Starting a new business is a serious challenge, with many things demanding a new business owner’s attention. There are lots of expenses associated with the start-up and day-to-day operation of a business. Fortunately, from a business profit-and-loss perspective, and from a tax point of view, many of the expenses are deductible on one’s Schedule C, with the effect of lowering the business’s net profit, and therefore the owner’s income tax.
Deductible expenses are defined in IRS Publication 535, Business Expenses, as those that are “ordinary and necessary.” In this context, “ordinary” means a common and accepted expense for your industry. For example, a mobile computer repair person might legitimately purchase an oscilloscope, but an accountant would not ordinarily do so. “Necessary,” on the other hand, means that the expense is for something helpful and appropriate for the business. It does not mean that it is indispensable.
Many expenses are common to most business, such as office supplies, printer paper and toner, mailing expenses, advertising, insurance, and mileage. Although tracking these expenses may seem tedious or cumbersome, doing so will pay off by lowering your tax bite.
Here are five deductions that can benefit those who own small businesses or are self-employed.
Tax Deductions for Freelancers and Business Owners
Most forms of advertising expenses are deductible, including flyers, mailers, print ads, and business cards. In addition, table fees or other small business expenses incurred for the promotion of your business may also be deducted as advertising expenses. Fees that you pay Yelp or Google, for example, for advertising associated with your online presence are also deductible.
2. Website Expenses
If you have a business website, costs associated with creating and maintaining it are also deductible business expenses. Such costs could include fees for hosting, domain name, website design, software, or licensing fees for images used. As long as these are for the exclusive use of the business, they are fully deductible. Although frequently listed under “Other Expenses,” the business use portion of Internet access fees and router rental are also deductible (see Schedule C, line 27a, and Part V on page 2).
3. Home Office Expenses
If you use some part of your home or property for business use and you use it exclusively and regularly for business, you may be able to take a deduction for expenses related to your home office. The two requirements are that:
- It is your principal place of business, and
- You use it regularly and exclusively for business
There are two methods to calculate the deduction:
- The Simplified Method, or
- The Regular Method
With the Simplified Method (specified in Revenue Procedure 2013-13 ), you multiply the square footage of the office or business area (not more than 300 sq. ft.) by $5 per square foot to determine the amount of the deduction. The deduction is the smaller of the business net profit and the calculated office deduction. For example, if your office area is 200 sq. ft., the potential deduction is 200 x $5 = $1,000. However, if your net profit is $800, then the deduction is limited to $800. The unused $200 cannot be carried forward to the next tax year. See Simplified Option for Home Office Deduction for more details.
The benefits of the Simplified Method are:
- Minimal record-keeping, just the square footage of the business-use area
- Other household expenses, such as mortgage interest and property taxes are deductible in full on Schedule A (Itemized Deductions)
- Depreciation is not allowed, so it does not have to be recaptured when the property is sold
The Regular Method is more complicated to calculate, but may result in a larger deduction. There are several steps to figuring the office-in-home deduction:
- First, measure the business-use area and divide by total square footage of the home. Multiplying the resulting decimal by 100 gives you the percentage of business use. For example, if the office is 200 sq. ft., and the house is 1,600 sq. ft., the percentage is 200/1,600 x 100 = 12.5%.
- Next, determine any direct expenses. These are expenses that apply only to the office, such as the cost of painting the office. There may not be any direct expenses.
- Third, determine the annual expenses for the home. If you own your home, this could include mortgage interest, property taxes, utilities, insurance, repairs and maintenance, and depreciation. If you rent, this could be rent, utilities, and insurance, for example. Unrelated expenses, such as lawn care or painting a room that is not the office, are not indirect expenses and are not deductible.
- Combine the direct and indirect costs for the year.
- Divide the total costs by the total square footage and multiply by the office square footage. Let’s say the total costs were $16,000. Then the deduction is $16,000/1,600 sq. ft. x 200 sq. ft. = $2,000.
The disadvantages to the Regular Method are:
- The calculation is more complicated, and it requires filing an additional form.
- Record retention needs to be detailed and thorough, including tracking depreciation.
- You must recapture the depreciation when you sell the house, even if you did not include depreciation in your calculation of the deduction – the requirement is to recapture depreciation “allowed or allowable.” See Publication 587, Business Use of Your Home, under the heading “Depreciation.”
It is more difficult to calculate and document the Regular Method, but, as you can see from the example, it resulted in a larger deduction than the Simplified Method. The Regular Method requires filing Form 8829 with your return. The Instructions for Form 8829 have more details that may be useful.
A similar limitation on the Office-in-Home deduction applies to the Regular Method as well as the Simplified Method. Namely, your net profit must be greater or equal to the calculated deduction for Office-in-Home. However, with the Regular Method, there is an ordering principal that determines how the business deductions are applied. This ordering is spelled out in Publication 587, Business Use of Your Home, but note that depreciation is applied last.
One last thing: If you itemize deductions, the deductible costs, such as mortgage interest and property taxes, that are not allocated to the business-use percentage are deductible on Schedule A as itemized deductions. In our example, where the business-use percentage was 12.5%, the other 87.5% of mortgage interest and property taxes, for example, would be deductible on Schedule A. See also IRS Home Office Tax Deduction – Rules and Calculator.
4. Business Travel
If you travel out of town for business purposes, some or all of the costs may be deductible as a business expense. The cost of plane, train, bus, or car rental for the trip is deductible. Lodging is also deductible. Meals and entertainment for business are 50% deductible.
