What Is a Tax Deduction? A Guide for the Self-Employed

What Is a Tax Deduction? A Guide for the Self-Employed
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When you're self-employed, you pay federal income tax along with both halves of Medicare and Social Security taxes. As a result, you can end up with a heavier tax burden than traditional employees. But at the same time, the Internal Revenue Service allows you to benefit from several tax deductions that small businesses and independent contractors can take. These range from deducting business expenses and part of your self-employment tax to deducting mortgage interest and utilities for a home office.

Use this guide to learn about several tax deductions available to the self-employed and why they're so important.

Tax Deduction and Its Importance

Before learning about specific tax deduction options for your business, it helps to understand how taxes work on self-employment income and how deductions can help you out. When you're self-employed, you'll pay a total of ​15.3 percent​ (​12.4 percent​ for Social Security and ​2.9 percent​ for Medicare) in self-employment taxes on your business's net profit as determined on your Schedule C. Then, you pay federal income tax on your taxable income as determined on your 1040 form.

Simply put, a tax deduction works to reduce your self-employment income that is subject to these taxes. The type of deduction can determine which taxes get impacted. For example, when you take deductions for business expenses like equipment, advertising, travel and other items on your Schedule C, these help decrease your business's net profit, and thus your income subject to both self-employment and federal income taxes. Other deductions, however, simply impact your income subject to federal income tax and don't change the self-employment tax due.

It's important to differentiate between a tax deduction and a tax credit as these often get confused. While a tax deduction cuts your taxable income, a tax credit actually directly lowers your income taxes due. So, while a ​$50​ credit would cut your taxes by ​$50​, a ​$50​ tax deduction would just cut your taxable income by ​$50​. Keep in mind that a tax credit may actually be refundable, meaning you could get the money even if your tax liability is zero.

Standard Deduction vs Itemized Deduction

It's important to note that the IRS requires that you itemize your deductions on your tax return rather than take the standard deduction for some types of deduction options. For the 2020 tax year, a single independent contractor would get a ​$12,400standard deduction for determining income subject to federal tax, while a married couple filing jointly would get ​$24,800​. But for a taxpayer to deduct things like miscellaneous and medical expenses, they'd need to take the itemized deduction option, and the total may be far less than the standard deduction would be.

Qualified Business Income Deduction

When the Tax Cuts and Job Act passed in late 2017, it added a new tax deduction for small businesses that can help you reduce your taxable income as long as your business meets some criteria. Whether you have a sole proprietorship, limited liability company or partnership, you could get to deduct as much as ​20 percent​ of your business's net income thanks to the qualified business income deduction. To qualify, you need to pass an earnings test where you made a max of ​$163,300​ if you're single and ​$326,600​ if you're married filing jointly.

The IRS has numerous rules on what constitutes "qualified" income, so you'll need to make sure your income counts. For example, you can't use this deduction for interest income, capital gains or dividends as well as international income. If you do qualify, your taxable income determines whether you get ​20 percent​ or a phased out rate.

The Internal Revenue Service allows you to benefit from several tax deductions that small businesses and independent contractors can take. These range from deducting business expenses and part of your self-employment tax to deducting mortgage interest and utilities for a home office.

Half of Self-Employment Tax

When you're a self-employed person, you determine how much Medicare and Social Security tax you owe when you complete your Schedule SE. And while you don't get an employer's help covering half of those taxes, the IRS gives you a benefit that regular employees don't get. You can deduct half the amount of your self-employment taxes when it comes time to calculate your adjusted gross income. This means you'll pay less in federal income taxes thanks to this tax deduction.

Home Office Deduction

If you're one of the many self-employed people who primarily work out of their homes, then the IRS offers a home office deduction that can benefit you financially to make up for some of the costs you've likely incurred to make part of your home suitable as a work area. This deduction requires that you use your home office exclusively for work on a regular basis, although the IRS still allows you to also meet your customers elsewhere occasionally.

The deduction also accounts for direct expenses, like repairs to your home office space, along with indirect expenses, like your rent, utilities, repairs, mortgage interest and insurance. Such costs are often prorated based on your home office's size in relation to your home.

The IRS allows for two approaches to determining this deduction. Along with having different requirements, they have their pros and cons for which you need to decide which best fits your home office situation and costs incurred.

