The (Almost) Ultimate Guide to Self-Employed Expenses and Tax Deductions
One of the biggest shocks of self-employment is the relatively large tax burden that usually comes with it. As a self-employed professional, you seek to reduce your taxes as much as legally and ethically possible. There are only two ways to accomplish this—either from working less (and earning less) or by claiming lawful deductions.
In this guide, we’re going to focus on the latter choice. This will help you understand what self-employed deductions are, how they’re made and which ones are relevant to you as a freelance professional.
How Do Tax Deductions Work?
A self-employed tax deduction is designed to decrease your taxable income, therefore saving you a bit of money on taxes. To claim certain deductions, you have to fill out specific IRS tax forms and verify whether you can itemize any expenses.
Most self-employed people will use the following forms:
- Form 1040 (Note: You cannot use Form 1040-A or 1040-EZ, as you cannot include self-employed income on either)
- Schedule C (or Schedule C-EZ, for claimed expenses less than $5,000)
- Schedule SE
Deductions reduce your taxable income and are placed on Schedule C of your Form 1040.
How Do I Make a Legitimate Business Tax Deduction?
To be a legitimate business expense, it must be both “ordinary and necessary” as it relates to the operation of your small business. An ordinary expense is accepted if it’s considered common within your industry or trade, while a necessary expense is both helpful and appropriate within the confines of your industry.
According to the IRS, ordinary and necessary expenses include business expenses, cost of goods sold, capital expenses and some personal expenses. To claim a legitimate business deduction, you must first separate your business and personal expenses. Business deductions are listed on Schedule C, which details the profit or loss from a business.
NOTE: There’s a very important difference between personal deductions and business deductions. Personal deductions can be claimed as itemized deductions on Schedule A, but only if you forego the standard deduction. Personal deductions are those commonly called “itemized deductions,” which include:
- Personal mortgage interest payments
- Personal medical expenses
- State and local income taxes
- Casualty or theft loss
- Unreimbursed employee expenses
- Investment costs
- Tax prep fees
You may qualify to fill out a Schedule A with your tax return if your total itemized deductions exceed your standard deduction (which is $6,300 if your filing status is single or $12,600 for married filing jointly). Itemized deductions only include personal expenses. They do not include deductions for business expenses.
With that out of the way, let’s get back to business-related self-employed deductions.
How to Deduct the Business Use of Personal Assets
Once you’ve separated your business and personal expenses, you can accurately deduct the cost of doing business. You cannot deduct regular living or family expenses, but you can claim business use of personal assets. These “mixed-use assets” can include your home and your car, as well as a portion of your phone and internet plans, home insurance and even your mortgage, as they relate to the home office deduction.
A “mixed-use asset” is an asset that’s used partly for business and partly for personal purposes. You can divide the total cost between business and personal use to come up with a percentage. Simply calculate the percentage of what each one is used for, then deduct the business portion of that expense.
For example, let’s say you drive your car 1,200 miles per month, but only 400 of those miles are for business-related trips. Thirty percent of the miles you drove constitute a business use of the car, and thus can be claimed on Schedule C.
What You Can’t Deduct (But Feels Like You Can)
Although a business transaction may be related to the cost of doing business, it doesn’t always mean it’s a legitimate business expenses. Here are six examples of deductions you cannot make for business.
- Business clothing and shoes: The only thing you can deduct for clothing is a uniform or protective clothing that you’re required to wear for work.
- Commuting costs: Business miles are deductible, but commuting from the house to your office is not.
- Coffee and dining out: You can only deduct the cost of a meal or coffee if you’re meeting with a client. You’re allowed 50% as a meal and entertainment expense, but not if you’re alone.
- Traffic tickets: Even if you’re on a business trip, any tickets, fines or penalties you incur are not tax-deductible.
- Tech gadgets and toys: Just because you want the latest and greatest technology doesn’t mean it’s deductible. Only computers, mobile phones and tablets that are essential to running your business qualify as a deduction.
What You Can Deduct
Now that you have an understanding of expenses that are not tax deductible, here are some examples of the most popular legitimate self-employed tax deductions.
Home Office Deduction
To accurately calculate and claim the home office deduction, this part of your home must be used exclusively for conducting business. It cannot be a dual-purpose space.
Prior to the January 2014 filing season, self-employed taxpayers had to use the Regular Method to calculate the home office deduction, where you had to determine the actual expenses of your mortgage, utilities, insurance and other costs.
Now, you can use the Simplified Option for computing business use of the home. You simply deduct $5 for every square foot of your home office, up to $1,500 per year (or 300 square feet).
It’s up to you to decide which method provides the biggest tax break for your specific case. But for a more in-depth guide to claiming a home office deduction, see our article on choosing the regular method or simplified method.
Car-Related Costs (Mileage vs. Actual Expenses)
When deducting the business use of your car, especially as a ridesharer, there are two options: the Standard Mileage Rate and the Actual Expense Method. With the Standard Mileage Rate, you take a deduction for a certain number of cents per mile. For tax year 2015, each business mile driven is worth $0.575 per mile.
