Filing Your Income Taxes

Form 1099

Self-Employed Tax Deductions, Benefits & More

Self-Employed Tax Deductions, Benefits & More
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Being self-employed comes with a lot of advantages. There’s a certain amount of freedom involved, and your work efforts contribute directly to your own bank account – you’re not limited to a prescribed wage or salary from your employer’s earnings. On top of that, you become eligible for a few nice tax breaks as well.

Your Business Income on Schedule C

Sole proprietors, sometimes referred to as independent contractors, aren’t incorporated. They're required to file a tax return if their net – not gross – earnings are ​$400 or more​, and completing Schedule C, "Profit or Loss From Business," tells you your net earnings. This is where you’ll calculate your taxable income and you must submit the schedule with your tax return. You’re not taxed on every dime your small business earns.

Schedule C begins with your self-employment income. This includes anything anyone has paid you for your services, including the fair market value of non-cash compensation, such as if someone repairs your oven in exchange for you redesigning their website.

Claiming Business Expenses on Schedule C

Now you get to begin whittling away at the total of your income. You can start subtracting your business expenses. The IRS indicates that a business expense is tax-deductible if it’s “necessary” and “ordinary” in your line of work. Necessary means that it helps you perform the service you provide. Ordinary means that most people who do what you do for a living also have to meet this expense.

The IRS makes the point that an expense doesn’t have to be “indispensable” to be considered necessary, but you must use it to perform your work in some way. It can’t be personal – the cost of that manicure isn’t deductible on your Schedule C unless you’re a hand model. It can do double-duty as both a personal and a business expense, however, subject to some rules.

You must figure out the percentage of each type of use if an expense has both personal and business associations. You could deduct $30 if you pay $100 toward an expense for which 30 percent is dedicated to your work. Otherwise, you can deduct ​100 percent​ of the cost of anything you spend purely for business purposes. It doesn't do double duty.

Business expenses can include the cost of rent or mortgage interest if you lease or own a business location, insurance premiums, ​57.5 centsper mile you drive for business purposes as of the tax year 2020 and if you decide not to deduct the business percentage of your actual auto expenses instead, utilities, office supplies, taxes and legal and professional fees.

Calculating the Home Office

Another particularly nice tax break for the self-employed business owner and freelancers is the home office deduction, but this, too, comes with some gray-area rules regarding business versus personal use.

Let’s say that you work from your spare bedroom, attic or garage. You don’t rent or own a separate business location. You can deduct the portion of your mortgage interest or rent, utilities, real estate taxes and insurance that are associated with the space you use for business purposes. Detached structures are okay, too – your space doesn’t have to be within the four walls of your home. It just has to be on your property.

You could deduct ​20 percent​ of your overall home-related expenses on Schedule C if your workspace takes up 20 percent of the entire square footage of your home. That’s $500 a month if these household expenses average $2,500 a month. You can also deduct ​100 percent​ of the cost of “direct” expenses that don’t also contribute to the rest of your living space, such as an alarm system in the garage where you store products that doesn’t also protect your home.

Rules for Home Office Deductibility

Other rules apply to claiming a deduction for your home office as well. You must use the work area exclusively and regularly as your place of business. You generally can’t claim a few square feet for that corner in your kitchen where you occasionally take care of business-related responsibilities because a whole lot more than business goes on in your kitchen. Nor can you claim that spare bedroom if you typically do your work elsewhere and you only visit it once in a while to get on the phone to scare up more business.

“Exclusively” means nothing else but business goes on in your workspace, and “regularly” means that you consistently spend time there, either performing your work or at least seeing to bookkeeping and other business-related tasks more or less on a daily basis. You don’t maintain any other location where you can take care of business.

Exceptions to the “exclusive” rule exist for spaces where you might store inventory and for daycare facilities, and the IRS offers a simplified option for the home office deduction if you don’t want to get bogged down in all these calculations. You can claim a deduction of $5 per square foot for up to 300 square feet of work area instead, but you might find that you’re shortchanging yourself if you take this easy way out. Doing the full calculation often works out to more. In either case, your home office deduction can’t exceed your gross business income. In other words, it can’t result in a loss on Schedule C, at least not by itself.

Don’t hang that “Open for Business” sign in your spare room’s window just yet. Some tax aspects of self-employment aren’t quite as sweet as those that pertain to your qualified business income, your home office and health insurance.

