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The Tax Deductions Every Sole Proprietor Should Know

Guest article written by on Jul 19

As a sole proprietor you also need to be a tax expert. Sharpen your edge by getting to know more about the ways to lower your tax bill.

While tax law is complicated, the benefit of utilizing tax deductions is simple. The more legitimate deductions you’re able to claim, the less tax you pay. As a sole proprietor, using a majority of their business earnings as income, these are some of small business deductions you should know:

Home Office Deduction

Many sole proprietors mistakenly fear that claiming the business use of their home will instantly result in an audit. While this has been proven to be untrue, in order to claim the home office deduction you need to ensure, that:

  • The portion of your home that you set aside for your office is used for business purposes only.
  • You must work in this space regularly as part of your business.

Note: Your home office does not have to be your primary place of business. For instance, if you have a storefront but do most of administrative tasks at home, you may still claim a home office deduction.

The Internal Revenue Service (IRS) allows two methods for filing a home office deduction:

  • The simplified method is exactly what it implies — you multiply the square footage of your home office, up to a maximum 300 square feet, by the set rate of $5 per square foot. If your expenses and needs are very simple, this is all you need to do.

  • The standard method requires more documentation and record keeping. However, if your expenses are higher, this will give you a larger deduction.

    • Using the standard method you may claim either direct or indirect expenses.

      • Direct expenses apply only to your home office, for example, a repair or renovation made exclusively to your home office. You may claim 100% of direct expenses.

      • Indirect expenses apply to the “running and upkeep” of your home. You may only claim a percent of these expenses.

        • To calculate the percent: All you have to do is make your elementary school math teacher proud by dividing the number of square feet in your office by the total number of square feet in your home.
      • Qualifying expenses may include:

        • Utilities (with the exception of a home landline phone).
        • Repairs and renovations.
        • Interest on mortgage or rental payments.
        • Mortgage and homeowner’s insurance.
        • Property taxes.
        • Depreciation (if you own your home).
        • Security system installation, maintenance and monitoring.
        • Up to $250,000 ($500,000 if married and filing jointly) on income gained from the sale of your home. (Only applies in the year of sale.)

The best way to know which method to choose is to do a rough calculation of each. If the simplified method is close to what you’d get with the standard method, then you can save yourself some work and use the simplified method. Note: Once you choose a method and submit you return, you can not go back and change methods.

If you run a licensed daycare from your home, the calculations for the standard method get a little more complex by factoring square footage of a room/space used with the percentage of time it’s used for your business.

Travel and Mileage

As a business owner you can deduct the actual expenses incurred on travel and mileage for business. Travel expenses may include airfare, hotel, rental cars, meals etc. (Note: If you bring your family with you, their expenses are only covered if they were also working for the company during the trip.) If your vehicle is used exclusively for business, you may claim the full amount of expenses, like parking, gas, tolls and repairs. If the vehicle is used for business and personal use, then the portion of expenses related to business use only can be claimed.

Like the home office deduction, you may use standard or simplified method to claim vehicle expenses:

  • With the simplified method, you multiply your business mileage by a standard mileage rate.

  • With the standard method, you claim the percentage of business use for each expense.

Meals and Entertainment

If you are having a meal, coffee or cocktail as part of a business meeting, entertaining a client or any other business function, you may claim 50% of the costs. But don’t get too crazy. Lavish or overly expensive claims are not allowed.

Social Security and Medicare Taxes

While you may know that you have to pay social security and medicare taxes, you may not be aware that you can actually claim some or all, of these costs on your return.

  • If you qualify as self-employed, you may deduct 50% of the quarterly social security and Medicare contributions made throughout the year.

  • If you’re an employer, you may claim the employer contributions made to social security and Medicare as part of your payroll throughout the year. Employers may also claim any eligible federal and state unemployment tax contributions.

Startup Costs

If you are in the first year of establishing your business, you may claim up to $5,000 in startup costs, such as legal, advertising and consulting fees, without having to capitalize the expenses across several years. Note: If your startup costs are $50,000 or more the deduction starts to decrease and if your total is $55,000 the deduction is taken away.

Section 179 Depreciation

As a stimulus act, Section 179 Depreciation, gives small businesses the opportunity to claim up to $500,000 in qualified equipment purchases, including software, within the purchase year — without having to allow for capitalization. Claiming Section 179 Depreciation requires the use of Form 4562. However, the benefits often outweigh the burden of one more piece of paperwork.

Health Insurance

A key advantage of being a sole proprietorship is having the ability to claim a health insurance deduction for yourself, your spouse and/or your dependents. This deduction is limited to your taxable income and can only be claimed for the months that you, your spouse and/or your dependents are not covered by any group insurance through an employer.

Bad Debts, Interest on Loans and Banking Fees

Sometimes money may seem like it’s gone when it really isn’t. If you can prove that an unpaid invoice was uncollectable, you can write off the full amount of a bad debt (if you are using the accrual method of accounting). Even the cost of doing business can be written off by deducting interest on business-related loans along with checking account, ATM and other banking fees.

Where to Find More Information

There are lists and lists of deductions out there, for instance, American Express has a list of the 10 Most Overlooked Small Business Tax Deductions, Lifehack has the Top 10 Tax Write-Offs for Small Business Owners and Wagepoint offers the Comprehensive List of Small Business Tax Deductions. To find more, simply enter the search terms “small business tax deductions.” (Be sure to consider the source and check the date of publication. The more recent the date, the more accurate the information is likely to be.)

Best Practices Every Sole Proprietor Should Follow

Planning for tax season shouldn’t start as the deadline approaches, it should actually be a part of the way you do business all year. A few of the basic principles include:

  • Document, Document, Document

    While the submission of documentation may or may not be required for certain deductions, you must keep records of these items for a minimum of three years. The phrase “better safe than sorry” definitely applies here. It may also be of value to keep electronic and hard copies.

  • Work With a Bookkeeper and Accountant

    It almost goes without saying that a best practice for filing small business taxes is to work with a qualified bookkeeper and accountant. Their understanding of the rules and how to comply can make a world of difference and bring you greater peace of mind. (Another perk: Bookkeeping and accounting fees are also deductible.)

  • Keep Business and Personal Expenses Separate

    If an expense is partly for personal and partly for business, only the business portion may be claimed as an allowable business deduction. All business owners, including sole proprietors, must always aim to keep personal and business expenses separate by using a dedicated business credit card and bank account.

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