How to Avoid Paying Taxes on 1099
Being self-employed comes with its benefits. Setting your own schedule, working as little or as much as you like, and being in control of your destiny just to name a few. But you probably haven’t thought about the tax benefits of being self-employed.
As a business owner, you’re entitled to many tax deductions not available to W-2 employees. And if you’re wanting to lower your tax bill, you’ll want to make sure you take full advantage of them.
We’ve highlighted the top four hidden tax breaks you’ll need to maximize your self-employment tax savings.
How an independent contractor can avoid paying taxes
Employees typically have social security taxes and Medicare taxes taken out of their paycheck. As a business owner taxpayer or non-employee on the other hand, you get no tax withholding. Your tax liability rests on your shoulders. You are responsible for paying self-employment taxes on your miscellaneous income.
The good thing is that you’re entitled to many tax deductions not available to W-2 employees such as writing off business expenses. If you’re wanting to lower your tax bill, you’ll want to make sure you take full advantage of them. In fact, here are 25 1099 deductions for independent contractors you may be missing out on to lower your taxable income.
We’ve highlighted the additional top four hidden tax breaks you’ll need to maximize your tax savings and lower your self-employment income.
1. Mileage and vehicle expenses
As a small business owner, even if you’re the only person working for your company, you’ll be able to deduct certain costs related to using your personal vehicle for business purposes.
While employees who commute to work are not allowed to take a tax deduction for their commute, you’ll be able to write off the expenses when you travel to a client’s office.
There are two different methods of calculating tax-deductible vehicle expenses.
For tax purposes, the easier method is using the standard mileage rate. Each year, the Internal Revenue Service (IRS) publishes a mileage rate for business use of a personal vehicle. For 2022, that rate is $0.585 per mile.
You’ll need to keep a mileage log where you track the miles you drive for business purposes. Your log can be a notebook where you record the beginning odometer reading and the ending odometer reading to calculate the total miles driven for each business trip.
For example, if you’re driving to meet your client for a meeting and your odometer reads 16,887 when you get in your car and reads 16,914 when you arrive at the meeting, you drove 27 miles one way for your meeting. And you’ll be entitled to deduct 54 miles (27 x 2) for the round-trip.
You would make these types of log entries each time you made a business trip.
However, there are several apps and software programs you can load on your phone that also track your mileage. These will typically provide a report at the end of the year that calculates the total miles you drove for business.
Going back to our example above, your 54-mile round trip turns into a $31.05 tax deduction (54 miles * $0.575/mile).
An important thing to note: If you want to be able to use the standard mileage rate, you’ll need to use it in the first year you use your car for business. In the later years, you can use either the standard rate or actual expenses (which we discuss below). But if you use actual expenses in the first year, you’ll be stuck using that method every year.
Whether you drive a little or a lot, tracking your miles for taxes can provide a sizeable deduction.
Actual car expenses
As a freelancer, you also have the option to deduct your actual vehicle expenses that relate to your business use. You’ll still need to track the total miles you drive for business but instead of using the IRS rate, you’ll use the actual expenses you incurred
The actual vehicle expenses that you can include are:
- Depreciation (There are limits on how much you can deduct)
For example, if your mileage log shows that you drove 9,000 miles for business this year and you drove a total of 20,000 miles, then you used your vehicle for business 45% (9,000 / 20,000) of the time.
Assume your total car expenses were $5,600, you can deduct $2,520 ($5,600 x 45%). Note that using the standard rate of $0.585/mile would result in a $5,265 (9,000 x $0.585) deduction. As long as you claimed the standard mileage deduction in the first year you used your car for business, you would be better off claiming the standard rate this year to get a larger deduction.
However, if there is a year when your actual expenses are significantly higher resulting in a large deduction, claim the actual expenses. So long as you make the first-year election to use the standard rate, you’ll be able to use either method in later years to get the maximum deduction.
2. Home office deduction
If you’re using a part of your home for your office, you’ll be able to deduct a portion of the costs to maintain your home. Beware there are some specific requirements for claiming this home office deduction.
