-employed individuals who earn more than $200,000 in a year.
Self-employment tax is based on the net income from your business, and it’s calculated on Schedule SE as part of your total tax calculation for the year. You can deduct half of the tax each year (equal to the amount employers pay for this tax) in calculating your total federal income tax for the year.
Sole proprietors, partners in partnerships, and owners of limited liability companies (LLCs) are considered self-employed for the purpose of paying self-employment taxes. Owners of corporations and S corporations, on the other hand, are shareholders and they are not considered to be self-employed for the purpose of self-employment tax.
If your business income is less than $400 a year, you don’t have to pay self-employment tax for the year. But you also don’t qualify for any Social Security credits for that year.
Qualified Business Income Deduction
Self-employed individuals may be eligible for a qualified business income deduction each year. The deduction is up to 20% of qualified business income in addition to the regular business income tax deductions for the year. It’s a deduction for the owner, not the business, and corporations aren’t eligible.
Some income that’s not included for this deduction is income from outside the U.S., business investment and owner dividend income, capital gains, and non-business interest income.
Home Office Expenses
If you work from home as a self-employed business owner, you may be able to take a deduction for the space you use regularly and exclusively for your business. To take this deduction, you may also have to show that it’s your principal place of business.
You have two options for calculating the amount of this home business space deduction—actual expenses and a simplified option.
Actual expenses include expenses specifically for the area and a portion of expenses for your home location. In this option, you must measure the area of your business space and divide by the total space of your home for some expenses.
The simplified calculation allows you to multiply your business space (up to 300 square feet) by the current IRS rate of $5 a square foot to take the deduction.
Both options have some limitations and neither option allows you to take a home office deduction that is greater than your business net income.
IRS Publication 587 Business Use of Home includes a flow chart to help you determine if you can qualify for this deduction.
Retirement Savings Plans
You may want to consider one of several retirement savings plans set up for self-employed individuals and small business owners and their employees. Benefits of these plans include:
- Taking income from a higher tax year to a lower tax year (after retirement, for example)
- Deducting your contributions as a business owner or employer, up to specific limits each year
- Using this benefit to attract and keep employees
The individual (business owner or employee) contributes to the plan for the year and the tax on the contribution is placed into a specific retirement plan (deferred), where it accumulates tax-free.
Two types of plans available to business owners and their employees:
- A Self-Employed Individual Retirement Account (SEP-IRA), for business owners to make contributions for themselves and their employees
- A SIMPLE IRA plan, with a savings incentive match plan for employees
In order to be qualified for tax benefits, retirement plans involving employees must comply with the Employee Retirement Income Security Act (ERISA). The plan must be set up in line with the tax law, with annual limits on contributions, and the plan must be operated according to IRS regulations.
You might also want to consider a Self-Employed 401(k) Plan for yourself and your spouse. This plan isn’t for employees, and these plans are not regulated under ERISA.
If you set up a plan that includes employees, you may be able to claim a tax credit for the cost of setting up several types of retirement plans. Talk to your tax professional to learn more.
If you buy major items for your business—a car, equipment, retail shelving, or equipment to make a product, for example—you can deduct the cost of these items over several years. This is a process called depreciation and it’s another type of deduction that can reduce your business tax bill.
Depreciation is expensing the cost of capital assets (lasting over one year) over a number of years. For example, if you buy a computer network system that costs $10,000, and its useful life is 8 years, you can deduct $1,250 a year as an expense.
To qualify for the depreciation deduction, your business must own the property and it must be used in your business. There are several ways to depreciate property and the IRS has some additional requirements and limitations, so check with your tax professional.
Business driving is an important expense for many self-employed individuals. If you use your car for both business purposes and personal reasons, you must separate the business driving and personal driving mileage and use only the business mileage to calculate this expense. The two ways to calculate this expense are to use either actual expenses or the standard IRS driving rate, which changes each year.
For example, if you put 10,000 miles on your car during the year, with 3,000 of those miles being driven for business, your business use is 30% of your mileage. Using the 2021 standard mileage rate of 56 cents a mile, multiply that by 3,000 miles to get a deduction of $1,680. Using actual total expenses of $3500, multiply by 30% for a deduction of $1,225.
Commuting back and forth from home to work is personal mileage and it can’t be deducted, except in some limited circumstances. If your home is your principal place of business, you can deduct costs going from your home to work locations.
The IRS looks closely at business driving expenses, so it’s important to keep accurate records of all business driving. For each business trip, note the date, time, miles driven, and business purpose. Using a mileage app is an easy way to separate business and personal miles.
Other Business Expenses
Rent and Leasing
You can deduct expenses involved with renting your business location. Rent for business use of your home is deducted as part of your home business expense (explained above). If you pay rent in advance, you generally can only deduct the rent for the year for which it applies. For example, if you pay 2021 and 2022 rent in advance, you can only deduct the 2021 portion on your 2021 business tax return.
If you lease a car, you can deduct your lease payments for each year as part of your actual driving expenses, or you can use the standard mileage rate (explained above).
You can deduct expenses for work-related education on your business tax return as a self-employed business owner. The education must meet one of these requirements:
- Required by an employer or the law to keep your present salary, status, or job like continuing education for professionals, for example
- Necessary to maintain or improve skills needed in your present work.
The education doesn’t qualify if it’s needed to meet minimum educational requirements or to qualify for a new trade or business.
Interest expenses are deductible business expenses for several types of interest. All of these types of debt must be part of your business activity. Some examples are:
- Installment sales
- Credit card debt
- Mortgage interest on business property
If you use a loan or credit card for both business and personal reasons, you must separate the interest according to the percentage of use. This is a good reason to get a separate credit card for your business.
Reducing Your Self-Employment Taxes
The best way to reduce your self-employment taxes is to reduce your business income. Increasing your business expenses to avoid (not evade!) taxes is a good way to do this.
As your business grows and your profitability increases, you may want to consider changing your business legal type to a corporation. The corporate tax rate of 21% may be lower than your personal tax rate and you won’t have to pay self-employment taxes. If your business is an LLC, you may consider electing corporate or S corporation tax status while keeping your business operating as an LLC. This decision is complicated, so talk to your financial and tax advisors first.
If your business has had losses from your business operations in past years, you may be able to carry some of those losses forward to current or future years and use those losses to reduce your taxable income in those years. There are temporary regulations for COVID-19-related situations in 2019, 2020, and 2021, so check with your tax professional if you think you might be able to use this provision.
For More Information
All of these business tax deductions come with qualifications and limitations. You can find more details on IRS Publication 535 Business Expenses. You should also get help from a licensed tax professional to report and file your business tax return.