Self-employed individuals incur a good many expenses in the course of earning income, but the Internal Revenue Service allows them to deduct most of these business costs, many of them dollar for dollar. You can subtract a dollar from your taxable business income for every dollar you spend when they're fully deductible, and that's a good thing indeed. Costs qualify as deductions if they're "ordinary and necessary" in your trade or business.
You can still get a tax break for paying expenses that aren't deductible dollar for dollar.
"Ordinary and Necessary" Business Expenses
According to the IRS, "ordinary" means that most other self-employed taxpayers who work in the same business or trade also commonly pay for these things. "Necessary" means that whatever you spent money on assists you in doing business. In fact, you might not be able to do business and earn money if you didn't make these expenditures.
For example, textbooks and teaching supplies would be both ordinary and necessary if you work as a tutor. But buying a pet guinea pig for your workspace might not be, at least if you can't convince the IRS that the little guy is a teaching tool. Even then, you might run into a problem with the "ordinary" part of the equation, at least without the assistance of a good tax professional.
Commonly Deducted Expenses
The most common fully deductible business expenses include:
- Accounting fees
- Bank charges
- Commissions and sales costs
- Consultation expenses
- Continuing professional education costs
- Contract labor costs
- Credit and collection fees
- Delivery charges
- Dues and subscriptions
- Employee benefit programs
- Equipment rentals
- Factory expenses
- Interest paid
- Internet subscriptions, domain names, and hosting
- Legal fees
- Maintenance and repairs
- Office costs and supplies
- Pension and profit-sharing plans
- Printing and copying expenses
- Professional development and training fees
- Professional fees
- Salaries, wages, and other compensation
- Small tools and equipment
- Trade discounts
Gifts to Customers or Clients
Not all expenses are fully deductible, even if they're ordinary and necessary, and gifts made to your customers or clients fall into this category. You can only claim a percentage of these costs. They're deductible up to $25 per person.
For example, you could only claim a deduction for $25 if you show your appreciation to your best client with a $100 bottle of bourbon. The other $75 is on you and your kind heart. But you could deduct the whole expense if you give them a $20 bottle of wine instead, because this is under the $25 limit. The caveat: Be wise with your gratitude.
Not all gifts are considered gifts for tax purposes. Some of these costs can be considered promotional.
This is typically the case with items that cost $4 or less. They're fully deductible up to $4 each as long as they bear your business name and you distribute a lot of them, such as pens you might offer to anyone who signs a contract with you.
Meals and Entertainment Expenses
It used to be that you could deduct up to 50% of entertainment costs that were directly related to conducting business—such as throwing a lavish holiday party and inviting your clients. Not anymore. The Tax Cuts and Jobs Act (TCJA) eliminated this tax code provision in 2018.
However, you still have options. You can deduct 50% of business meals if you take those clients out to dinner individually. You—or at least one of your employees—must be present and must conduct business in some way with a consultant, client, customer, or other business contact. The meal can't be over-the-top extravagant.
So if you take that same client to dinner and order a $100 bottle of bourbon to enjoy with the meal instead of giving them the bottle as a gift, your deduction doubles from $25 to $50—half the purchase price. And you can deduct half the cost of the meal and the tip, too.
Automobile and Transportation Expenses
You can deduct the portion of your automobile and transportation expenses equivalent to the miles you drove for business purposes during the tax year.
This doesn't include travel costs if you must visit another city or location—that's a separate category and it's fully deductible. Transportation costs are those you incur in the daily course of doing business.
Your business miles must be separated out from your personal miles. This can admittedly get complicated, so it's beneficial to keep a log, either in your smartphone or on a notepad stashed in your glove compartment.
Here's an example. You run your business from home and you drive 20 miles each way to service a client's computer system. Then you make a side trip of five miles to pick up some dinner on your return trip home. Technically, you must subtract 10 miles—assuming the meal pickup was five miles each way—from the total 50 miles you drove on that outing. So, 40 of your miles are tax-deductible. You can't add on that other 10.
