Self-employed business owners have the advantage of being able to deduct most of their business expenses for tax purposes. Being able to take these tax benefits can reduce your business tax bill. Tax regulations can change, but you can take some important tax deductions right now.
How Business Tax Deductions Work
Most self-employed business owners report and pay their income taxes on their personal tax returns. They calculate their income and deductions on a separate form, usually Schedule C, then they add their total net income from their business to their other sources of income on their Form 1040 or Form 1040-SR.
The Internal Revenue Service (IRS) says these expenses must be both ordinary (common and accepted in your type of business) and necessary (helpful and appropriate).
The more legitimate deductions your business can take, the less your business net income for taxes will be, including calculations for federal and state income taxes and the self-employment tax.
Self-employment taxes are those paid by self-employed individuals for Social Security and Medicare taxes. The rate includes the combined employer and employee tax: 15.3% each year, up to a maximum amount or "wage base" for the Social Security portion.
The first $142,800 of your 2021 combined wages, tips, and net earnings is subject to any combination of the Social Security part of self-employment tax, Social Security tax, or railroad retirement (tier 1) tax. The amount increases to $147,000 in 2022. This tax also includes an additional Medicare tax for self-employed individuals who earn more than $200,000 in a year.
The self-employment tax is based on the net income from your business, and it’s calculated on Schedule SE as part of your total tax calculation for the year. You can deduct half of the tax each year (equal to the amount your employer would normally pay if you worked for someone else) in calculating your total federal income tax for the year.
Sole proprietors, partners in partnerships, and owners of limited liability companies (LLCs) are considered to be self-employed for purposes of paying self-employment taxes. But owners of corporations and S corporations are shareholders. They're not considered to be self-employed so they don't have to pay this tax.
You don’t have to pay self-employment tax for the year if your business income is less than $400 a year, but you don’t qualify for any Social Security credits for that year unless you use an "optional method" of reporting on Schedule SE.
Qualified Business Income Deduction
Self-employed individuals may be eligible for a qualified business income deduction each year. The deduction is up to 20% of qualified business income in addition to regular business income tax deductions you can claim for the year. It’s a deduction for the owner, not the business, and corporations aren’t eligible.
Income from outside the U.S., business investment and owner dividend income, capital gains, and non-business interest income aren't included for this deduction.
Home Office Expenses
You may be able to take a deduction for the space you use regularly and exclusively for your business if you work from home as a self-employed business owner. You may also have to show that it’s your principal place of business to qualify for this deduction.
You have two options for calculating the amount of your home business-space deduction. You can use your actual expenses, or you can use a simplified option. You must measure the area of your business space and divide it by the total space of your home to claim a percentage of your actual expenses that's devoted to your actual work space.
The simplified calculation allows you to multiply your business space (up to 300 square feet) by the 2021 IRS rate of $5 a square foot to take the deduction.
Both options have some limitations, and neither option allows you to take a home office deduction that is greater than your net business income.
IRS Publication 587 Business Use of Your Home includes a flow chart to help you determine if you can qualify for this deduction.
Retirement Savings Plans
You may want to consider one of several retirement savings plans set up for self-employed individuals and small-business owners and their employees. Benefits of these plans include:
- Taking income from a higher tax year to a lower tax year (after retirement, for example)
- Deducting your contributions as a business owner or employer, up to specific limits each year
- Using this benefit to attract and keep employees
The individual (business owner or employee) contributes to the plan for the year, and the tax on the contribution is placed tax-deferred into a specific retirement plan. It accumulates tax-free.
Two types of plans are available to business owners and their employees:
- A Self-Employed Individual Retirement Account (SEP-IRA), for business owners to make contributions for themselves and their employees
- A SIMPLE IRA plan, with a savings incentive match plan for employees
Retirement plans involving employees must comply with the Employee Retirement Income Security Act (ERISA) in order to qualify for benefits. The plan must be set up in line with the tax law, with annual limits on contributions, and the plan must be operated according to IRS regulations.
