Self-employment deductions you might be missing

Self-employment taxes are Social Security and Medicare taxes that self-employed individuals must pay, with a combined tax rate of 15.3%. Employees are subject to the same tax, but the tax is split between employer and employee, with each paying 7.65%. The IRS considers self-employed individuals, both the employer and employee, hence the higher self-employment tax rate.

Self-employment includes many benefits, but higher taxes are a concern for many and, like accounting, require periodic effort to understand and manage. Paying the lowest amount of self-employment tax possible is a high priority to maximize profits.

How can I avoid paying self-employment taxes?

The good news is that there are many techniques you can utilize to minimize your self-employment tax. Here are some tips every self-employed business owner should know about.

Entity structure

Consider making an S corporation election with the IRS. As a sole proprietorship or an LLC that does not choose this option, you will pay self-employment tax on your entire share of business earnings. As an S corporation, you will only pay self-employment tax on a reasonable salary based on business earnings and not on the remainder of the business profits.

Self-employment tax deduction

The IRS allows you to deduct half of your self-employment tax from your net income. While this does not reduce your self-employment tax, it does effectively reduce your taxable income. This gives you a bit of a break on the portion that your employer would have paid had you been employed.

Health insurance premiums

If you are not eligible for employer-sponsored health insurance on your own or through your spouse, you may be eligible to use health insurance premiums for yourself, your spouse, and your dependents under age 27 to reduce your personal income tax to the extent that you had business income. This is not a business deduction; it appears on your personal tax return and can be taken whether you itemize or not.

Qualified business income deduction

The Qualified Business Income (QBI) deduction allows certain business entities with pass-through income under IRS thresholds to deduct up to 20% of their business income on their personal tax return.

Timing

With a little creativity, you can use timing to minimize your taxes in a perfectly legal manner. For example, you can choose to defer income that would put you in a higher tax bracket this year. And, if you're confident that you will be in a lower tax bracket or have less income next year, you can purchase assets this year to take Section 179 or bonus depreciation, thereby lowering your business income. Of course, only try this if you have an accurate financial picture of the coming year as well.

Deduct valid business expenses

You can and should lower your net profit by deducting any necessary and ordinary expenses for running your business and generating income. These expenses can significantly reduce the amount of your self-employment income that will be subject to tax. Use a Schedule C and be as thorough as possible in documenting all legitimate business expenses.

Keep in mind that these expenses must be directly related to your business; the IRS can scrutinize these deductions since there is so much room for abuse. In many cases, valid business use may be mixed with personal use, such as a business trip where you took your spouse along or a vehicle used for both personal and business use. Always be sure to deduct only the legitimate business portion as a business expense.

As a rule of thumb, ask yourself the same question that the IRS would ask: Is this expense ordinary and necessary in my line of work? If the answer is yes, then go for it.

Here are some common deductible business expenses; with each one, whether you use a standard IRS-provided allowance or go the itemized route, it cannot be overemphasized that detailed records are an absolute must.

• Home office expense
• Phone and internet bills
• Rent for equipment or office space
• Travel and meals
• Vehicle usage
• Office supplies
• Education
• Professional fees
• Publications, subscriptions, and memberships
• Business insurance
• Advertising
• Interest on a business loan
• Startup costs
• Contributions to retirement plans

There is no way to get around paying self-employment tax, but with proactive planning and meticulous record-keeping, you can significantly reduce the tax burden you face and enjoy being your own boss.