24 tax tips for self-employed clients

August 25, 2023 4:15 PM

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Being your own boss creates big opportunities for tax savings — but only if financial advisors and their clients understand all of the complex rules surrounding self-employment, experts said.

Financial Planning compiled the below list of two dozen tax tips for self-employed clients by speaking with five advisors and tax professionals about retirement plans, company structures and deductions available to business owners and independent contractors. Since they're not having their taxes withheld automatically, they should be aware that they will usually need to begin making quarterly payments to the IRS rather than once a year, according to Calley Bjorkman, the tax lead advisor for Seattle-based Brighton Jones.

"Overall the takeaway is your taxes will get a little more complex once you do become self-employed," Bjorkman said in a webinar about self-employed tax strategies held by the firm earlier this week. "When you are an employee, you might incur expenses for the business you're working for that could be reimbursed. So you're tracking those expenses in which to get reimbursed. But when you are self-employed, you also have a lot more options of what tax deductions you can actually take, meaning there's more tracking of those income and expenses."

Besides the rising number of independent contractors working for Uber, DoorDash or other mobile-application technology firms, the ranks of self-employed clients can include lawyers, consultants, athletes collecting endorsement deals or even social media influencers, according to Chelsea Ransom-Cooper, head of wealth management and financial planning at Philadelphia-based Zenith Wealth Partners.

Brand ambassadorships, public appearances or merchandise sales from athletes or entertainers starting their own clothing line could also qualify a client as self-employed, said Brandon Williams, a director and wealth advisor with the TRUE Cresset | Sports + Entertainment division of Chicago-based Cresset.

"It is important to consider estate planning, retirement planning, proper insurance planning and residency planning," Williams said in an email. "All of these areas lead to tax strategies that a tax professional can model out for you."

The group of self-employed clients extend to physicians and other high-earning medical professionals — a niche served by Alexis Gallati, the founder of Knoxville, Tennessee-based Cerebral Tax Advisors and Andrew Altfest, the president of New York-based Altfest Personal Wealth Management.

"While their wealth can grow, business owners often feel pinched because they don't want to draw on their assets fearing adverse tax consequences," Altfest said in an email. "Tax strategies to reduce tax liability include Roth conversions, particularly in low-income years such as just after retirement, qualified charitable distributions, 1031 exchanges, step-in basis planning for their estates, loans and, when it comes to selling a business, proactively allocating for goodwill vs equipment/materials which will produce better and worse tax treatment."

Each of the five experts recommended speaking with an advisor or a tax professional to gain a full understanding of the below strategies and questions facing self-employed clients.

Scroll down the slideshow to see two dozen tax tips for self-employed clients, their financial advisors and their tax professionals. For a breakdown of the key tax-related questions relating to paying off student loans, click here. To find analysis of potential shifts in the required minimum distribution rules of inherited individual retirement accounts, follow this link.

Keep it in the family

Business owners may reduce their incomes by hiring members of their immediate family to actual jobs on their team, according to Gallati, who noted that taxpayers employing older parents "have to be careful" not to bump them into higher income categories for Social Security and Medicare purposes. Self-employed people's children who "have a legit job" in their business could save for retirement and cut the company's taxes, she noted.

"The business gets a deduction for their salary and their payroll taxes and they're not having to pay any taxes at all on that income," Gallati said.

Section 179 car deductions

Self-employed people using a car for their business such as real estate professionals or ride app or delivery drivers can claim Section 179 deductions the year they bought the vehicle and, in some cases, bonus depreciation exemptions as well, according to Ransom-Cooper. The benefits depend on factors such as the gross vehicle weight, whether it's a luxury car and how the taxpayer is claiming other business-related auto deductions.

"It's something that's been really popular," Ransom-Cooper said. "The car really needs to be used for, at a minimum, 50% for business. It can't be a personal car driving to the office."

Bonus depreciation and mileage apps

For 2023, the maximum allowable bonus depreciation rate for cars dropped to 80% from 100% of the amount from the first year, Gallati noted, pointing out that the highest deduction would be available to a taxpayer driving 100% of the time for business. Someone driving the vehicle 60% of the time for business would need to claim 60% of the 80% sum, she said. Technology can help drivers calculate and verify the business use of their car for their records as well.

"With different apps nowadays, it's so easy to track mileage," Gallati said. "There's really no excuse not to have a good mileage log."

Other vehicle options

Self-employed people can deduct an amount based on the mileage of the vehicle used in their business and costs of the vehicle, according to Bjorkman. The IRS set the distance-based deduction at 65 and a half cents per mile in 2023, which self-employed people can use on its own or in combination with maintenance and other expenses, she noted.