The home office tax deduction can be claimed by both renters as well as real estate homeowners. This deduction only works on the portion of your home that you use for your office must be exclusively and regularly used for business.
Your home office doesn’t need to be a permanently defined space like a guest bedroom. It could be a corner of your bedroom that you use only for working on your business. However, if the space is also used for other purposes, it won’t meet the exclusive use test. An example would be using the dining room table for business but also using it to eat meals.
And you must also use the home office space regularly for business. If you use it only sporadically because you have a rented office space somewhere else or you usually work at client offices, then it won’t meet the regular use test.
As a freelancer, your home office must also be your principal place of business. That means you can’t have an office or building somewhere else that you use as your principal place of business. There are exceptions for administrative only home offices.
To calculate your home office deduction, calculate the area of your home used for business. If you use a bedroom that’s 200 square feet and your home is a total of 1,500 square feet, then 13.3% (200 / 1,500) of your home is used for business.
Next tally up all the expenses you incurred to maintain your home. Include things like utilities, insurance, and home security. And in our example, you’ll take 13.3% of those total expenses as a tax deduction.
If you made direct improvements to your home office, like installing new lighting or flooring, you can take 100% of those direct expenses as a deduction.
However, if you don’t want to keep track of your home expenses, the IRS allows you to use the simplified method.
The simplified method uses $5/square foot as your deduction. In our example above, the 200 square feet of office space equals a $1,000 ($5 x 200) tax deduction.
Check the IRS's summary page for more information.
3. Qualified business income deduction
For certain types of businesses, you may be able the qualified business income deduction. This allows you to deduct up to 20% of qualified business income.
Caveat: This deduction is only allowed for what the IRS calls pass-through entities, which are sole proprietorships, partnerships, LLCs, and S Corporations, and is set to expire in 2025 unless Congress takes action to extend it.
The calculation for this deduction is very complicated but tax preparation software will do the math for you if you are a pass-through entity.
4. Become an S Corporation
We are commonly asked if you should form an S-Corp or LLC for independent contractors. S-Corporations, or S-Corps for short, is a tax structure that provides tax advantages. Besides the qualified business income deduction we discussed above, you’ll also be able to save on self-employment tax when you elect to be taxed as an S-Corp.
Caveat: To be taxed as an S-Corp, you’ll need to have formed a legal corporate entity like an LLC or a partnership. That means if you’re a sole proprietor, you’ll need to create an LLC or partnership.
Once you have your corporate entity you can choose to be taxed as an S-Corp by filing Form 8832 and Form 2553.
As an S-Corp, you’ll be required to pay yourself “reasonable compensation”. What’s reasonable compensation will vary between industries.
You’ll pay self-employment tax of 15.3% on your reasonable compensation. But remember you’ll also get a business deduction for half of that tax and you’ll be able to take dividends and distributions from the business in lieu of paying yourself a larger salary.
Let’s look at a simple example:
You are the only owner of an LLC providing IT consulting services and you file the correct forms to be taxed as an S-Corp.
You do some research and learn that a reasonable salary for the type of work you do is $60,000/year. You pay yourself $60,000 a year as a salary and pay the 15.3% self-employment tax of $9,180 ($60,000 x 15.3%).
But your business earned $150,000 for the year. Instead of increasing your salary and paying more in self-employment tax, you can take the additional $90,000 ($150,000 - $60,000) as a distribution/dividend and avoid paying $13,770 ($90,000 x 15.3%) in tax.
However, if you don’t elect to be taxed as an S-Corp, the entire $150,000 will be subject to self-employment tax.
It's time to lower your tax bill!
Filing your tax return for your 1099 income doesn’t need to be scary. Using tax software designed specifically for those who receive tax Form 1099s takes away the headache and worry at the end of the tax year. Simply answering some yes/no questions will get you the tax savings you are entitled to for your income taxes. Also, don't forget to file estimated tax payments or quarterly tax payments before tax time to avoid a penalty.
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At Keeper Tax, we’re on a mission to help freelancers overcome the complexity of their taxes. That sometimes leads us to generalize tax advice. Please email email@example.com if you have questions.