The Basics of Tax Deductions for Self-employed Individuals

by Josh Biggs in Finance on 5th October 2021

Since self-employed workers are often paid in cash without all the necessary forms to officially report income for tax purposes, it becomes important to file quarterly estimated federal tax returns. This way, you can at least pay some amount each quarter. It doesn’t get out of hand when April comes around.

Also, since there’s no employer withholding tax from your paycheck, it’s up to you to keep track of what you owe and make sure you pay enough so that you don’t incur penalties. You can hire a tax accountant or do it yourself. You can use this chart of professional tax software to help you know the best tool to use.

Should You Claim Standard or Itemized Deductions?

Self-employed individuals have two options when claiming their tax deductions: standard and itemized. While itemizing your deductions each tax year is an option, most self-employed workers find that it’s easier to take what’s called a standard deduction instead for three reasons:

  • Standard deduction often increases every year. For 2021, it’s 12,550, and it doubles for couples filing jointly.
  • It is simpler and faster since you can immediately reduce your taxable income with the limit.
  • A law passed by the U.S. Congress in 2017 allows business owners who operate as sole proprietorships or through a pass-through entity such as a limited liability company (LLC) to deduct 20 percent of their first $315,000 from their taxable income from that year.

Since you cannot claim both, you can itemize deductions when your total allowable business-related deductions exceed $12,550.

What Tax Deductions Can You Claim?

The general rule is that all business expenses are deductible against earned income for federal tax purposes. This means that any expense made for earning business revenue is considered legitimate and can be deducted from taxable income when filing an annual tax return.

As long as they are ordinary and necessary, they do not have to be related to the industry in which you are doing business. This includes things like:

1. Upkeep

This covers necessary expenses for keeping your business up and running, such as buying office supplies or paying for Internet services. Maintenance of equipment is also included under this category.

To qualify for this deduction, items must be used exclusively in your business, not something that you use for both personal and business purposes (for example, using a laptop at home). The limit on this expense is the actual cost of the item being deducted over its useful life.

If you have already depreciated an asset or taken bonus depreciation on it—that means deducting away more than what it’s worth—then your deduction is limited to the current value of that item.

2. Insurance

Any premiums paid for insuring yourself and your business can be deducted from annual taxes, such as health, liability, and fire insurance, as long as you can justify that they’re necessary to maintain your company. Expenses like agent commissions and other fees paid to insure an asset or liability are also deductible against earned income.

Business interruption insurance is also covered under this category. This means that any lost revenue you get due to a required closing during a natural disaster (for example) can be deducted from taxable income when filing an annual tax return.

Be sure to save all supporting documentation related to your expenses should you need it later on for reimbursement or proof of losses incurred. Tuition payments made by a business owner for work-related training are also deductible.

3. Utilities

Any cost of keeping your business running is deductible, such as the rent for office space, lighting, and heating. If you’re leasing equipment like vehicles or furniture required for your business, then the monthly fees paid out to lease these items can be deducted against earned income. Be sure to save all invoices related to this throughout the year so you can deduct costs evenly on tax returns.

4. Travel

Any expenses that allow you to travel directly in the performance of your business can be deducted from taxable income. This includes costs related to transportation, lodging, and food for both yourself and any employees under your supervision. Meals at conventions or required company events are also deductible against earned income.

If you were out on business but had a personal adventure during the trip, such as going sightseeing or taking a weekend vacation, then those costs cannot be deducted from taxes.

5. Car Expenses

Businesses that use their car for business purposes must choose whether they want to deduct actual expenses incurred while using the car, which allows them to keep track of gas mileage and maintenance costs, or they can add a flat amount to their annual taxes and include the percentage of business use for that car.

As a good guide, claim the mileage rate if the vehicle is economical. If you are spending more on maintenance, loans, depreciation, and gas, deduct the actual expenses.

As long as your business is earning, you can never get away with paying taxes. However, you can make the most of the money you’ve spent to run it and reduce your tax liability without getting in trouble with the IRS. 

Categories: Finance