Business Expenses for the Self-employed

Whether it's a full-time business or just some freelance work that you do occasionally alongside your day job, being self-employed usually means you'll run up some expenses over the course of the year. The good news is, those business expenses can save you a bundle in taxes. Here's a quick checklist of some common, and perfectly allowable, business expense deductions.

Common Business Expense Deductions

Following is a list of possible business expenses for self-employed individuals that I've created for clients. Not all people will qualify for all expenses, but you should review each one for a possible deduction. Each dollar of “captured” business expenses directly offsets self-employment income on Schedule C, in the process reducing your federal and state income taxes as well as the self-employment tax (the substitute for payroll taxes you and your employer pay at a W-2 job). This latter tax comes as a surprise to many new to contracting; it's 15.3% on your first $113,700 earned in 2013, and 2.9% for amounts above that (in 2014, the full tax will apply to your first $117,000 in earned income). These rates apply to your "first dollar earned" from self-employment, and are comparable to what many people pay in income taxes. So business expense deductions are potentially more useful than itemized deductions on your income tax return, which have no effect on self-employment taxes.

The general rule to apply is: any money that you've spent because of your business is potentially deductible. When in doubt, track it and save your receipts, and we can review the expense at tax time.

Diligent record-keeping is essential. If an expense is questioned, the first thing the IRS will look for is documentation of the expense. Save all of your receipts, keep a log of your activities and car use if claiming car-related expenses, invoice your customers, record all payments...you get the idea.  The record-keeping is much easier if you maintain a separate bank account for your business, so opening an account is one of the first things you should do when starting your business.

This is just a quick overview that leaves out a lot of the details. If you have any questions about any of these, I’d be happy to help. Just jot down your questions and bring any supporting documentation when we meet.

Office/Home Office

First, the easy one: if you rent office space, the rent is deductible. The trickier one is the home office expense deduction, for those who work from home. You can deduct part of costs of your home if it's your principal place of business, and you use some space in your home regularly and exclusively for your business. That means you need to set aside space in your home that isn't used for anything else.

If you meet the rules, then you're able to deduct a portion of the expenses of your home. This is nice deduction, because it might let you turn what would otherwise be personal expenses into tax deductions. Allowable expenses include:

For renters - rent, renter's insurance, utilities

For owners - mortgage interest, property tax, insurance, utilities

In general, the way it works is that you calculate the fraction of your home used for business, and apply that fraction to all of your expenses. If 15% of your home is for business use, 15% of your heating bill becomes a business expense. [Starting with tax year 2013, there is an alternative method of calculating the home-office deduction, based on square footage; it requires much less record keeping, but may result in a lower deduction.]

While the IRS isn't likely to show up for a surprise visit to you home to see your office, it wouldn't hurt to document the space in a digital photo showing clearly that you have a space set aside for exclusive business use. And of course, keep records of all of the expenses associated with your home.

Telephone

The cost of your primary home line is never deductible, even if you have a home office, but long distance charges for a business are deductible, as is the cost of a second phone line for your home office. A cell phone that you use only for business is fully deductible, but the IRS will assume that it's for personal use too if you only have one. If you have a cell phone or land line with both business and personal use, come up with a good estimate of how much you use it for business.

Transportation

The cost of commuting between your home and your job is never deductible. But the cost of travel from your place of business to job sites is deductible. If your home is also your office, that means trips done from home for business purposes may generate deductible business expenses.

Some of these expenses are easy to track. A cab to the airport, the airline ticket to see a client, the hotel to spend the night between client meetings, meals while on that trip. If you bring along the family, or tack on some personal days, you typically lose some of the deductions - but keep track of it all so you can sort it out at tax time.

How to deduct the costs associated with your car is a complicated topic. The two basic methods are deducting actual costs, including depreciation or lease payments on your car, or using the IRS's standard mileage rate <(56.5 cents per mile in 2013). With both, you also can deduct costs like tolls and parking. The per-mile method can be easier and is the only option if you don't really use your car much for business.

