Many self-employed U.S. citizens who live and work abroad can take advantage of the foreign earned income exclusion (FEIE) to exclude up to $105,900 from income tax in their 2019 report. While this is a valuable tax-savings provision, many do not know that, even if they qualify to exclude income under the FEIE, their business income is still subject to self-employment tax. Self-employment tax includes Social Security and Medicare tax.
Here’s an example: Ann lives in Peru and earns $45,000 a year preparing U.S. tax returns. She qualifies for the FEIE and will owe no income tax on her excluded income but will owe approximately $3,400 in self-employment taxes. To reduce her self-employment tax, Ann can offset her business expenses against her $45,000 of gross income.
If she can substantiate $10,000 in expenses, for example, her net income becomes $35,000 ($45,000 less $10,000.) She would still owe no income tax, but now her self-employment tax would be reduced to approximately $2,500.
The IRS allows deductions for ordinary and necessary business expenses. Ordinary means common in your industry and necessary means helpful or appropriate for your business. The cost of tax preparation software would be an ordinary and necessary expense for Ann. The cost of a massage table and oils would be deductible expenses for a masseuse.
IRS Publication 535, Business Expenses, provides explanations and details about what expenses can be deducted. Here are some frequently overlooked common deductible expenses available to small business owners.
Home Office, Internet, and Utilities
If you work primarily from home, you can deduct expenses related to the portion of your home that you use regularly and exclusively for business. For renters, rental payments, heat, electricity, and other expenses (such as the cost of cleaning associated with the home office are deductible in proportion to its size.
For example, if the office comprises 5% of the house, 5% of the annual electricity bill can be deducted. Homeowners can deduct these expenses as well as a proportionate share of mortgage, homeowner insurance premiums, and property taxes.
The home office deduction is calculated using either the standard or simplified method; both are explained in IRS Publication 587, Business Use of Your Home. Whichever method you choose, you will need to have records proving your expenses, as well as measurements of the size of the office, to substantiate the deductions. This information does not need to be submitted with a tax return but should be kept handy in case of an IRS audit.
Advertising, Software, Office Supplies, and Professional Fees
You can deduct costs to promote your business.
The cost of envelopes, notebooks, printer paper, and other common office supplies may not amount to much individually but can add up. You can also deduct costs to promote your business on social media, for advertising space in local newspapers, or even for flyers you post on community bulletin boards.
If your business requires specific software, you can deduct the software cost or monthly subscription, as well as the cost of any malware or antivirus software used to protect your business.
Fees paid to professionals for business-related advice or for preparation of business tax returns can be deducted. Payments made to technicians to resolve computer issues in your business can also be deducted. If you pay any person who is not your employee more than $600 in a year, you may be required to file Form 1099-MISC to report the payments.
Health Insurance Premiums
Many U.S. citizens living abroad purchase private health insurance coverage. These premiums, including medical, dental, and long-term care insurance, are deductible if the policy is in the name of the business or the business owner. The deduction is limited if income is excluded under the FEIE.
Licensing and Continuing Education Costs
License or regulatory fees paid to state or local governments are generally deductible. Additionally, the cost of continuing education to maintain or improve business skills or the price paid for specialized magazines or subscriptions can be tax deductible.
Travel and Meal Expenses
If you travel from your foreign tax home to the U.S. for business, the costs of getting to and from your destination, your accommodation, and 50% of your business-related meals is deductible. To be considered a business trip, you should have a specific business purpose planned before you leave home, and you must actually engage in business activity—such as finding new customers, meeting with clients, or learning new skills directly related to your business—while you are on the road.
The rules for deducting business travel expenses can get complex. IRS Publication 463, Travel, Gift, and Car Expenses, has more details. A tax preparer can help, too.