You might also want to consider a Self-Employed 401(k) Plan for yourself and your spouse. This plan isn’t for employees, and these plans are not regulated under ERISA.
You may be able to claim a tax credit for the cost of setting up several types of retirement plans if you set up a plan that includes your employees. Talk to a tax professional to learn more.
You can deduct over several years if you buy major items for your business, such as a car, equipment, retail shelving, or equipment to make a product. This process is called depreciation, and it’s another type of deduction that can reduce your business tax bill.
Depreciation is expensing the cost of capital assets (those that last more than one year) over a number of years. For example, you could deduct $1,250 a year as an expense if you buy a computer network system that costs $10,000, and its useful life is eight years.
Your business must own the property and it must be used in your business to qualify for the depreciation deduction. You can depreciate property in several ways and the IRS has some additional requirements and limitations, so check with a tax professional.
Business driving is an important expense for many self-employed individuals. You must separate your business driving and personal driving mileage if you use your car for both business purposes and personal reasons. You can use only the business mileage to calculate this expense.
You can use either your actual expenses or the standard IRS driving rate to calculate this expense. The standard driving rate changes each year.
Your business use is 30% of your mileage if you put 10,000 miles on your car during the year, with 3,000 of those miles driven for business purposes. Using the 2022 standard mileage rate of 58.5 cents a mile, you would multiply that by 3,000 miles to get a deduction of $1,755. Or you can multiply your actual expenses by 30%. This would give you a deduction of $1,050 if your actual expenses were $3,500.
Commuting back and forth from home to work is personal mileage. It can’t be deducted, except in some limited circumstances. But you can deduct costs going from your home to work locations if your home is your principal place of business.
The IRS looks closely at business driving expenses, so it’s important to keep accurate records of all your business driving. Note the date, time, miles driven, and purpose for each business trip. Using a mileage app is an easy way to separate business and personal miles.
Other Business Expenses
You may also have other, less common deductible business expenses.
Rent and Leasing
You can deduct expenses involved with renting your business location. Rent for business use of your home is deducted as part of your home business expense. You generally can deduct only the rent for the year for which it applies if you pay rent in advance. You could deduct the 2021 portion on your 2021 business tax return if you pay 2021 and 2022 rent in advance.
You can deduct your lease payments for each year as part of your actual driving expenses if you lease a car, or you can use the standard mileage rate. If the standard mileage-rate method is chosen, it must be used for the entire duration of the lease period, including renewals.
You can deduct expenses for work-related education on your business tax return as a self-employed business owner. The education must meet one of two requirements:
- It's required by law to keep your present salary, status, or job—like continuing education for professionals.
- It's necessary to maintain or improve skills needed in your present work.
The education doesn’t qualify if it’s needed to meet minimum educational requirements or to qualify for a new trade or business.
Several types of interest expenses are deductible business expenses. All of these types of debt must be part of your business activity. Some examples include installment sales, credit card debt, and mortgage interest on business property.
You must separate the interest according to the percentage of use if you use a loan or credit card for both business and personal reasons. It's usually advisable to get a separate credit card for your business.
Reducing Your Self-Employment Taxes
The best way to reduce your self-employment taxes is to reduce your business income. Increasing your business expenses to avoid (not evade!) taxes is a good way to do this.
As your business grows and your profitability increases, you may want to consider changing your business legal type to a corporation. The corporate tax rate of 21% may be lower than your personal tax rate and you won’t have to pay self-employment taxes. You may consider electing corporate or S corporation tax status while keeping your business operating as an LLC if it's already an LLC. This decision is complicated, so talk to financial and tax advisors first.
You may be able to carry some of those losses forward to current or future years if your business has had losses from your business operations in past years. You can use those losses to reduce your taxable income in current years.
There are temporary regulations for COVID-19-related situations in 2019, 2020, and 2021, so check with your tax professional if you think you might be able to use this provision.
For More Information
All these business tax deductions come with qualifications and limitations. You can find more details in IRS Publication 535 Business Expenses. You should also get help from a licensed tax professional to report and file your business tax return.