We all know small business owners are super busy running their operation, planning their strategy and making sure they earn a healthy profit. As a result, understanding and staying up to date on the latest tax rules is not always top of mind. Be a trusted advisor to your clients and educate them as often as you can. Even though these tax breaks are ultimately claimed on the tax return, year-round tax planning is important to fully maximize any tax benefits.
In general, these tax breaks are not specific to 2020, but available in any year. Under the tax code, self-employed individuals are treated like small business owners, so the rules apply uniformly.
#1: General rules. Businesses are generally allowed to deduct the costs of carrying on the trade or business. To be deductible, the Internal Revenue Code requires that business expenses be ordinary and necessary. “Ordinary” means the expense is common and accepted in an industry, while “necessary” means the expense is helpful and appropriate for the trade or business. Examples of allowable expenses are salaries paid to employees, rent expense for office space and interest paid on a company loan.
The personal portion of an expense is not deductible, such as personal use of a company automobile. The rules apply to small businesses regardless of the type of entity (sole proprietorship, partnership, corporation or S corporation).
#2: 20% Qualified Business Income (QBI) deduction. Under the Tax Cuts and Jobs Act (TCJA), there is the QBI 20% deduction on business income for small business owners who report their operations on Form 1040, including sole proprietors who use Schedule C (as well as income from partnerships, S corporations and limited liability companies).
This is a big windfall for small business owners because $20,000 of $100,000 of business income would go untaxed! This deduction allows small business owners to keep more earnings tax free, and helps curb high tax rates and the 15.3% self-employment tax. Small businesses qualifying for the 20% tax deduction could see their effective marginal tax rate reduced to 29.6%.
There are some calculations and limitations surrounding this deduction, including a phase out of the deduction for high-income earners (over $160,700 for single filers, $321,400 for joint filers and $160,725 for married filing separate filers).
#3: Home office deduction. If your clients use part of their home regularly and exclusively to perform administrative or managerial activities for their business, they can claim a home office deduction for utilities, rent, mortgage interest, depreciation and cleaning fees based on the square footage of the home used for the business. Any allowable home-related itemized deductions, such as mortgage interest and real estate taxes, can still be claimed.
The IRS also provides a simplified calculation for figuring the deduction for using a home for business. This simplifies the calculation and recordkeeping requirements, but does not change the criteria as to who may claim the deduction. A portion of the home must still be used exclusively, and on a regular basis, for business purposes. In general, figure the deduction by multiplying the area of a home used for business by $5, up to a maximum deduction of $1,500.
#4: Start-up costs. The government encourages people to open a new business by allowing a $5,000 write-off for start-up expenses. This $5,000 deduction is reduced by the amount that total start-up expenses exceed $50,000. Any start-up costs that are not allowed to be expensed can be amortized over a 15-year period, beginning in the month the client starts operating.
Start-up costs include amounts paid either to create a trade or business, or to investigate the creation or acquisition of a trade or business. Examples include ads for the opening of the business, as well as travel and other necessary costs for securing prospective distributors, suppliers or customers. Once the enterprise actually begins operations, all business expenses are deductible.
#5: Retirement plans. It’s always a good idea to plan for retirement, especially with some nice government incentives. There are a variety of retirement plans available to small businesses that allow the employer and employee a tax-favored way to save for retirement. Contributions made by owners for themselves and employees can be deducted.
There are lots of choices in retirement plans:
- Set up a 401(k) or SIMPLE plan if you want to cover employees.
- IRAs, SEP IRAs and SIMPLE IRAs avoid the complex rules, red tape and expensive administration costs that apply to qualified retirement plans.
The small business owner is also allowed a tax credit equal to 50% of the first $1,000 incurred in starting a plan. It’s smart to consult with a financial planner before deciding on a plan that best suits the business’s needs.
#6: Depreciation. Business owners are allowed to fully write off the entire cost of new purchases (100% bonus depreciation), such as computers, furniture and equipment, in lieu of depreciating the cost of the asset over a number of years. Another huge bonus: Used property now qualifies.
Under a companion measure, the government increased the popular Section 179 tax break to $1,020,000, which represents the amount of assets clients can deduct in their first year. Sports utility vehicles carry a $25,500 Section 179 limit.