Regardless of how you take the deduction, you have to keep track of your business and personal use of the car for each calendar year. The IRS asks for written documentation of the business use so the more you can document, the better. A few possible methods:

  1. Open an Excel spreadsheet and enter each trip at the end of each day, or the end of the week. Include the date, mileage, and purpose.
  2. Email yourself with the same information, using a subject line that you can sort on at the end of the year like "2013 Car Trips for Work."
  3. Keep a log book in your car with that info, including a running total
  4. If your use is consistent month to month, take a sample period with detailed records and use that to estimate your other months; update the sample occasionally

Whichever method you use, it's helpful to your tax preparer to at least write down the mileage on your car at the beginning and end of each year.

Meals/Entertainment

Meeting a client over lunch? That's a valid business expense, but only 50% of it is deductible. Keep track of all of your meals with clients; an easy way to meet the IRS documentation requirements is to jot down a quick note on the back of the receipt, including the names of the people you met with and your reason for meeting.

Entertainment is a bit trickier, in that there are some strange rules about when you do business and what types of entertainment are acceptable. Check with me for details if you're planning to entertain clients.

Insurance

Insurance for your business, such as an errors & omissions policy or premises liability insurance, is a deductible expense. Health insurance for you or your spouse/dependents is also deductible, though exactly how has changed a bit each year (in some tax years it has reduced your self-employment taxes, but that hasn't always been the case). Some of your car insurance may be deductible, but that depends on how and whether you're able to deduct car costs.

Legal & accounting fees

The costs of the services of lawyers and accountants are deductible. If you obtain legal or tax advice that relates to both you individually as well as your business, ask for an invoice that lists out specific charges for each. Estate planning isn't usually tax-deductible, but a buy-sell agreement for your business done as part of an estate-planning review may be.

Computers, Printers, Furniture

You know..."stuff." This category is a little trickier because unlike the others, these are capital assets of your business that must be depreciated. Using a Section 179 election, you can often write them off in the first year, but fundamentally these are treated differently on your tax return and accounting records. Keep track of all the things you buy for your business, including both the purchase date and the date you first start using it for your business (which may be different from the purchase date).

Software

Software of all types used in your business is a deductible expense. But special rules apply, so it's a bit easier if you buy it as part of a computer system instead of as a separate product. Regardless, keep track of these costs because they're deductible.

Inventory

This is tricky too. Service businesses don't usually have any inventory, but if you sell goods to your customers there can be a lot to keep track of. Definitely something to talk through in detail before opening your business; the accounting very quickly becomes difficult to catch up with.

And the Obvious Stuff

Don't forget these, which can add up to quite a bit over the course of a year:

Office supplies - paper, toner, pens, business cards

Internet access - DSL line, website hosting

Photocopies and printing - flyers, brochures, etc

Postage, FedEx, UPS

Conferences, seminars, continuing education (though not all qualifies)

A word about Record-keeping

How to keep track of all this stuff? Many small business owners use QuickBooks, which is an industry standard that any accountant or bookeeper will be familiar with. It can pay to have your chart of accounts set up by a professional, who can also walk you through the use of the software. Done right, tax time can be as easy as printing off a one-page report from QuickBooks. And throughout the year, it'll be easy to know how much you're actually earning, which helps with figuring out your required estimated tax payments.

If your business is very simple, you can get by using something like Quicken, or even Excel. It all depends on how frequently you have income or expenses to keep track of, and what you see for the future of your business (if you'll need QuickBooks soon anyway, might as well get started while it's easy to do). If you're completely unfamiliar with accounting and these software packages, it may make sense to pay someone to do it rather than spend valuable time learning it yourself. The more organized you are though, the less expensive it will be to prepare your income taxes.

As for documentation, it may be easier to save every receipt than to figure out which receipts you need to save. And save the originals or a clean copy. Credit card statements may not be sufficient, because they usually don't show enough information to document an expense. If you're organized, scan all of this information to a common format, like PDF; back it up online and you'll never need to worry about losing your tax records. Or, if you don't mind paying a lot of money for tax preparation, just throw it all in a shoebox!

Need More Info?

A very detailed resource about all sorts of Business Expenses is the IRS Publication on the topic, Publication 535<. Also helpful is Publication 583<, Starting a Business and Keeping Records. Or, give me a call.