"That would require you to be tracking during the year the cost of gas, repairs, maintenance, oil changes, insurance, et cetera," Bjorkman said. "But you then apply those actual costs against the tracked business miles over your total miles for the year to get an allocation of business use for that car. We find that that method tends to be actually a lower tax deduction, just because the 65 and a half cents a mile is already a pretty good tax deduction, because not only is it accounting for the price of gas, but also assuming that there's some wear and tear by using your vehicle for business purposes. So that's why it's very generous, 65 and a half cents per mile. We find that tends to be the larger tax deduction of those two options."

Deduction for business tax preparation

A change effective in 2018 reserved for business owners alone a potential deduction previously open to anyone, Bjorkman noted.

"The Tax Cuts and Jobs Act eliminated for individual taxpayers the deduction for tax preparation costs, unless there was a business purpose for those tax preparation costs," Bjorkman said. "So being able to utilize that as a tax deduction strategy, you could probably put a portion, a part of those preparation costs against your business, because now you have all of those new tax forms included in your tax return. So you could, in turn, take some deductions against those tax preparation costs."

Equipment depreciation

Taxpayers can deduct the full price of any piece of equipment that declines in usefulness over time and costs $2,500 or less at purchase the year they bought the items, according to Bjorkman.

"If you're buying equipment to use in your business that is $2,500 or less in its purchase cost, you can claim that as a year-one tax deduction for the full tax benefit in that first year, instead of it having to be allocated among a depreciable life," she said. "So it became a great opportunity when someone's buying a cell phone or computer. If those are under $2,500, you can expense it all in year one when those costs were incurred."

Self-employment tax deduction

Self-employed people effectively pay "almost double" the Social Security and Medicare taxes of other employees, so they receive a 50% deduction on them, Bjorkman noted.

"You're paying the employee and employer portion," she said. "The IRS is trying to make you whole as if you were an employee."

Health insurance

Health and dental insurance, as well as long-term care and Medicare premiums for those at least 65 years old, reduce taxable income for self-employed people, according to Bjorkman.

"You're probably already paying for health insurance premiums," she said. "So when you become fully self-employed or have a new business, you're actually able to take a tax deduction against those costs for you and your family."

How the home-office deduction works

Self-employed people who meet IRS requirements that they use their homes on an "exclusive" and "regular" basis for their business can choose either the "simplified" or "regular" method of calculating their deduction, according to Bjorkman. The "simplified" method comes from multiplying the size of the home office by $5 up to 300 square feet — meaning the maximum deduction would add up to $1,500. The "regular" method carries the obligation for "a lot more due diligence on your end for tracking those actual expenses" on Form 8829, she noted.

"The regular method tends to result in a higher tax deduction," Bjorkman said. "And that is calculated by taking your home-office space, divided by the square footage of your home to get a percentage allocation. And then you take that — say it's 5% of your home is used for your home office. Now you're able to apply that 5% among actual home costs. Property tax and mortgage interest are big ones. Those also, if you itemize your individual taxes, you're already getting a tax deduction for those. But really where this becomes the most lucrative is, now you're able to claim your homeowner's insurance, all your utilities, cleaning fees, security alarm costs, all of those. Now, once again, normally not any kind of a deductible expense, you're now able to take those costs you're already incurring, and apply it against this home-office deduction, which reduces your business income and you get tax reduction for it."

Home is where the office is

More clients are asking about deducting their home-office expenses these days, according to Ransom-Cooper.

"The home-office deduction is advantageous for business owners. During the pandemic, everyone was asking about it," she said. "The home-office deduction can be very attractive, especially for consultants and service providers."

Secure 2.0 small business tax credits

The owners of businesses with 50 or fewer employees may qualify for the maximum tax credit of up to $1,000 per employee based on their matching retirement-plan contributions, according to Ransom-Cooper. That tax credit and one for starting up a retirement plan for the first time became available due to the passage of the Secure 2.0 Act last year.

The credit could help small business owners "if they want to increase how much they're putting toward their employees in their retirement accounts," Ransom-Cooper said. "The goal and the intention is to increase Americans' readiness for retirement."

The Masters play

The "Augusta" or "Masters" rule, an exemption named for the PGA major golf tournament held in Georgia each year, gives taxpayers an opportunity to deduct as much as 14 days of rental income in a year. As long as they aren't using their residence as their primary place of business, self-employed people could find other ways to get the exemption, Gallati pointed out.

"I even have clients who do this for the Masters. It's really great," she said. "However, you can also apply this to your business. Your business can rent your home for 14 days or less and you don't have to pay any tax on that income as the individual. And your business gets a deduction for the rental expense."

The retirement-plan decision

For retirement, self-employed individuals can take their pick among a Simplified Employee Pension Individual Retirement Account (SEP-IRA), an individual 401(k), a profit-sharing Keogh plan, a Savings Incentive Match Plan for Employees Individual Retirement Accounts (SIMPLE IRA) or a defined-benefit pension, Bjorkman said. They each have limitations and downsides in certain situations.