These generous depreciation deductions allow the small business owner to increase their deductions, and thereby reduce their taxable income, self-employment income and tax liability. The depreciation deduction for vehicles is limited.
#7: Transportation expenses. Clients cannot deduct the cost of the commute between their home and place of business, but they can deduct business-related trips throughout the day, such as traveling to get supplies or attending meetings offsite.
There are two methods to calculate the cost: actual expense or standard. The standard mileage rate for 2019 is 58 cents per mile. This figure is meant to reflect each of the following expenses: gasoline, lease payments, insurance, maintenance and repairs, vehicle registration, and depreciation. On the other hand, the actual cost method entails deducting each business-related car expense by itself, including gas, insurance, maintenance, depreciation and lease payments.
#8: Health insurance deduction. A client can deduct the costs of personal health insurance premiums as a self-employed person, as long as they meet certain criteria:
- The business is claiming a profit. If the business claims a loss for the tax year, the taxpayer can’t claim this deduction.
- They were not eligible to enroll in an employer’s health plan and not eligible for a spouse’s plan. If they were eligible to enroll in one and chose not to, they cannot claim this deduction. They can only claim premiums paid for the months they were not eligible for an employer’s health plan.
#9: Meal expenses. Meal deductions can be taken either within the context of business travel, or if provided to a current or potential business customer. A taxpayer can deduct up to 50% of the meal expense as long as the food or beverages are not considered lavish or extravagant. For business meals, the meeting must include business either directly before, during or after the meal is consumed.
#10: Business travel. If traveling out of town for business, the cost of getting to and from the destination, and any business-related expenses occurred at the destination, are deductible. To be allowable by the IRS, the travel expenses must be considered reasonable, and not lavish or extravagant.
Meals are deductible when away from a tax home in pursuit of the taxpayer’s trade, and the business trip is overnight or long enough that the person would need to stop for sleep or rest to properly perform their duties. Meal expenses must be reduced by 50% before being deducted, but lodging expenses are not reduced.
#11: Self-employment tax deduction. Where traditional employees have their FICA taxes split between themselves and their employers, self-employed individuals are responsible for paying their own share of Social Security and Medicare contributions. Self-employed individuals can claim a portion of the self-employment tax as a deduction (roughly 50%).
#12: Gifts for business associates. Holiday gifts for clients, customers and other business associates qualify as deductible business expenses. However, there’s a catch: A taxpayer can deduct only $25 annually for business gifts given directly or indirectly to any one person. Promotional items, such as calendars or pens, don’t count toward the $25 limit if each item costs $4 or less, has the taxpayer’s name clearly and permanently imprinted on the gift, and is one of a number of identical items widely distributed.
#13: Credit for paid family and medical leave. The TCJA implemented a new credit for employer-paid family and medical leave, allowing business owners to claim a credit for wages paid to employees on family and medical leave. It starts at 12.5% for payments of 50% salary, and goes up to 25% if the leave payment rate is 100% of the normal rate. The maximum leave allowed for any employee is 12 weeks per year.
#14: Credit for research and development expenses. To qualify for this credit, the business must incur expenses for the purpose of discovering information that is technological in nature, and for the development of a new or improved business component. For example, a bakery that invests in developing machinery that automates the icing process may qualify. Ordinary testing and inspection; consumer, management and efficiency studies; and promotions do not count as research.
#15: Work opportunity credit. This credit is available to businesses that pay first and second year wages to certain targeted employees, including veterans, long-term family assistance recipients and summer youth. The credit is figured as a percentage of the employee’s wages, and can range from $2,400 to $9,600 per employee depending on the type of targeted employee. To qualify, the taxpayer must first request, and be issued, a certification for each employee from the state employment security agency to prove they are a member of a targeted group.
Help Your Clients Throughout the Year
As discussed, there are a multitude of tax breaks available to small business owners to reduce their tax liability and put more money in their pockets – to be rolled back into their business, saved for retirement or spent on personal items. Help your clients plan ahead, document any expenses and retain receipts.
Editor’s note: This article was originally published on the QuickBooks® Resource Center.