You’ve probably heard someone say “it’s a tax write-off” right before buying something expensive. Unfortunately for them—tax write-offs aren’t so simple. It takes a lot of planning and accounting to make write-offs worth it. Learn how tax write-offs actually work . . . so you can make better purchase decisions and pay less taxes.
When people throw around the term “write-off” it means either a tax deduction or tax credit. These have different effects on your tax bill.
It’s important to know which ones you’re eligible for and the difference between the two, because knowing how do tax write-offs work can save you a significant amount of money in the long run.
What Are Tax Deductions?
When asking how do tax write-offs work, some of the answer lies in understanding what a tax deduction is.
Here in the United States, we have a graduated tax system. The percentage of income the federal government takes in taxes increases as your gross income increases.
A tax deduction is money you subtract from your gross income for federal tax purposes. Sometimes, deductions are big enough to move you down to a lower tax bracket.
Most Americans (including business owners) take the standard tax deduction, which is $12,000 for a single filer and $24,000 for a married couple in 2019.
The standard deduction is the amount that the Internal Revenue Service (IRS) allows every person filing taxes deduct from their gross income before determining your tax rate.
Here’s an example. If you’re a single person with a salary of $90,000, you subtract the standard deduction of $12,000 and that makes your adjusted gross income $78,000. You will only pay taxes on the $78,000.
If you make $90,000, you are in the 32% bracket for single filers. If your adjusted gross income is $78,000, then you are in the 24% bracket for single filers.
Here’s the key point: the deduction doesn’t just lower the amount of money that’s taxed—it can also put you in a lower tax bracket. That’s why tax write-offs can really benefit you. When someone asks how do tax write-offs work, that’s the concise way to explain it.
But you can’t take both the standard deduction and the different write-offs. You have to choose between one or the other.
The tax write-offs that are deductions are beneficial if you decide to itemize your deductions. Itemizing means you add up many deductions specific to your business. Again, if you do this, you can’t take the standard deduction.
If you have business write-offs that add up to $20,000, you could take those instead of the standard deduction of $12,000. If your income is $90,000 and you deduct $20,000, your adjusted gross income is $70,000. Assuming a 24% tax rate, your tax bill is 24% of $70,000—$16,800.
If you had taken the standard deduction, your tax bill would have been 24% of $78,000, or $18,720. In this example, itemizing the deductions saves you $1,920.
If you don’t itemize, the deductions you can take for business expenses are moot. Luckily for business owners, there are many deductions available to make itemizing worthwhile.
What Are Tax Credits?
Unlike a deduction, a tax credit is a dollar-for-dollar refund.
If your income is $90,000 with a tax rate of 32%, your tax bill is $28,880—but a $20,000 credit reduces it to $8,800.
You might think credits are better based on that example. But the truth is that $20,000 credit may not exist. While plenty of deductions are worth that much, most credits are worth a couple thousand at most.
Plus, all write-offs are not created equal. Credits are worth more to lower income earners and phase out as your income increases, while deductions are mostly available to anyone who can properly claim them.
The most popular credits are:
- child tax credit
- earned income tax credit
Neither of these credits are specific to business owners.
There are tax credits for:
- developing a new patent or software
- spending money to make your office accessible for those with disabilities
- using alternative fuel
- providing benefits like health insurance or paid family leave to employees
These don’t phase out as quickly as the basic ones.
But if you’re in the majority of freelancers or entrepreneurs, these don’t apply to you. Most, if not all of your write-offs, will be deductions.
So how do tax write-offs work for most small business owners?
You combine the write-offs available for you as an individual with those available for you as a professional to reap the highest rewards.
What are Ordinary and Necessary Expenses?
What kind of business expenses count as tax deductions? The IRS says that an expense must be both “ordinary” and “necessary” to be deductible.
How are those terms defined? An ordinary expense is normal for your industry. A necessary expense is “helpful and appropriate” for your industry.
This means an expense has to be directly related to your business and essential to running it.
For example, the web hosting fees for maintaining your company’s website are both ordinary and necessary. Whatever your industry, you need an online presence in today’s digital era to advertise and connect with clients. Well-maintained websites aren’t free.
Industry practices matter. If you run a kayak school, the kayaks you purchase for children to learn in are both ordinary (all kayak schools need equipment) and necessary (you can’t learn to kayak without being in one).
