As the global pandemic spread across the world earlier this year, millions of Americans started working from home in order to minimize their exposure to the deadly virus. Doing so has resulted in a lot of individuals slowly shifting from being employees to working as independent contractors who receive 1099 income. So, in terms of taxes and applicable deductions, what does this mean? In addition, what type of home office deductions can these individuals claim?
In order to understand how remote workers, also known as telecommuters, pay taxes and what home office deductions they can take, you must first understand the difference between an employee and an independent contractor. An employee is someone who works for a company that withholds federal taxes, Social Security, and Medicare from their paychecks. They also have limited control over the specific hours that they can work or the nature of work that might be assigned to them. Instead, it is all employer-driven while the employee relies on a salary that is usually paid out annually instead of through hourly rates.
Independent contractors, on the other hand, are workers that operate independently from the person or company that hires them. Common examples include truck drivers, online freelancers, certain software developers, and similar. Unlike employees, independent contractors are usually paid on an hourly basis and they are responsible for covering federal taxes, Social Security, and Medicare on their own since the employer does not withhold anything from their paychecks. Moreover, these workers usually have more autonomy when it comes to how, when, and where they complete their tasks.
Differences In Taxation
Since telecommuters have a lot more freedom to operate their venture, the IRS deems these individuals to be actual “businesses.” Namely, someone who works as a freelancer will file a tax return siting all of their earnings as the earnings of their sole-proprietorship business. Due to this, they are eligible to take deductions for any expenses that were connected to their work. So, if a freelancer spent thousands of dollars on equipment that permits them to do their job, they will be able to deduct that entire amount from the income that they made during the year as it was a necessary expenditure.
Employees, however, will not have such a broad spectrum of deductions. The mere fact that they work for someone else immediately excludes them from consideration of being one’s own “business.” Thus, they cannot claim the vast majority of their expenditures as they do not have a sole-proprietorship. According to the IRS Publication 529, there is only a limited category of employees that can take a deduction for unreimbursed employee expenses:
– Armed Forces reservists;
– Qualified performing artists;
– Fee-basis state or local government officials;
– Employees with impairment-related work expenses.
Most other employees will not be allowed to claim practically any expenses against their W-2 income. These workers will enjoy the benefit of getting their employer to cover half of their Medicare and Social Security tax which independent contractors have to pay themselves, thus spending an extra 7.65% of their paycheck.
Common Deductions for Remote Workers
As a remote worker who operates at home, you have the ability to claim a wide range of deductions related to your “home office.” Contrary to the term, you do not actually have to have a complete office setting where you see your clients or conduct important meetings. On the contrary, the room that you use for work will qualify as your home office since that is the primary location where you conduct your business. The IRS will let you take a deduction for this space that can help bring your taxable earnings down to a minimum.
1. Home Office Example
For instance, if you spent the entire year working in your home office that occupies 100 square feet and you live in a house that has 1,000 square feet, you will be able to take a deduction amounting to one-tenth of your home-related expenses. So, if your annual rent was $20,000, the IRS will let you take $2,000 as a deduction. Similarly, if you spent $6,000 on home utilities such as electricity, wireless, and so on, the IRS will let you take $600 against the income you made through your independent contracting. In translation, you will basically be able to subtract one-tenth of any expense related to your house as long as it is considered to be “reasonable.”
It is important to note that the IRS will also let you choose between a “standard” home office deduction and a square-foot-based one. The standard deduction, which the IRS refers to as the “simplified” option aims to help taxpayers avoid making complex calculations based on allocations of space and time. Instead, it simplifies the process by letting you deduct $5 per square foot of your home office, up to 300 square feet. In translation, the highest deduction you might qualify for under this method is worth $1,500.
If you spent more than that during the year on your rent, utilities, and other expenses that are partially allocated to your home office, you should utilize the previously mentioned formula where you base everything off of square footage. For instance, going back to the previous example of a 100-square-foot office, the taxpayer would only qualify for a $500 deduction if they decided to use the “standard” one. If they decide to use the square foot allocation of expenses, however, their rent alone will result in a $2,000 deduction. Hence why it is important to keep track of your expenses.
2. Large Purchases
Just like companies have the right to claim depreciation on their depreciable assets, independent contractors can also utilize these deductions. For instance, if you work as an independent freelancer who spent $1,000 buying a new computer that will be used for work, you will be allowed to take depreciation on that asset. While the specific method of depreciation that you choose is up to you, it is imperative that you remember to take this deduction as it can be quite hefty. For instance, if you claim bonus depreciation on a $1,000 computer, you will be able to deduct the entire cost against your earnings since the Tax Cuts and Jobs Act allowed for a 100% deduction. This deduction applies to any large purchase that can include everything from technology upgrades to actual furniture that you buy for your home office.
3. Home Internet and Cell Phone
As with your home office, other tools that are necessary for you to work as an independent contractor can also be deducted. For instance, if you work as an online freelancer, you will need to have reliable internet access. Thus, your monthly expenditures for wireless services can be deducted. One thing that you should keep in mind, however, is that the IRS will ask you to prorate how much time you spent using such services for personal use versus work-related use. For instance, if you spent $100 on your internet package per month but also use that package to stream Netflix or listen to Spotify, per se, you will not be able to claim the entire $100 per month as your deduction as it was not all solely used for your business.
4. Meals and Entertainment
Another large group of expenses that many telecommuters see is meals and entertainment. While your meals and entertainment expenses will usually be limited to 50% of the original cost, you should keep close track as these numbers can add up fast. It is also important to note that you cannot deduct any food that you buy and write it off through your independent venture. Doing so would be an easy way to succumb to an IRS audit. Instead, you must carefully choose meals that you actually bought as a part of your workday. For instance, if you have a virtual lunch with an important client, the IRS will let you claim this meal as a business expense since the underlying goal was to gain more client work.
While the list of eligible expenses continues, these represent some of the major categories where you will find most of your deductions. To discover other hidden items that you might be able to deduct, consider finding a certified accountant who can help you analyze your industry and uncover less popular expenses.