Contractors: don’t leave these tax deductions on the table
If you are like most independent contractors, you value your freedom. You work when you want, where you want, and, if you are really lucky, as often as you want.
That freedom does not extend to your business taxes, however. Whether you’re a freelance accountant or a self-employed yoga instructor, all of your business dreams and triumphs get funneled into the same unforgiving IRS 1099-misc forms come tax time. The bill this generates can feel anything but liberating.
It doesn’t have to be this way. Identify the right deductions and that tax bill can lose some of its wallop. Here are some tips that will help you.
First of all, everyone gets taxed
But not everyone gets taxed the same.
Deductions – those IRS-sanctioned rules that lower an individual’s or business’s taxable income – are a gold mine for those who use them wisely.
As a contractor, you are responsible for paying your share of income taxes -- calculated from the income your business generated. These taxes are not deducted automatically, as they would be if you worked for someone else. Your clients pay you the same way they would any other vendor – no deductions. And then there’s this: you are also responsible for paying both the employer’s and the employee’s share of the so-called self-employment taxes – Medicare and Social Security.
Sounds like a double whammy, right? Not exactly. While you pay about twice as much (15.3%) as a company employee would (7.65%), you get to deduct half of this tax from your net income. Also, your self-employment tax is calculated based on 92.5 percent of your net income (not your gross income).
The folks at KeeperTax have come up with a tax calculator that can help you estimate your self-employment tax liability.
Know your numbers
As a small business owner, your job is to make the IRS work for every penny. Be prepared to keep up with new tax laws, breaks, and credits. And make sure you know how they apply to your business’s financial health: income, expenses, bills, invoices, profits, losses.
A good bookkeeping software package, like QuickBooks Online, can help you stay in command of these numbers all year long – instead of playing catch-up at year’s end. (You can deduct the cost as a business expense!) You can also hire an independent contractor or a bookkeeping service to manage your books.
Now that you have a firm grasp of your business’s finances, you are ready to hunt down all of the deductions for which you qualify.
1. Your home office
If you use a portion of your house or apartment principally to conduct your business, the IRS offers a choice of two possible deductions: a Simplified Option for Home Office Deduction or a Standard Home Deduction. As the name suggests, the simplified deduction requires less complex calculations - $5 per square-foot of office space, up to 300 square feet (or $1,500). It also does not include a depreciation deduction that can come back to haunt you with a recapture charge if you sell your home. The standard method requires you to calculate what percentage of your entire home’s square footage your office occupies. From there, you need to keep detailed records of the actual expenses involved. It’s worth it to run the numbers for both to see which works for you.
2. Vehicle expenses
If you use your car to conduct business, the IRS will allow you to deduct either a per-mile charge for business driving or your actual automotive expenses – but not both. Choose the deduction that gives you the best tax advantage but be certain to follow all the rules. Allowable automotive expenses include lease payments, repairs, new tires, gas, license, registration, insurance, and depreciation. As of January 2021, the allowable mileage deduction is 56 cents per mile. Before you file, check with the IRS to get the latest rates.
3. Travel costs
The IRS allows you to deduct all reasonable expenses you incur when traveling a significant distance from your ‘tax home’ to principally conduct business activities. Your ‘tax home’ is the location from which you normally conduct most of your business. As expected, the IRS defines allowable purposes, distances, and other standards very precisely, so it’s worth checking the IRS travel expense regulations. The rewards for this research are sizable. You may find you can deduct everything from your food, lodging and transportation to the dry-cleaning and WI-FI access you needed to prepare for a client presentation. The deductions can be reported on your taxes using the IRS’s Schedule C (Form 1040)
4. Business meals
If you pay for a meal that is consumed while you are consulting with a client, recruiting a new one, or discussing business with a colleague, the IRS will allow you to deduct 50 percent of your tab. Keep your receipt. Recent changes in the IRS regulations have clamped down on deductions that used to be allowable for entertainment. So, those tickets to the Superbowl? Not deductible – even if you buy your client a hot dog. Check out the IRS’s Expenses for Business Meals.
5. General business expenses
In this category, you should consider all of the costs that allow your business to meet its regulatory, licensing, and normal operational requirements. For instance, you can deduct the cost of business licenses, fees, certifications and regulatory taxes. A newly launched business can deduct as much as $5,000 in start-up costs (market research, advertising, consultants, promotional events), and another $5,000 to cover the costs of establishing an LLC, partnership, or corporation.
6. Business insurance premiums
The premiums you pay for general liability and professional liability insurance are not only wise investments, they are deductible expenses. Neither are mandatory, but if you are thinking you can save money by skipping them, consider this: they protect your personal assets in the event you are sued for injury or negligence. Before you get dragged down by either possibility, talk to us at Hiscox.
7. Health insurance premiums
A portion of the premiums you pay to insure yourself can be deducted from your taxable income if you are an independent contractor. The amount cannot exceed the income that your business generates, and you won’t be able to deduct anything if you’ve declined available coverage from another source (such as your spouse’s or a previous employer’s plans). Find out more about this deduction from IRS Publication 535.
8. Workers compensation costs
Mandatory in every state except New Jersey and Texas, workers compensation insurance premiums are another deductible expense for independent contractors. If your growing business hires employees rather than contractors, it will generally have to pay the entire cost of this insurance (some states allow exemptions for small LLCs). But it doesn’t have to break the bank. Hiscox has been tailoring plans to meet the needs of small business owners for years. Let us give you some options.
9. Retirement plan contributions
Self-employed retirement plans can provide a two-fold benefit for you as an independent contractor. The funds that you invest in a one-participant 401(k), a SEP IRA, or a SIMPLE IRA not only make your eventual retirement more comfortable, they reduce your current tax burden.
The IRS sees you as both the employer and the employee. That means, when it comes to retirement, you can contribute as both. So, for instance, with a solo 401(k), you can contribute as much as $19,500 ($26,000 if you are over 50) plus another 25 percent of your net earnings. In 2021, this allowed independent contractors to sock away as much as $58,000 (not counting catch-up contributions of $6,500, if eligible).
10. Keep current with the tax law
If you are serious about mastering your deductions, your search will not end here. The IRS frequently adds more deductions. And new laws, rules, and regulations frequently change the way it all works. Consider partnering with a tax professional to maximize your understanding and use of these and other tax deductions. And keep in mind, too, that there are operational tactics, like making purchases before year end or waiting until January to bill your clients, that can optimize the impact of even a brilliant tax deduction strategy.
While no one likes to pay taxes, the good news is that a tax bill means your business made money. Just make sure you’re taking all the deductions you have coming, so you’re not paying more tax than you have to.