Other expenses for luggage fees, taxi fares, dry cleaning and laundry, business calls, public stenographer fees, and computer rental or Internet access fees are also deductible. So are tips paid in conjunction with any of the noted items. If you drive your own car, rather than take public transportation, you can deduct the associated business mileage at $.535 per mile for 2017. You can also deduct parking fees and tolls. More information may be found in Tax Topic 511 – Business Travel Expenses.
If you use your vehicle for business purposes, you have the choice of deducting actual expenses or the standard mileage rate for your business miles. Included in actual expenses are the costs for gas, oil, repairs, tires, insurance, registration fees, licenses, and depreciation (or lease payments). The total of these expenses for the year is prorated according to the business use.
For example, of the 20,000 miles you drive in a year, if 4,000 miles are for business, then the business use is 4,000/20,000 x 100 = 20%. So, if your actual costs were $6,000, the deduction would be $6,000 x .20 = $1,200. The standard mileage rate for those 4,000 business miles would be 4,000 x .535 = $2,140. So, the standard mileage rate generates a pretty generous deduction. Even if you use the standard mileage rate, you can still deduct related tolls and parking fees.
You need to maintain a written record of your mileage for the IRS to allow your mileage deduction. Although this may seem tedious, there are many apps available for your smartphone that can help streamline this function . Remember, you must keep receipts and a mileage record to deduct actual expenses as well.
Be aware, you cannot deduct commuting miles as business miles. If you have a regular job, and a business on the side, the miles you drive to and from your regular place of employment are commuting miles and are not deductible. See Tax Topic 510 – Business Use of Car for more information.
5. Self-Employed Health Insurance Deduction (SEHI)
Self-employed individuals frequently must purchase their own health insurance. Besides the health benefits, you may also qualify for a deduction on your personal tax return.
If you file a Schedule C as a sole proprietor, independent contractor, freelancer, or single-member LLC, your business shows a profit, and you have no other health insurance, you may be able to deduct health and dental insurance premiums for yourself, your spouse, and your dependents (under age 27 at the end of the tax year). You may also be able to deduct long-term care insurance premiums.
The SEHI deduction is not taken on Schedule C. It is taken on Form 1040, page 1, in the Adjustments section, at line 29.
The amount of the deduction is the smaller of the insurance premiums and the business’s net profit. Note that Medicare premiums may be used for this insurance deduction. The insurance can be in your name or in the name of the business. If your business profit limits the amount of the SEHI deduction, you can deduct the balance as a medical deduction on Schedule A (Itemized Deductions).
To summarize: You can take the SEHI deduction if the following conditions are met:
- Your business shows a net profit
- You have no other health insurance
- You pay for health insurance purchased in your name or the business name
- Your deduction is the smaller of the premiums paid and your business’s net profit
Premiums for qualified long-term care insurance may be included in figuring the deduction, but are limited for 2017 according to the age of the person insured, as follows:
- Age 40 or younger: $410
- Age 41-50: $770
- Age 51-60: $1,530
- Age 61-70: $4,090
- Age 71 or older: $5,110
With these allowed long-term care premiums, combined with regular health insurance premiums, the deduction is the smaller of the net business profit or the total insurance premiums.
Tax Tips for the Self-Employed
As a self-employed person, whether you think of yourself as a freelancer, independent contractor, or sole proprietor, there are a few best practices that will keep you in good stead in the event of an IRS audit.
1. Keep All Your Records
If your return sets off a red flag and that results in an audit, you will need to verify and justify your business expenses. If you are being audited for prior years, it can be difficult to remember all the details of all your transactions. It is important that you keep good records and have an organized way to store your receipts.
If you use a cash-based accounting system and use QuickBooks, you’ll want to record your income when received, and record your expenses when paid. With the online version, you have easy access and can record your income and expenses as you go, rather than waiting until the end of the month, for example. If storing and organizing your receipts is a problem for you, Shoeboxed has a number of solutions that could benefit you, one of which is free.
2. Set Up Separate Accounts for Business and Personal Use
At minimum, you should keep your personal and business transactions separate. Having a business bank account and credit cards are a must. If you do business online, having a business PayPal account is important as well. Without separate accounts, it may not be clear to the IRS that you do, in fact, have a business. To keep track of what money belongs to you vs. the business, write yourself a check to get funds into your personal account (if the company makes a profit).
3. Get a Post Office Box for Business Use
You can keep your business and personal mail separate by renting a post office box for the business. The USPS says it increases privacy, security, and accessibility. A small post office box will probably run between $50 and $60 for six months. The fee is a deductible business expense.
4. Don’t Go Overboard With Deductions
Although a business may legitimately end up with a loss for the year, be careful that it doesn’t happen too often. The IRS considers a business to be engaged in for profit if it shows a profit in three of the past five years. If it is not engaged in for profit, then it would be considered a hobby, and expenses could only be deducted up to the amount of income. A hobby “loss” cannot offset other income. More information can be found in IRS Publication 535, Business Expenses.
There is no compelling reason to pay more tax than necessary, so deduct all of your eligible business expenses. But be sure to maintain thorough and accurate records of those expenses. You do not want to lack appropriate documentation during an audit and end up owing not only back taxes, but penalties and interest as well.
If you’re a freelancer and independent contractor, what other small business deductions have you used?