I have a full-time job now, but this is the first time I’ve worked for a single company in almost four years; between 2006 and 2009, I was self-employed. When I decided to try freelancing in earnest, I didn’t have even the foggiest notion about the logistics. But practice makes perfect, and over the course of my three years working from home, I figured out how to prioritize my deadlines, how to shift gears on a moment’s notice, and how to stay on top of clients who didn’t pay up in a timely fashion. But by far the most important lesson I learned was that the tax structure for self-employed Americans is entirely different from the one full-timers are accustomed to.
While ponying up roughly 35 percent of your income for the IRS four times a year is about as desirable as a Saturday trip to the DMV, the trade-offs can be significant—that is, if you know all the deductions for which you’re eligible as a contractor. The IRS’s Schedule C tax form, on which sole proprietors report business gains and losses, “doesn’t even begin to hint at all the things that a business can legitimately deduct,” certified public accountant Bernard Kamoroff, who wrote 422 Tax Deductions for Businesses and Self Employed Individuals, 7th Edition, told BusinessWeek. To keep your payments low and your profits high, get in the habit of saving your receipts for every purchase you think might classify as a work expense, starting with these categories.
Home Office Space
According to the National Association for the Self-Employed, this is one of the two write-offs that people overlook most often (the other is vehicle usage for business purposes, detailed below). If you have a home office that you use as your primary place of business, you can write it off. (To determine the exact deduction, measure the square footage of both your home office and your entire house, then divide the former by the latter to calculate what percentage of your living quarters your workspace comprises.) Because many sole proprietors pad this ratio or misrepresent a primarily residential space as a work area, some taxpayers worry that the home-office deduction symbolizes a red flag to the IRS, but if you’re precise with your measurements and honest about your home-office usage, you most likely won’t incur an audit. In addition, if you’re a renter whose home doubles as your place of business, you’re allowed to deduct your rent as a work expense.
The IRS Web site states that people who use their cars or trucks for business are eligible to deduct work-related gas, maintenance, and insurance expenses, parking and toll fees, and the cost of overnight vehicular travel and local transportation. The IRS defines “local transportation” as driving from one workplace to another within your tax home (your regular place of work, including the general geographical area in which you conduct business); visiting clients; driving to offsite business meetings; and traveling to temporary workplaces when you have multiple employers. Keep in mind, however, that these criteria apply only to contract workers, not to full-time employees of a single company for whom these activities fall under the personal-commuting category.
Sole proprietors who qualify for vehicular deductions base their calculations on either their actual expenses or the standard mileage rate set forth by the IRS—for 2009, it’s fifty-five cents per mile. People who opt for the latter method must state their intention to use it during the first year they use their vehicle for business purposes.
Don’t go thinking you can write off your next vacation to Bora Bora just because you’re self-employed, but if you’re traveling for a legitimate business reason, you can deduct many of the expenses you incur during your trip. These include:
- Airplane, train, bus, or automobile travel between your home and your business destination
- Taxi, commuter bus, and limousine fares between the airport, your hotel, and your temporary work location, as well as rental-car fees
- Meals (generally, 50 percent of the total cost is deductible) and lodging (if your trip is one night or longer, you’ll need sleep and sustenance to carry out your work responsibilities satisfactorily)
- Even dry cleaning and laundry!
Meals and Entertainment
The IRS defines business entertainment as activities whose primary purpose is “the active conduct of business” or during which “you did engage in business with the person during the entertainment period, and you had more than a general expectation of getting income or some other specific business benefit.” Possible acceptable venues for business entertainment include nightclubs, athletic clubs, theaters, and sporting events. If you pay for meals, accommodations, or a vehicle for your clients, those expenses are deductible as well—though the IRS typically reimburses taxpayers for only 50 percent of meal- and entertainment-related costs. It also stipulates, “You cannot deduct expenses that are lavish or extravagant under the circumstances.”
Computer and Phone Expenses
In this information age, computers and cell phones are the lifeblood of almost every businessperson. If you’re newly self-employed, the cost of a high-powered laptop, a whole suite of software, security-monitoring applications, an external hard drive, and a smartphone can seem prohibitive, but you can recoup these expenses if you use any of this equipment to perform your job to the best of your abilities. You’ll also be able to write off any utilities charges (such as cell phone service, Internet access, and electricity) related to your livelihood.
The specific items in this catchall category vary widely, depending on the taxpayer’s particular profession. A freelance book editor, for example, might claim red pens, correction tape, printer paper and ink cartridges, and The Chicago Manual of Style as necessary business expenses, whereas a Web designer would amass an entirely different selection of essential tools. As a general rule, any time you make a big Office Depot run, you’re bound to emerge with purchases that are largely tax-deductible. And don’t forget to pick up—and write off—a high-quality office chair if you spend long hours sitting in front of a computer.
Shipping Materials and Postage
If your profession requires you to ship materials to your clients, save your receipts for all your work-related stamps, packing materials, and charges from the U.S. Post Office, FedEx, UPS, and the like. Heck, you can even write off bubble wrap.
When you consult a lawyer or an accountant for a work-related purpose—including preparing your taxes—the IRS permits you to deduct that specialist’s fees, as well as any others you pay for advertising, business licenses, membership in professional organizations and civic clubs, and vocational training.
Health insurance premiums may be skyrocketing in the United States, but the IRS considers your individual policy a tax-deductible expense. Other types of insurance related to your business that you can write off include fire, theft, flood, liability, auto, malpractice, and credit insurance. (Not bad, right?)
Depreciation and Section 179
If you buy business equipment that you expect to use for more than one year, the IRS will usually not allow you to deduct the item’s entire price in the first year in which you acquire it; instead, you’ll disperse the cost over either five or seven years and itemize these partial deductions on Schedule C annually. This gradual-deduction process is known as depreciation. However, the U.S. government has established an initiative called Section 179 that encourages business owners to invest in themselves by allowing them to sidestep depreciation and write off the entire price of qualifying equipment that they’ve bought or leased during a single tax year (in 2009, the maximum allowance for this purpose was $250,000). Some taxpayers also call Section 179 the “Hummer deduction,” because of all the Hummers and SUVs businesses have purchased under this tax code.
’Cause I’m the Taxman
If you’ve always worked for companies that withhold your taxes from every paycheck they issue, cultivating the fiscal discipline that self-employment requires can be a rude awakening. Even when you believe you’ve acclimated to your home office and your irregular schedule, you’re still faced with the knowledge that IRS will be watching you to ensure that your business operating costs qualify as “ordinary and necessary” expenses. But take comfort in these words from June Walker, author of the useful book Self-Employed Tax Solutions: “Look at everything that you do as a possible business connection and define your business as broadly as you can.” By analyzing your professional overhead from every possible angle, taking advantage of any windows of opportunity the IRS offers you as a sole proprietor, and, most of all, maintaining an immaculate paper trail, you may wind up pleasantly surprised by how little you end up owing for your quarterly payments to Uncle Sam next year.
Updated February 18, 2011