If you are a freelancer or considering becoming one, you probably have questions about what kinds of tax deductions you can take.
How you are taxed as a freelancer depends on the structure of your business:
Sole Proprietorships: The sole proprietorship, in which the business is owned and managed by an individual proprietor, is a common structure for freelancers. Bottom line: You are the company, and as the owner, you pay taxes on business income as part of your personal income tax.
Limited Liability Company (LLC): An LLC protects a freelancer from personal liability, but it has a more flexible management structure than a corporation. An LLC can choose how it wants to be taxed—as a sole proprietorship, S corporation, or C corporation. Profits and losses are reported on the owner’s individual tax return if the business is a sole proprietorship or S corporation.
S Corps and C Corps: Because a C Corp is the costliest and most complicated form of business, the structure is not popular (or necessary) for freelancers. However, if you plan to make more money than you would have made at an equivalent full-time job as an employee, an S Corp allows you to split your profits between your employee wage and distributions of profits from your business. The employee wage portion is taxed at the higher self-employment rate, but the remainder is treated as distributions of profits from your business.
The good news: Being a freelancer allows you to claim most of the same deductions as a larger business. In general, you can deduct the costs of running your business. The IRS deems a business expense deductible if it’s both ordinary and necessary. An ordinary expense must be common and accepted in your field of business. A necessary expense must be helpful and appropriate for your business.
Here are the most common tax deductions you can take as a freelancer:
Startup expenses: If you started your business in the calendar year for which you’re filing taxes, you can deduct expenses related to startup such as research, marketing, professional fees (such as attorney or accounting fees) equipment purchases, marketing costs, etc. You can even deduct the costs of startup if you didn’t start in that year, as long as you were buying or starting a specific business. If you were researching several business ideas, however, you cannot deduct those expenses. If you do decide to set up an S Corp or LLC, you can also deduct organizational expenses.
Home-based business: To take the home office deduction, you must meet two general rules: A portion of your home must be set aside for the exclusive use of running your business, AND it must be your principal place of business. If you meet these requirements, calculate the percentage of your home’s square footage that you use for business, and that percentage of your rent or mortgage or rent, utilities, etc., becomes deductible. Another option is to deduct $5 per square foot of your home used for business, up to 300 square feet. Talk to your tax expert and check IRS Publication 587 for more details.
Self-Employment Health Insurance Tax Deduction: Freelancers with a net profit for the year may be eligible for the self-employed health insurance deduction. An adjustment to income, instead of an itemized deduction, the adjustment is for premiums you paid on a health insurance policy covering medical care, including a qualified long-term care insurance policy for yourself, your spouse, and any dependents. The policy also covers children under the age of 27, even if the child wasn't a dependent. If you don't claim 100% of your paid premiums, you can include the remainder with your other medical expenses as an itemized deduction on Schedule A (Form 1040 or 1040-SR (PDF).
Transportation: You can deduct costs associated with transportation to and from meeting with clients, running business errands such as buying supplies, attending seminars and meetings, and more. If you use your car for transportation, keep a log and receipts for costs associated with the business use of your car, such as mileage, maintenance, repairs, and fuel. The standard mileage rate allowed by the IRS changes annually, so be sure and check with your accountant for the current amount. For 2020, the mileage rate is 57.5 cents per mile.
Travel: Travel expenses associated with the running, marketing, and sales of your business are deductible, including plane and train fare, car rental, hotel stays, meals, tips, dry cleaning, and phone bills.
Entertainment and gifting: The 2017 Tax Cuts and Jobs Act (TCJA) eliminated the deduction for any expenses related to activities generally considered entertainment, amusement, or recreation.
Charitable contributions. You can only claim contributions to charities approved by the IRS, and you’ll be taking the deduction on your personal tax return.
Education: As a freelancer, you can deduct expenses for “qualifying work-related education” such as tuition, books, supplies, lab fees, and transportation to and from classes. This reduces the amount of your income subject to both income tax and self-employment tax.
Bank loans. Interest on a bank loan you took out for your business is a tax-deductible business expense.
Business insurance. Premiums on business insurance such as liability and fire insurance are deductible.
The Gig Economy
To offer some clarity on tax issues for multitudes of freelancers, the IRS has created a dedicated page within its website called the Gig Economy Tax Center. The IRS describes the gig economy as an “activity where people earn income providing on-demand work, services or goods.” The website helps freelancers or gig workers find the right tax forms, how to keep records, deduct expenses and pay taxes.
A Note about California’s AB5 Ruling
California’s new AB5 law has made it a bit more complicated to remain an independent freelancer and other states could soon follow suit. The law, which went into effect January 1, 2020, cracks down on employers hiring independent contractors to avoid paying employment taxes and providing benefits and yet managing the workers like employees. Specifically, to stay classified as an independent contractor, workers must pass a three-point test:
- “The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact.”
- “The worker performs work that is outside the usual course of the hiring entity’s business.”
- “The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.”
As a freelancer, you’ll need to be sure your clients understand the rules and what you can and cannot agree to in the scope of the work and the project management.