One of the keys to running a successful sole proprietorship is to take advantage of the various income tax deductions for self-employed individuals. The deductions are designed to level the playing field with other types of business entities.
Schedule C – Profit or Loss From Business is the income tax form that’s used to report income and expenses of a sole proprietorship. Deductions include cost of goods sold for businesses with inventory and various operating expenses. The latter includes salaries, payroll taxes, health insurance, and retirement plan deductions for employees. Expenses for business use of your home can also be claimed if you use an area exclusively for business on a regular basis.
In addition to the various Schedule C deductions, there are five other deductions available to self-employed individuals. All five can be taken whether or not you itemize your deductions. Four have been in existence for several years, while one is brand new in 2018. This post provides an overview of each of the five deductions.
The calculation of the deductions is complicated, requiring either a separate income tax form or a worksheet. It’s important that you work with a CPA or enrolled agent who is experienced with preparing income tax returns for self-employed individuals to obtain the greatest amount of tax savings.
Qualified Business Income – The New Kid on the Block
The Tax Cuts and Jobs Act of 2017 changed the “Subchapter C” corporate income tax rate structure in 2018, reducing four tax brackets with a top rate of 35% to a flat rate of 21%. In response to this, something was needed to level the playing field for other types of business entities, including sole proprietorships.
The solution is a new income tax deduction known as “qualified business income,” or QBI. Unlike the corporate tax rate reduction which is permanent, the QBI deduction expires at the end of 2025. For self-employed businesses, QBI is net self-employment income, i.e., gross income less total expenses, as reported on Schedule C.
For businesses that qualify, the deduction is the lesser of 20% of QBI or 20% of income before the QBI deduction. Income before the QBI deduction is adjusted gross income reduced by the greater of total itemized deductions or the standard deduction.
There are special rules for specified service trades or businesses (SSTBs) that reduce the deduction if taxable income exceeds $315,000 for a married couple filing a joint return and $157,500 for all other taxpayers. No deduction is allowed when taxable income exceeds $415,000 and $207,500, respectively.
Self-Employment Tax Deduction – Everyone with Net Self-Employment Income Qualifies
One of the easier deductions to calculate is the deductible part of self-employment tax. Self-employment tax is the equivalent of Social Security and Medicare tax for employees. For self-employed individuals, it’s calculated on the amount of one’s net self-employment income reported on Schedule C and Schedule K-1’s, with the latter reduced by business expenses paid personally.
Social Security and Medicare taxes are withheld from employees’ salaries at a rate of 6.2% and 1.45%, respectively, for a total of 7.65%. Social Security withholding is subject to a wage limitation, which was $128,400 in 2018.
Employers match employee withholding of 7.65%, resulting in a total tax of 15.3%. This is the same rate that’s used to calculate self-employment tax. Self-employed individuals can deduct one-half of self-employment tax, matching the deduction to which employers are entitled.
Self-Employed Health Insurance Deduction – Who Needs to Itemize?
It’s never been easy to take medical deductions. IRS allows you to deduct qualified out-of-pocket medical expenses, including health insurance, on Schedule A – Itemized Deductions to the extent that they exceed 7.5% of adjusted gross income. The threshold is increasing to 10% beginning in 2019. Even if you have medical expenses that exceed the adjusted gross income threshold, your ability to itemize deductions beginning in 2018 may be curtailed by various changes in the tax law.
Given the fact that employers are entitled to a deduction for payment of employee health insurance premiums, self-employed individuals can also take a deduction for this expense. This includes medical and long-term care insurance premiums, with the latter subject to a limitation based on age. The self-employed health insurance deduction is allowable up to the amount of net self-employment income reduced by the self-employment tax and self-employed retirement plan deductions.
Health Savings Account Deduction – Often Overlooked
As stated above, there are onerous hurdles when it comes to deducting medical expenses. In addition to the self-employed health insurance deduction, there’s another opportunity for-self employed individuals to deduct qualified out-of-pocket medical expenses that are otherwise nondeductible. The vehicle for doing this, which is often overlooked, is a Health Savings Account, or HSA.
All individuals who have no other health coverage and aren’t enrolled in Medicare are generally eligible to open and fund a HSA provided that they’re covered under a high deductible health plan, or HDHP. Contributions to a HSA account are deductible and earnings aren’t taxable provided that distributions are used to pay for eligible medical expenses. 2018 contribution limits are $3,450 for a single plan and $6,900 for a family plan with an additional $1,000 for those 55 and older.
Please see Deductible Medical Plans Make More Sense for additional information about HSAs.
Self-Employed Retirement Plans – Incentive to Save for Retirement
As is the case with the first three deductions which are designed specifically for self-employed individuals, the ability to contribute to various types of retirement plans with an associated income tax deduction is intended to offer the same retirement saving incentives that are available to employees.
There are various types of retirement plans with specific contribution limits available to self-employed individuals. These include SEP-IRAs, SIMPLE plans, and qualified plans such as 401(k) and defined benefit plans. While contributions to most plans are deductible, those made to Roth 401(k) plans aren’t.
There’s a limit on the amount of annual compensation that you can take into account when calculating the amount of allowable retirement plan contributions. The limit was $275,000 in 2018 and has increased to $280,000 in 2019.
Self-employed individuals must reduce their net earnings from self-employment by the following two deductions in order to calculate the amount of their plan compensation:
- The deductible portion of self-employment tax
- The amount of their own retirement plan contribution
A popular type of retirement plan that’s easy to administer and is the default for many self-employed individuals is a SEP-IRA. Contributions an employer can make to an employee’s SEP-IRA cannot exceed the lesser of (a) 25% of the employee’s compensation, or (b) $55,000 in 2018 or $56,000 in 2019.
Substantial Income Tax Savings are Possible
The four income tax deductions that were available before 2018 provide an opportunity for substantial income tax savings individually and on a combined basis. The introduction of the qualified business income (QBI) deduction in 2018 is an additional opportunity for potential sizable income tax savings for those who qualify.
Disclosure: Robert Klein is a self-employed CPA who has been preparing business, fiduciary, and individual income tax returns, including self-employed individuals, for the last 37 years.