New business owners are often unprepared for the tax that comes along with self-employment income. With wages, which are subject to federal income tax, Social Security (SS) tax and Medicare tax, the burden for the SS and Medicare is split between the employee and employer. Those who are self-employed must pay both portions and it can come as a big surprise if you don’t plan ahead.
It is important to document your deductible expenses to protect yourself in the case of an audit. Knowing what is deductible in the first place will help you make sure that your expenses are documented appropriately. Here are some business deductions that are frequently missed.
Deduction for Business Use of the Home (Home Office Deduction)
If you use a portion of your home exclusively for business[i], you can take a business deduction for various expenses. If you use the traditional method, you are able to deduct a portion of expenses such as insurance, utilities, mortgage interest and property taxes. The deductible amount is a percentage of total expenses and is based on square footage of the home office as compared to the total square footage of the home.
For 2013, a new “simplified” method is available for the home office deduction. The new method allows for a flat $5 per square foot of home office space, up to 300 square feet maximum. This new method lessens the administrative burden for the taxpayer. A second benefit of the simplified method is that you can take the $5/square foot and claim 100% of your home mortgage interest and property taxes along with your other itemized deductions.
Under either method, a taxpayer will receive a home office deduction of $1,500 or less. The real benefit of establishing a home office is an increase in deductible vehicle expense (mileage). When tracking business miles, commuting miles don’t count. Business miles only include travel from the main office to a secondary work location, or between multiple work locations. Travel from home to main office doesn’t qualify. But, if you have a home office, travel between home and the office is now travel between two offices.
Food and Meals on Premises
Business owners can deduct the cost of “Meals and Entertainment (M&E)” with clients, prospective clients and employees. This category of expenses includes any meal and entertainment expense incurred during, directly preceding or directly following conducting business and they are 50% deductible. There is a similar deduction called Food and Meals on Premises (FM), except these expenses are deductible in full. The distinction is location; on premises refers to in office. Below are some examples of each of these expenses.
- Meals and Entertainment
♦ Lunch with a potential client at a local restaurant to discuss your services
♦ A concert with a client immediately after a business meeting
- Food and Meals on Premises
♦ Coffee and cookies purchased for your office reception are
♦ Food provided for a required in-office staff meeting
Small Employer Health Care Credit
Considering the coming implementation of the Affordable Care Act, this is one credit employers must know about. For tax years 2010-2013 eligible employers can get a credit of up to 35% of premiums paid for employee health care. The maximum credit amount is scheduled to increase to 50% in 2014 and to apply to premiums paid to a Small Business Health Options Program (SHOP) Marketplace.
You may be an eligible employer if you pay 50% of the cost of single coverage for your employees and you have fewer than 25 full-time employees who are paid an average of less than $50,000/year. If you aren’t able to realize a benefit from the credit, you are allowed to carry the credit forward to a future year.
Charitable “Contributions” that are actually Marketing Expenses
Charitable contributions are a personal itemized deduction going against ordinary income. Don’t confuse this with marketing expenses, a common and costly mistake. If you receive any benefit in return for your donation it is not charitable it is marketing, and that’s a good thing. Marketing is a business expense going against self-employment income which is taxed at a higher rate than ordinary income. In other words, a business deduction (marketing) is more beneficial than a personal deduction (charitable contribution).
For example, if you give money to a non-profit and they put your name on a banner or in a brochure, that’s an advertising expense, despite the fact that the money was given to a charitable organization. Deduct this on your business’ Schedule C, not on your Schedule A for itemized deductions.
Self-Employed Health Insurance
Self-Employed taxpayers are allowed an above the line deduction for qualified health insurance premiums paid for the taxpayer, spouse, or dependents.[ii] Above the line means that the deduction is calculated before arriving at Adjusted Gross Income (AGI). While the deduction is limited to the net profit from the business, most taxpayers do not reach that limit.
The ability to deduct the cost of health insurance as an adjustment to income, instead of an itemized medical deduction on Schedule A, is highly advantageous. Medical expenses deducted as itemized deductions are subject to a much steeper limitation. They are only deductible to the extent that they exceed 7.5% of AGI. For most taxpayers, the 7.5% rule means benefit is only realized in years where an unusually large medical expense such as surgery is incurred.
[i] There are some exceptions to the exclusivity requirement.
[ii] The IRS has not yet made comment on the Windsor decision about how they will define “spouse” for 2013 and beyond.