If you choose to use the Actual Expense Method, you can deduct the actual costs of using your vehicle, which includes gas, oil changes, repairs, maintenance, business-exclusive car insurance and others, along with any depreciation costs. This method requires much more record keeping, but could result in a larger tax deduction in certain fringe tax situation.
Most drivers will be better served by the Standard Mileage Rate.
Meals and Entertainment
To claim costs you spent on meals and entertainment, you’ll need to keep adequate records. Save all receipts, and include the total amount, time, place, purpose of business meeting and the business nature of your relationship. For example, any costs for meals you incur while on a business trip, at a conference or meeting up with clients can qualify for the meals and entertainment deduction.
In spite of the fact that you can only deduct 50% of what you spent, your expense can include tax and gratuity.
Make sure you distinguish between business and personal trips. Only your portion of the business travel is deductible, not the part where your spouse joined you for an extra day. This includes the cost of:
- Airline tickets
- Taxis and public transit
- Parking and tolls
- Hotel and lodging
- Baggage charges
- Cleaning and laundry expenses
When it comes to deducting an unpaid invoice (or debt), you must first determine if it is partially or totally unpaid. In other words, if the business closed or the client had an accident before they made any payments, you will likely never receive the funds you’re owed, and can claim the entire unpaid invoice as a “bad debt.” You can only take the portion of the bad debt that you’re unable to claim.
Remember to include any bad debts in your gross income figure, and make sure the debt you’re claiming is from the year for which you’re filing your return. Bad debts and unpaid invoices are claimed under Section V of the Schedule C under “Other Expenses.”
Advertising and Marketing
Marketing is often a huge chunk of any small business, but parts of it are often a deductible chunk. Deductible expenses include logo and branding design, promotional material production, business cards and other costs related to promoting your business and services.
Office Expenses and Equipment
Any office equipment, such as computers, desks, chairs, tablets and printers, that are used for business purposes can be either expensed outright or depreciated. Don’t forget to claim office supplies like paper, pens and printer ink.
Penalties for Rejected Deductions
Be sure to keep accurate records of the business deductions you claim every year so there won’t be room for errors. Keep all business-related receipts in a safe place, so in the event you’re audited, you can provide proof.
For some deductions, like the business mileage deduction, you have to pay a 25% inaccuracy penalty if you’re unable to prove your case for claiming certain deductions. This is in addition to any tax that’s required to be paid and interest on the amount accrued during that time.
If you end up not qualifying for the home office deduction, it will raise your taxable income, forcing you to pay any back income taxes as well as self-employment tax. Take your time when claiming these deductions to ensure accuracy.
How to Properly Document Your Deductions
How do you avoid paying penalties for rejected deductions? You do it by properly documenting your expenses and keeping clean records. There are multiple ways of doing this:
- Take pictures of your home office space each year
- Use bookkeeping software to correctly organize your deductions
- Save your receipts in a fire-safe box, or scan them into a file on your computer
- Write down the purpose of your business trip or expense on the receipt
- Be specific: Use dates, names and places (you won’t remember a year from now, so make it easy)
Another way to ensure you won’t be hit with any penalties is to stay updated and compliant with IRS rules and changes. Tax rates change every year, so make sure your bookkeeping software is up to date.
Also, check in with your accountant on a quarterly basis and ask about any changes in tax laws that might affect your situation.
How to Recognize a Potential Tax Deduction
The reason why we call this “the almost ultimate” guide is because even after all of these deductions, there may still be expenses that are unique to your self-employed business that are both “ordinary and necessary.” But while we’re unable to make custom recommendations about what you should deduct, we will provide some advice on how to recognize a legitimate deduction that is unique to your business.
The common refrain, which is worth repeating, is “ordinary and necessary.” If you feel comfortable justifying what you can prove is a routine expense in the event you’re audited, and know it’s used for business purposes in a legitimate way, then you’re likely on solid ground for claiming it.
Nonetheless, when determining whether a self-employed deduction qualifies as a business expense, you want to err on the side of caution. Not every self-employed business can attempt deductions for carrier pigeons and expect to get away with it. If you’re unsure about a business expense and whether it meets the “ordinary and necessary” guidelines, ask your accountant or tax professional for help.
You could also ask around to fellow professionals and verify what deductions they’re claiming to confirm if yours sounds like a common expense. Also, take your time when listing out your self-employed deductions so you don’t rush and make any mistakes.
Looking for More Information on Self-Employed Deductions?
There’s a lot out there. In fact, in addition to ridesharers, we’ve prepared lists for the most common deductions for consultants, construction and general contractors and cleaning professionals, not to mention our exhaustive list of deductions that apply to most self-employed professionals and freelancers. If you’re bouncing back and forth between the simple and more complicated methods of deducting your home office expense, we’ve got you covered there too.
If you’re wondering about deductions that are employment-related but aren’t appropriate for Schedule C, check out our guide to deductions that are appropriate for Schedule A. What you find might surprise you, and leave your wallet just a little heavier than you expected.