"What makes retirement plans a great tax deduction strategy is you are funding a retirement plan to avoid taxes in the current year," she said. "We're also having forced savings now for your retirement. Those are your assets. So it's a great benefit of saving taxes, but still kind of keeping your money with you instead of paying the IRS. These retirement plans, once again, have a lot of nuances to them in what plan might make sense for you and your business."

‘Low-hanging fruit’

The decision on which retirement plan to use looms large for business owners and other self-employed clients, Gallati said.

"That's one of the easiest low-hanging fruits for getting tax savings is putting it into a retirement account instead of putting it into the IRS's bank account," she said.

Individual 401(k) advantages

Certain business owners see big tax and retirement benefits from individual 401(k) plans, Altfest said.

"A favorite for contractors and solo practitioners is the individual 401(k), as you get to contribute as the employer and the employee, potentially allowing for much larger contributions," Altfest said. "This not only helps with savings but reduces taxes."

Does solo 401(k) still fit?

Business owners should remember to review whether an individual 401(k) still works for their company if they plan to grow in coming years, Ransom-Cooper said.

"You can put in a significant amount of money," she said. "The challenge is, if you have the intention of hiring at any point, then you are not able to use the solo 401(k). This is where people get tripped up a little bit."

Big savings potential

Certain business owners may find substantial tax savings by using defined-benefit pension plans, Altfest said.

"As business owners get older and have a steady reliable stream of income, defined benefit plans allow for large tax deferred contributions to be made," he said. "The tax savings of large defined-benefit contributions can exceed seven figures!"

Cost concerns

Defined-benefit pension plans come up "way less frequently" than other types of retirement accounts, and they usually "only make sense when the business owner is closer to retirement age," Bjorkman said. An actuary must determine the level of a pension plan's funding basis, she noted.

"These tend to be very costly plans to figure out how much you would need to retire on through a pension," she said. "That's an unlimited bucket, but they're trying to figure out how to fill that bucket with you being closer to retirement. So these you can take, maybe, up to a $200,000-to-$250,000 tax deduction, depending on your income and age. So it could be very, very high, but very high costs."

Going through the ‘backdoor’ Roth

The "backdoor" Roth individual retirement account process carries so many complexities that Gallati referred FP's question about the tax strategy to a lengthy blog post by Dr. James Dahle, the founder of The White Coat Investor, a personal finance and investing website for physicians. Users and Dahle made more than 3,200 follow-up comments about the topic below the post.

"Setting up a backdoor Roth can be confusing, so I thought I'd put together a tutorial on the backdoor Roth IRA steps people can refer to when they go through this process," Dahle wrote.

What type of business

Self-employed people can pick their best fit as a business entity for tax purposes among a sole proprietorship, a single-member limited liability company, a partnership, a C-corporation or an S-corporation. For athletes, the choice "depends on the reason for the entity, such as a desired number of partners or whether it is needed for legal liability or just tax planning," Williams said.

"There are many factors to consider for each entity type (LLCs, S-corps, etc.)," he said. "It's best to discuss the unique situation with a tax professional."

Pay yourself and deduct the salary

An S-corporation usually proves the "most beneficial" entity structure for clients with large annual income or revenue and low expenses, Ransom-Cooper said.

"You're required to give yourself a reasonable salary," she said. "You're reducing the amount that is subject to those self-employment or payroll taxes, which, in turn, is reducing your tax liability."

Don’t try this at home

Picking between a single-member limited liability company or an S-corporation often entails a close look at the pros and cons of either choice with a professional, Bjorkman said.

"This is a very, very common question we get," she said. "This is an area that, please, reach out to your tax advisors and your attorneys to help if you're trying to weigh these options."

Potential SALT limitation workarounds

With the Tax Cuts and Jobs Act limiting deductions for state and local tax payments to no more than $10,000 for individuals, many states are allowing pass-through entities such as a partnership or an S-corporation to bypass that ceiling, Gallati noted.

"The business can actually pay the associated state tax through it," she said. "Essentially what you're doing is paying the tax through the entity and getting a deduction as opposed to paying it on your individual tax return."

Qualified business income

The 20% deduction for qualified business income created by the Tax Cut and Jobs Act enables substantial potential savings for certain business owners. The opportunity comes alongside many "nuances and wrinkles" involving the thresholds for claiming the deduction and whether the business is service-based, according to Bjorkman.

"If you're consulting, if you're using your technical skill to generate income in your business, you are a service-based business," she said. "This is definitely an area where you have to speak with your tax and financial advisors to make sure you're properly taking advantage of this deduction if you qualify for it."