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Thanks to the COVID-19 pandemic and the recession, more than 6 million additional people are working part time in the gig economy. Many of these adults who are involuntarily self-employed are working for lower wages than they had at their previous jobs and getting fewer benefits, too. The tax breaks for the self-employed can help soothe some of that pain — but taxes can also sting you if you're not prepared. Here's how to manage your taxes if you're suddenly self-employed.
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Know which deductions you can claim
A big break for the self-employed
Under the 2017 Tax Cuts and Jobs Act, self-employed individuals can deduct 20 percent of their qualified business income (QBI) from their federal income taxes. If you generated $45,000 in income from your business and had $10,000 in deductions, your QBI would be $35,000. You can then deduct 20 percent of that, or $7,000, from your income, which will reduce the amount of tax you owe.
You don't have to form a special type of business to get the self-employment deduction. If you're a sole proprietorship — as many self-employed people are — you're entitled to the tax break. Other fine print:
- The break reduces only federal income tax, not the self-employment tax.
- The deduction is phased out for joint filers with $315,000 to $415,000 in personal income, and between $157,500 to $207,500 for all other filing statuses. You get no deduction if your personal income is above those ranges.
- The deduction is limited for individuals in some traditionally high-paying service businesses, such as lawyers and doctors.
"It's a phenomenal deduction, and most businesses qualify,” says McNeill. “You may be able to generate income this year and pay almost no income tax on it at all."
If you're self-employed, you can claim a federal income tax deduction for your ordinary and necessary business expenses. “Ordinary” in this case means common and accepted costs in your line of business. “Necessary” means something that is helpful for your business. (It doesn't have to be indispensable to be deductible.) A deduction lowers your income, which, in turn, reduces your taxes. You report your business income and expenses on Schedule C, Profit or Loss From Business, on Form 1040.
One advantage for the self-employed: Most business deductions aren't subject to the same limitations as personal deductions. For tax year 2020, for example, your personal medical deductions have to be more than 7.5 percent of your adjusted gross income in order to deduct them. But self-employed individuals may be able to deduct some medical expenses, such as the cost of their health and dental insurance, from their business income. If you have a disability, you can deduct any medical expenses necessary for you to work, instead of claiming them as personal medical deductions.
The other advantage is that in some businesses, the deductions for being self-employed can be quite large. For example, drivers for Uber and Lyft (as well as other similar companies) can deduct the cost of gasoline, regular car maintenance, registration fees, auto and health insurance, and even the cost of car washes. Similarly, if you make things, such as cakes, you can deduct the cost of the goods required to create your products: in this case, flour, sugar, cake boxes, baking utensils and cleaning supplies.
Other deductions may seem small, but they can add up over the year. If you accept credit cards, for example, you can deduct the fees that credit card companies charge your business. And you can also deduct fees for licensing your business. For a full rundown on what you can and can't deduct, see Internal Revenue Service (IRS) Publication 535, Business Expenses.