But if you’re a lawyer and you buy a kayak to “take clients out” it doesn’t count, because you don’t need a kayak to practice law. Make sense?
Likewise, a private chef uses a fancy blender to make food for her clients, but an accountant who buys the same blender to make smoothies for the waiting area doesn’t have that justification.
There’s no hard and fast list covering every industry, but the IRS does tend to audit small business owners who claim interesting deductions, so playing by the rules is strongly advised.
Popular Small Business Tax Deductions
There are, however, some popular deductions that apply to business owners across many different industries. Let’s look at 10 of them.
Business owners subject to paying self-employment taxes (“SECA”) can deduct the employer-equivalent portion on their income tax return.
SECA taxes cover Social Security and Medicare contributions. The rate is 15.3%. This includes 12.4% for social security and 2.9% for Medicare.
If you would owe at least $1,000 in taxes on your freelance income for the year, you should be paying SECA taxes every quarter. Be sure to check.
You can deduct up to $5,000 in costs incurred in creating or acquiring an “active trade or business” although higher startup costs end up going on your tax return for years to follow.
These costs could include anything from purchasing a domain name for your company website, to advertising in the local paper, to paying the fees to incorporate or set up an LLC in your state.
If you are going to incur a lot of startup costs, it is important to thoroughly consult IRS Publication 535 to understand some of the special rules applied to different kinds of startup costs and very large amounts.
Business Supplies and Postage
If you print anything for your business, the cost of the paper and ink count as tax deductions. If you mail what you printed, so does the cost of the postage.
You can deduct the portion of expenses from using your car for business. You can calculate the value of gasoline and car depreciation, or use the standard mileage rate published by the IRS.
If you fly on a plane, stay overnight in a hotel, or eat a meal on a business trip, these expenses are deductions. The IRS is strict about what counts.
You can write off the cost of your home office if it is your principal place of business. This means it’s the place you work every day.
If you have an office space nearby that you work out of and use the home office on other days, the home office does not qualify as a deduction. But you can deduct the rent on your other office space. You cannot deduct both.
If your home office qualifies, you can deduct costs like mortgage interest, utilities (internet connection, electricity, water) and repairs, for the percentage of your home occupied by the office.
For example, if you live in a 1,500 square foot house and use one 300 square foot bedroom as your office, you can deduct 20% of those expenses. Routine repairs to your office space are also deductible, but big improvements are treated differently.
If you’re deducting expenses for a rented office instead of your home, the same rules applies for things like utilities and repairs.
The costs of an owner’s policy, malpractice coverage, and health insurance for you and your spouse and dependents, are all deductible.
Legal and Accounting Fees
If they’re for your business, they’re deductible (you cannot write off your divorce lawyer’s fees as a business expense, even if the stress of getting divorced is hurting your business).
State and Local Taxes
These properly attributed as a business expense are deductible on your federal tax return.
If you have a pass-through business or are a sole proprietor like most freelancers, you can deduct up to 20% of your business income on your personal tax return. This is a new deduction created by the late 2017 tax law.
A “pass-through” business is a business where the owner puts all of the income on his or her individual tax return and the business doesn’t file its own tax return. LLCs are pass-through businesses.
If your business generates $50,000 of profits in 2019, you can deduct $10,000 on your return for the year. This deduction alone puts many business owners over the hump for itemizing, rather than taking the standard deduction.
Doing the Math Saves You Money
If you do the math, adding up all of these deductions can put the total above the amount of the standard deduction, saving you money by decreasing the amount of taxable income.
But remember, these write-offs do not give you money back dollar-for-dollar that you spent on a nicer office space or a new computer.
Does that mean you shouldn’t buy a new computer? As always, the answer depends on what the computer is worth to your productivity and your business.
It’ll probably save you a few bucks on your taxes—just not enough to recoup the cost unless it also increases your efficiency, because it’s a deduction rather than a credit.
Keep that in mind when you’re incurring expenses for your business. This way you won’t be surprised with a large tax bill the following year.
Alyssa S. Grossbard
Alyssa S. Grossbard is a 2012 graduate of the University of Oxford, where she majored in history, and a 2015 graduate of Columbia Law School. She is licensed to practice law in New York.