Tax Deductions for Independent Contractors

Taxes as a 1099 contractor can be complex, which is why Right Side Up invited Greg and Amita from Harrison Accounting Group, Inc. to join us for an hour-long webinar to share their expertise and answer your questions ahead of the upcoming tax filing season. As a reminder, the 2020 tax filing deadline was recently extended to May 17, 2021.

We’ve transcribed and organized all of the information they shared with us, and we’ve broken it down into three key sections: an overview, info about tax deductions (which you're currently reading), and details about the CARES Act and Paycheck Protection Program. Disclaimer: This is neither financial nor legal advice; please speak with your CPA.

There aren't a lot of hard, physical costs associated with digital marketing consulting. What are some of the most common deductions for these types of contractors?

• Computer
• Cell phone and plan
• Software costs
• Internet
• Home office space (more on how to calculate this in the next question)
• Home office furnishings and supplies, e.g. desk, chair, computer stand, keyboard, mouse, extra monitor, printer, ink, paper, pencils, etc.
• Rent for an office space, including coworking spaces
• Marketing, which can sometimes include meals (if networking/discussing your business), subscriptions to networking groups, business cards, website upkeep, ads, etc.

How do you calculate a home office deduction? 

Let’s say 200 square feet in your house is dedicated to your office space. Take that 200 square feet and divide that by your entire home square footage. That would be your business use percent—and it extends not only to the space itself (i.e. the percentage of your rent or mortgage expenses), but also to utilities and internet.

Are there factors that increase or decrease the risk of getting audited? How do you know how aggressive to be with business expenses?

If you're running a 1099 business and you’re showing losses for five years straight, you're likely going to get audited because the IRS will be suspicious. They will likely look at your expenses and ask you to substantiate them with receipts and credit card statements. You essentially need to be able to prove that the expenses you’re running against your 1099 income are necessary to your business. For example, is the software you’re listing as an expense only used for business, or do you use it for personal use, too? Same goes for your cell phone, computer, and so on.

As for how aggressive to be, we encourage everybody to stay within their own comfort zone. An example: some people are confident arguing that their gym memberships are deductible because that's where they do their networking, while other people are introverts and don’t talk to anybody at the gym, meaning they wouldn’t deduct their gym memberships. Use the sleep test—if you think you’ll have trouble sleeping over a deduction, skip it.

Is there any sort of average ratio of 1099 income to deductions?

It differs by profession, of course. I’ve seen expenses as low as 10% of income all the way up to 50-60% of income, with an average in the 15-20% range. And again, it really depends on how creative each person wants to be.

One thing the IRS has stated—if your 1099 income is greater than $150,000, they believe there’s a higher propensity of you combining personal expenses with business expenses. We completely agree with them. As long as you have proper documentation—receipts, credit card statements, etc.—you should be okay. It’s on them to disallow a deduction.

I live with a roommate and pay half our rent, and my office takes up 19% of our total square footage. Do I just deduct 19% from my portion of the rent? 

That’s correct. There are a lot of ways to go about it, it just depends on what you’re comfortable with. You can look at square footage, you can look at the number of rooms. A lot of our clients think about what’s most advantageous for them. For example, if you rented a two-bedroom apartment and one of the bedrooms is an office, I would argue it’s going to be a higher percentage than 19%.

I think one takeaway worth noting is that if you just look at your taxes on a personal level, and you don't look at business income, and you just add 1099 income, to Greg's earlier point, you will pay slightly higher taxes. But if you really look at the deductions, and you treat it like business income with both income and expenses, then your effective tax rate can be lower on that income than if you were a W-2 employee. This underscores the value of having somebody that you trust who can help you navigate the business component of your taxes.  

Agreed. Also, it’s worth noting that W-2 employees used to be able to have unreimbursed business expenses, but the Tax Cut and Job Act of 2017 eliminated those for federal purposes. So the outside sales rep who drives his car, entertains clients, and gets all the orders, now, that's on his own dime, where there is no deduction to offset that for a W-2. We still get those as 1099 employees because we're paying based on the net. So it's huge. In most of my career, I always joked and said I'd rather be a 1099 employee because I'd be aggressive at my expenses and pay significantly less in taxes than I would as a W-2 employee.

Another pretty common deduction that self-employed people can take is the health insurance premiums deduction.

Absolutely. Yes. You're claiming a front-page deduction (more info on those here), you don't have to itemize it or anything. If you’re a sole proprietor, they don't go on your Schedule C, but they are adjusted to arrive at Adjusted Gross Income (AGI).

And that's just for premiums, right? Not for other medical expenses.  

So, you can claim other medical expenses like doctor and hospital visits, but on a Schedule A, not a Schedule C. (Note: Schedule A is an income tax form that taxpayers use to report their itemized deductions, which can help reduce their federal tax liability.) These expenses would have to exceed 7.5% of your AGI in order to qualify for the deduction. A lot of people don't end up qualifying, since something pretty catastrophic must happen in order to accrue such high medical expenses in a year.

Instead of a home office, I use a coworking space. That can also be subtracted as a deduction, right?

Yes. You can say it’s rent. The nice thing about a coworking space is that you pay for it, and it’s a clean, definitive transaction. There’s no subjectivity to that.

Is there anything special we have to do if we want to take a SEP IRA deduction?

You have to calculate it based on your net profit business. The SEP IRA does not have to be opened up prior to 12/31 of the year, it just has to be paid and funded prior to filing the return or the due date of the return, which is July 15 this year.

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