The Standard Mileage Rate vs. Actual Expenses
Now you have a choice to make. The IRS allows you to either deduct your actual costs incurred in driving those miles, or you can deduct the standard mileage rate of 57.5 cents per mile for the 2020 tax year. This drops to 56 cents in 2021.
The standard mileage rate tends to change a little annually because it's indexed to inflation.
Those 40 miles you drove to service the computer system would shave $23 off your business income using the standard mileage rate—40 miles times 57.5 cents for each of them. But you should do a little more math to determine if claiming your actual costs would result in a greater deduction.
Your deduction would equal 50% of your actual auto expenses if you drove 30,000 miles during the year overall, and if 15,000 of those miles were business-related—15,000 is half of 30,000. These costs include things such as depreciation, auto loan interest, fuel, maintenance, insurance, and registration. Or you could simply deduct $8,625, or 15,000 miles times 57.5 cents. Obviously, you'd want to use whichever method works out to more tax savings.
Home Office Expenses
You can also claim a deduction for expenses incurred in maintaining a home office, and the rules are similar to those that apply to auto and transportation costs. You have to separate business and personal use.
You can only deduct the portion of the expenses that are associated with the area of your home that you use exclusively for business. For example, you can claim a deduction for the square footage of the space where you actually work, not the entire room, if the room does double duty as your child's playroom. But if you dedicate an entire extra bedroom to your work and do nothing else in that room, the entire room's percentage of your home is tax deductible.
The space must also be your principal place of business. This doesn't mean that you can't leave to make house calls to customers or clients, but you must actually run your business from this home location.
The Home Office Deduction Simplified Method
The home office expense deduction is an either/or decision as well. The IRS also gives you a choice between two options. One is to use the simplified method and simply claim $5 for each square foot of your home that's devoted to your business. This method caps out at 300 square feet, however, so it might not be beneficial if your work area is larger than this.
Home Office Expenses—Actual Overall Costs
Your other choice is to deduct a percentage of the actual overall costs of maintaining your home. The percentage would be equal to the percentage of your home that you use for business purposes.
For example, your entire home might be 2,500 square feet. You've converted the garage to an office space, and it comprises 375 square feet. That works out to 15% of your home's space. You could claim a $6,300 home office deduction if the total costs of maintaining your home for the entire year were $42,000—15% of $42,000.
You'd get only a $1,500 deduction, or $5 for 300 square feet, if you used the simplified method, given that you'd have to leave 75 square feet on the table because of the 300-square-foot cap and you have relatively high household expenses.
Your actual expenses include rent or mortgage, insurance, utilities, repairs, and maintenance made solely to your office space. They also include depreciation if you own your home rather than rent.
Again, calculate the deduction both ways to determine which works out best based on your personal circumstances. Most taxpayers find that the percentage method is more advantageous.
Nondeductible Business Expenses
Some business costs are never deductible even though they might be directly related to your trade or profession. These include bribes and kickbacks—which are usually illegal to begin with—and contributions to political parties or candidates. Dues and membership fees you might pay for social clubs aren't deductible, nor are lobbying expenses, penalties, and fines.
Publication 535, Business Expenses on the IRS website offers more in-depth information on non-deductible expenses.
How to Deduct Business Expenses
You must complete and file Schedule C with your tax return to itemize your business costs and to calculate how much business income is left over after you deduct them. (Schedule C-EZ is only available for the 2019 tax year and earlier.)
The resulting number from Schedule C is then entered on line 3 of Schedule 1 of the 2020 Form 1040. This is your taxable income from your business. The total of Schedule 1, which is found on line 9, then transfers to line 8 of Form 1040.
The 2020 Form 1040 is different from the returns that were in use in previous years. With the exception of Schedule C, these lines and tax schedules do not apply to years 2018 and earlier.