The Self-Employed Health Insurance Deduction

Not all your self-employment deductions are calculated on Schedule C. You can claim the self-employed health insurance deduction right on your 1040 and without itemizing, something employed taxpayers aren’t permitted to do.

You can deduct the costs of personal health insurance premiums for yourself and your family, subject to certain rules. And yes, this deduction is purely personal, not business-related – that’s why it doesn’t go on Schedule C. It’s an adjustment to income, which is why you don’t have to itemize to claim it. You can take it then claim the standard deduction or itemize as well. You must show a net profit on your Schedule C to be eligible for this tax break.

The QBI Deduction

The IRS has one more very nice gift for you if you’re self-employed: the qualified business income deduction. You’ll recall that tax reform – the Tax Cuts and Jobs Act – turned several aspects of the U.S. tax code upside down and inside out beginning with tax year 2018. One of the provisions included in the TCJA was the QBI deduction for small businesses. It amounts to up to ​20 percent​ subtracted from your qualified business income.

Of course, there’s that word “qualified” again. Certain rules must be met. There are some limitations on the deduction based on your taxable income, the nature of your business, wages you might have paid to employees and the value of any business assets you own. You must operate as a sole proprietor, an S corporation or a partnership. C corporations don’t qualify.

Your taxable income must be ​$163,300​ or less as of ​2020​ if you’re filing as a single taxpayer, head of household or qualifying widow(er). This income limit increases to ​$326,600​ if you’re married and filing a joint return. Certain “specific service trades or businesses” are excluded, such as:

  • Healthcare services
  • Lawyers
  • Accountants
  • Performing arts
  • Consulting
  • Athletics
  • Financial and brokerage services

You can additionally take ​20 percent​ off any real estate investment trust and publicly traded partnership income you might have. This is another separate deduction from those you would claim on Schedule C, and you can itemize or take the standard deduction in addition to claiming it. It’s a percentage of your net business income after you make all those calculations on Schedule C. It doesn’t apply to any wages or salary income you might also earn, or to other types of investment income.

The Self-Employment Tax

Don’t hang that “Open for Business” sign in your spare room’s window just yet. Some tax aspects of self-employment aren’t quite as sweet as those that pertain to your qualified business income, your home office and health insurance.

You’re also liable for paying the self-employment tax if your net earnings on Schedule C, after claiming all your business expenses, are ​$400 or more​. This tax represents the Medicare and Social Security taxes you would split with your employer if you worked for someone else. You ​are​ your employer when you’re a sole proprietor, so you get to pay both halves – sort of. The IRS lets you claim another adjustment to income on your tax return for the half of these taxes that would normally be paid by your employer. So yes, you’re paying that other 50 percent, but you get to subtract it from your overall income to reduce your income tax.

You can calculate your self-employment tax on Schedule SE and submit it with your Form 1040 tax return. The Social Security portion is ​12.4 percent​, and the Medicare tax adds on another ​2.9 percent​, for a total of ​15.3 percent​. But you only have to pay the Social Security portion on the first ​$142,800​ you earn in the ​2021 tax year​, at least until 2022 arrives. Then you have to start paying the Social Security portion of the self-employment tax once again until you hit that year’s wage base. It’s adjusted a little annually to keep pace with inflation.

Paying Estimated Taxes

There’s one more downside to the sole proprietor tax picture, at least if you’re not fond of bookkeeping and calculations. Everyone – employees and sole proprietors – must pay taxes on an ongoing basis, but employees have this little detail taken care of for them by their employers. The IRS wants to be paid as you earn, so employers deduct or withhold taxes from their workers’ pay and remit the funds to the IRS on their behalf. You must take care of this detail on your own if you’re self-employed and if you expect that you’ll owe the IRS ​$1,000​ or more when you file your tax return.

You don’t have to do it every week or even once a month. You must pay estimated taxes quarterly. You’re effectively taking an educated guess at what you think you’ll owe the IRS at year’s end and dividing that number by four, then sending that amount to the government every three months. Your calculations should include the self-employment tax you’ll owe.

You’re not locked into doing this just four times a year. You can remit estimated tax payments monthly or even more often if you find that makes your calculations easier. You just can’t do it less frequently than four times a year or you could be hit with a tax penalty.

All told, some might say that the tax breaks associated with self-employment outweigh these drawbacks.