These two calculation methods are:

  • Simplified method​: Does your home office space take up at most ​300 square feet​ and you'd rather not worry about complex calculations and record searches? To make things easy, the IRS will let you multiply your home office space in square feet by ​$5​ to get an amount you can deduct from your self-employment profit. For example, a ​150-square-foot​ home office would allow a ​$750​ deduction. There's no accounting for actual costs with this method.
  • Standard method​: Do you have good records of your home office costs and want to potentially get a higher deduction? If so, the IRS allows you to total up your indirect and direct costs, as well as account for your home's depreciation, and get a deduction based on actual costs. Direct expenses allow for a ​100 percent​ deduction, but indirect ones have to be prorated based on the percentage of your home that your home office space utilizes. For example, if your home office takes up a percentage of ​15 percent​, you could deduct just ​$450​ of ​$3,000​ indirect expenses.

Business Vehicle Deduction

If you travel to perform your work or meet clients, then you can benefit from the business vehicle deduction. This helps you account for gas used and the wear and tear on your car. At the very least, you need to know how many miles you drive for work. If you plan to use a more involved calculation method, you need to save receipts associated with costs like parking fees, car maintenance and repairs, gas, insurance and lease payments.

As a simplified option, you can multiply your business mileage by the 2020 standard mileage rate of ​57.5 cents​ to get a deduction. Otherwise, you gather your receipts and records for car expenses and calculate a deduction based on those costs for the actual business (vs. personal) use of the vehicle.

Business Insurance Deduction

Depending on where and how you work, you could have one or several business insurance policies. For example, you might rent a storefront that has property insurance, or you might need a liability insurance policy to cover incidents that may occur when you work. As long as it makes sense or is required for your self-employed work, then you can deduct it along with all your other business expenses on your Schedule C.

Credit and Loan Interest Deduction

As long as the loan or credit card belongs to you, and you've got a formal agreement that shows your liability, you can often deduct the interest to help lower your taxable income. For example, business credit cards and business loans could qualify, while loaned money from family along with personal credit cards used to buy personal items wouldn't. The IRS requires that the charges be for business expenses and that you've actually used the loan money. Certain items like capitalized interest and origination fees aren't deductible.

Startup Cost Deduction

The IRS understands that becoming self-employed can require a large sum of money up front to buy what you need to get started. So, it offers an exception to its usual rule of needing to spread out such costs over many years as long as you didn't incur ​more than $50,000​ in startup costs. If you qualify, you can deduct ​as much as $10,000​ in combined business and organizational costs for the tax year during which you started the business, and the rest will be spread over time. Otherwise, you need to deduct the costs over a ​15-year​ term.

Professional Business Services Deduction

Whether you've contracted with a web designer to make a website for you, hired someone to give your office a one-time cleaning or sought legal advice through a local lawyer, these kinds of business services and expertise often qualify as deductible expenses. However, keep in mind the services must be related to your business, so asking your lawyer to help with personal issues won't count. Other things you can deduct on your Schedule C in this category include tax preparation and licensing fees.

Read More​: Types of Business Expenses

Continuing Education Deduction

To succeed as a self-employed person, you often need to pursue continuing education to learn about changes in your field and offer more value to clients. Luckily, the IRS allows you to deduct many related education costs such as class tuition, books and examination costs as long as they're for maintaining your current business skills or building onto them in a way that doesn't prepare you for a whole new profession. So, a certified public accountant could deduct continuing education courses to stay licensed, but if they started taking courses to become a real estate agent, the cost for those wouldn't count as a deduction.

Office Equipment and Supply Deduction

Whether you need a computer, pens, phone or furniture for your business, you can usually deduct such office supplies on your Schedule C if they're reasonable for your line of work. Items ​up to $2,500​ can usually be deducted outright that tax year, while items like more expensive electronics would need to be depreciated over several years. If the item has a mixed business/personal use, you can only deduct the percentage used for business.

Read More:​ Depreciation of Business Assets: Definition, Calculation & How it Affects Your Taxes

Business and Advertising Cost Deduction

Costs for spreading the word about your business through various advertising and marketing activities also count as a deduction. For example, you can deduct the costs of making flyers, airing radio and TV advertisements, using online ads and even hosting a website for your business. Just keep in mind the advertising should be related to giving your business a good word rather than promoting personal or political causes to qualify.

Internet and Phone Deduction

Since there's a good chance you have phone and internet service for your business, you should know you can deduct these costs whether you work from home or an outside office. If the lines are dedicated, you can deduct the whole cost. Otherwise, you calculate the percentage used for business and then determine the business expense accordingly. You can pair this with the equipment deduction to account for your business phone and internet equipment too.

With these common tax deduction options for the self-employed in mind, know that there are plenty of other deductions available. Take a look at Schedule C to see a complete list of business expenses. There are also plenty of personal tax deductions you could qualify for, especially if you itemize on your tax return.