Self-employment comes with freedom, responsibility and lots of expense. While most self-employed people celebrate the first two, they shrink from the second, especially at tax time. They may not be aware of certain tax deductions to which they are entitled.
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“Often, an overlooked deduction is for education costs. If someone takes courses or buys research materials to be more efficient in their work, that may be deductible.”
Individual Retirement Plans (IRA)
John L. Hillis, president of Hillis Financial Services in San Jose, Calif., said the best tax deduction for the self-employed is a retirement plan. A person without employees can set up an individual 401(k).
“The individual can contribute $19,500 in 2021 as a 401(k) deferral, plus 25% of net income,” Hillis said.
If you have employees, Hillis recommended a SIMPLE IRA (Savings Incentive Match Plan for Employees), an IRA-based plan that gives small employers a streamlined method to contribute to their employees’ retirements. Starting in 2021, an employee can defer up to $13,500, Hillis said, and employees over age 50 can defer an additional $3,000.
“A third retirement plan is Simplified Employee Pension IRA (SEP IRA),” Hillis said. “The employer can contribute the lesser of 25% of income or $58,000 in 2021. If the employer has eligible employees, an equal percentage of their income must be contributed.”
Hillis claimed that pension plans are “absolutely the #1 tax deduction. The government helps fund retirement.
Commercial use of the house or dwelling
Accountant and consultant Jéneen R. Perkins, principal of Éclat Enterprises LLC, in Milwaukee, Wisconsin, said most self-employed taxpayer businesses start as home-based businesses. These people need to know that some of the business expenses are deductible, she said, adding, “It’s very important that you track expenses related to your housing costs.”
If your gross income from your business exceeds your total expenses, you can deduct all of your expenses related to the business use of your home, Perkins said. If your gross income is less than your total expenses, your deduction will be limited to the difference between your gross income and the sum of all business expenses you would pay if the business was not in your home. These expenses could include phone lines, internet and other costs of doing business.
You also need to have a home office that is actually used for work. Hillis said the Internal Revenue Service may ask you to document this.
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Deduction of automobile expenses
If you travel for business, even short distances within your own city, you can deduct the dollar value of business miles flown on your tax return, Perkins said. The taxpayer can report actual expenses incurred or use the standard IRS prescribed mileage rate, which is 56 cents as of 2021. IRS authorized mileage rates should be checked annually because they can change.
“If you decide to use actual car expenses, be sure to include payments, depreciation, registration, insurance, garage rent, licenses, repairs and maintenance, as well as parking and toll charges,” Perkins said. “If you decide to use the standard mileage rate, it would be in your best interest to keep a log – daily, weekly or monthly – of miles driven to distinguish personal from business use.”
Depreciation of property, plant and equipment
Some self-employed individuals may purchase goods and equipment for a business. If they expect the property to last longer than a year, it should be depreciated on the tax return, Perkins advised.
Perkins said property claims, according to the IRS, must meet the following criteria: You must own the property and it must be used or held to generate income. The property should have an estimated useful life, which means you should be able to guess how long you can generate income from it. It cannot have a useful life of one year or less and cannot be bought and sold in the same year.
Certain repairs carried out on goods used for commercial purposes can also be deducted.
Any school expense is potentially tax deductible.
“Many times an overlooked deduction is for education costs,” Hillis said. “If someone takes courses or buys research equipment to be more efficient in their work, it may be deductible.”
Think about all the books, online courses, local college courses, or other courses or materials you’ve purchased to improve your job or business. It’s easy to forget a work-related webinar or business e-book purchased online, so remember to save electronic receipts.
Perkins also mentioned subscriptions to trade or professional publications and donations to commercial organizations, which are often necessary for the continuation and growth of your business.
Other areas to explore
Other deductions that can easily be missed are advertising and promotion expenses, bank charges, and plane, bus, or train tickets. Restaurant meals and other entertainment expenses can be deducted as long as they are necessary business expenses.
Additionally, Hillis said to consider health insurance premiums, which in most cases are a credit rather than a tax deduction.
“A credit goes directly against his taxes, rather than a reduction in income,” he said.
Whatever expenses you discover that you can write off, the most important thing is to keep accurate records throughout the year. Keep receipts, including email receipts, and file or save them for easy access at tax time. Not only does keeping receipts, mileage logs, and other expense records make filing taxes easier, it also facilitates a system that allows you to track changes from year to year.
Long-term tax-saving strategies
Don’t just look at last-minute write-offs when considering self-employment tax deductions. Consider establishing long-term strategies to save money from year to year, especially if you earn a lot of money.
“Accountants usually tell you what to pay,” said Stephen K. Davis, chief investment adviser for Safe Harbor Asset Management in Huntington, New York. “They don’t always tell you strategies to lower your payments.”
To lower your gross taxable income, consider setting up a defined benefit pension plan, Davis said. This plan is based on your age and income: the older you are and the higher your income, the more you are allowed to contribute. An alternative plan is a profit-sharing plan, which is similar and can benefit those with multiple employees.
Another strategy for high-income business owners who own their own building through a limited liability company or similar business structure is to pay themselves rent, Davis said. This rent is used to pay off the mortgage, but it is also considered a business expense for tax purposes.
Independent professionals who are required to have liability insurance should consider setting up their own insurance company. A captive insurance company is one that insures the risks of the business — or businesses, in the case of a cooperative. Its premiums may be tax deductible.
But, Davis warned, if the money accumulates and the claims are minimal, the money withdrawn is taxable as capital gains. Davis pointed out that it’s not a retirement strategy, but it can save you money by allowing you to “pay yourself” instead of an insurance company and always deduct premiums.
With any of these more complicated long-term strategies, consult a business lawyer or financial planner to ensure you have the best possible plan for your business.
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