How do tax write-offs *actually* work (when you're self-employed)?

July 14, 2022

“Don’t worry, it’s a write-off”, says the businessman who just spent $60,000 on a new boat.

The allure of “write-offs” can make them feel magical, like they become unlocked once you own a business and make a lot of money.

I hate to be the bearer of bad news, but they aren’t magical.

And they don’t make extravagant expenses vanish..

What they actually do is help you pay less in taxes (so they’re still pretty cool).

How do write-offs work?

A tax write-off (aka tax deduction) is an expense that you can use to lower your taxable income.

A real life example: If you made $80,000 last year as a freelancer and you had $15,000 in eligible business expenses, you would be able to “write off” that $15,000 against your taxable income ($80k), so that you’d only owe taxes on $65,000.

Once you understand what they are, tax write-offs are relatively straightforward.

For an expense to qualify as a write-off, the IRS states that it must be ordinary and necessary for your business.

Unfortunately, that means you can’t write off a year’s worth of DoorDash deliveries to your home office 🚗

For small businesses, common write-offs include:

  • Advertising
  • Computer & softwares
  • Contractor payments
  • Phone bill
  • Start-up expenses

Since freelancers have unique businesses, here’s a quick list of deductions that are more career-specific:

Also read: 17 important tax deductions for freelancers

With an understanding of deductions, you can start to piece together the tax puzzle.

These next few paragraphs get a little bit into the weeds, but let’s take it a step further and see what write-offs look like in practice:

First off, your business income is reported on Schedule C (Form 1040). This is also where your write-offs to calculate your net profit or loss for the business would go.

For example - let’s say you have have $70,000 in revenue from your freelance business and $50,000 net profit (i.e. after deductions).

After you know your business income, self-employment taxes are then calculated and reported on Schedule SE - Form 1040 (below).

Based on the scenario above with $50,000 in profits, your self-employment tax would be about $7,650 and the income tax (for a single filer) would be around $2,600 (federal) and $1,200 (4% state) or ~$11,450 total tax.

If you didn’t use write-offs and you paid both self-employment and income tax on the full $70,000, you’d owe roughly $10,700 in SE tax and almost $6,500 in income tax - or $17,200 total.

So by using $20,000 worth of deductions, this person would save almost $6,000 on taxes than if they hadn’t.

Another deduction: After calculating your self-employment tax, you can then make an “adjustment to income” on Form 1040 (Schedule 1) for half of the self employment tax amount, which will further reduce your taxable income and your tax bill.

So using the same numbers from the above example, this person would be able to write off $3,825 worth of self-employment tax, which would save another ~$840 in taxes.

Personal write-offs vs Business write-offs

Now, it’s important to understand the difference between personal & business write-offs.

When you claim specific deductions, that is considered “itemizing”. Business deductions are always itemized, but you most likely don’t itemize your personal deductions.

Why?

Because everyone in the U.S. is able to claim the standard deduction ($12,950 for singles in 2022) on their income taxes, and 87% of taxpayers claim the standard deduction.

Those who don’t use the standard deduction are typically high-earners ($200k+) that use strategies such as charitable giving to reduce their tax bill, so their benefits exceed what the $12,950 deduction would provide.

But if you’re a business owner (or receive 1099 income), most of your deductible expenses fall under the business, not your personal finances.

So after you’ve completed the Schedule C for the business, claimed your deductions, and laid out your self-employment tax, you’d report the income on your 1040 and then typically, claim your standard deduction.

For example, here’s my tax return from the year I started my business.

In line 1, I had some W-2 income because I didn’t leave my job until June of that year.

Then in line 8, you can see my business income, which was a loss.

Most of those losses were from startup costs and monthly expenses (both were deductions) before the business became profitable. But that loss pushed my total income down to $18,557.

Then, I was still able to use the standard deduction ($12,400 at the time) to further reduce my income until there was only $6,156 left to be taxed.

Because I didn’t have any large, itemized personal deductions to take, the $12,400 standard deduction was sufficient and I was still able to write-off the business’ expenses as well.

That’s a brief overview of the tax filing process and the role that deductions can play 🎉

But what about estimated quarterly taxes? If I don’t know what my final deductions are until the end of the year, how do I avoid overpaying?

This is why tax planning is so important. But for starters, if you expect to owe over $1,000 in taxes for the year, you should be making estimated quarterly payments to the IRS.

The key word here is estimated because you’re right, you won’t know the exact amounts until the end of the year.

You can use an estimator calculator to figure out what you should pay the IRS based on what you expect to make, but you should have a general idea of your upcoming expenses, and can then make close-to-accurate payments based on the projections.

If you’ve been freelancing for a few years, you should already have a general idea of your total tax bill based on your income, so you can use past payments to help determine upcoming payments.

Also read: IRS' Guide to Estimated Taxes

The Takeaway

To see the benefits from tax write-offs, you have to spend money - which is why they can be so impactful for small businesses. Businesses, no matter the size, require money to function, so the IRS rewards your entrepreneurial efforts with tax breaks.

Spending money just to get the write-off usually doesn't make sense because you're still incurring that expense.

But, if you have regular expenses within your business or there's a large purchase that would help your business grow and would qualify as a write-off, take the deductions and save that (tax) money 💸

Whatever you do, don't be this person:

Disclaimer: This should should be viewed as "education-only" and for legal purposes, this should not be considered investment, tax, or legal advice.

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