Saturday, April 20, 2024

Tax facts in Mexico: Deductible expenses on the Schedule C

One of the things I liked best about working as an attorney for the Internal Revenue Service in Washington D.C. was the variety of the work. On any day, we might assist an IRS revenue agent with an audit, work with the Department of Justice on a tax case, advise Congress and the Department of the Treasury on tax legislation, or correspond directly with taxpayers. Each of these roles was challenging and rewarding in its own way, but my favorite assignment was helping to draft instructions for IRS forms.

The IRS Tax Forms and Publications division spends literally the entire year creating and revising the forms and instructions for each form that every U.S. citizen uses to complete their taxes. As an undergraduate journalism major, I appreciated that the goal was to write in plain English so everyday people could accurately complete the form. While many people, including my wife, might laugh at the notion that anything the IRS does is easily understood, believe me: with over 1000 pages of laws in the Internal Revenue Code, all written in complex legalese, the people in Forms and Pubs do an amazing job.

One form that I’ve become more familiar with since moving to Mexico is the Schedule C, Profit and Loss from Business. This form is used to report income earned in a business that is operated as an unincorporated sole proprietorship. Both my wife and I are self-employed, as are many of the clients for whom I prepare tax returns who live and work in Mexico.

The Schedule C and its instructions have remained unchanged for years, but the world and the way people live and work have changed dramatically. As much as I respect Forms and Pubs, nothing related to the Schedule C reflects the fact that we’ve entered the 21st century. There is no mention of cell phones, computers, online payment platforms, or web-hosting services. The section on how to deduct utility expenses still explains what to do if you have two landlines coming into your home.

Clearly an update of the Schedule C is overdue. In a previous article I wrote about the importance of tracking income. In this article, I’ll rewrite in plain English Part II of the form, which lists over twenty different categories of expenses that can be used to reduce your business income. For self-employed people, understanding what you can deduct as expenses is especially important because you pay both income and self-employment tax on business income, so reducing that income reduces both taxes.

Schedule C, Part II, Expenses

Lines 8 to 27 of the form categorize expenses to reduce your gross self-employment income to determine taxable business income. Each of these expenses must be ordinary and necessary to your business. This means that generally, any person in your line of work would have these expenses. Following are a brief explanation of each category and some examples of expenses that fall under them.

Line 8, Advertising – You can still deduct whatever it costs to put an ad in the phone book, but you can also use this line to deduct expenses to advertise your business on websites, in digital newspapers and on other online media sources.

Line 9, Car and truck expenses – Deductible vehicle expenses are not those that help you get to work, but are those that help you do your work. For example, an architect can’t deduct the cost to drive to her office, but can deduct the actual expenses — gas and oil — or a standard mileage rate for driving to meet with potential clients or to construction sites. Keep a real-time record of the date, destination and number of miles driven on your phone or in a notebook to meet IRS record-keeping requirements. Part IV of the Schedule C asks about your personal use of the vehicle.

Line 10, Commissions and fees – Have a website for your business? You can deduct the domain and web-hosting fees on this line. You can also deduct bank fees and commissions taken by online payment platforms such as PayPal.

Line 11, Contract labor – Payments to people who do work for you that are not your employees are deductible. For example, the person who designs and maintains your website or the person who cleans your office. If you pay anyone more than $600 in the year, you may be required to give them a Form 1099.

Line 12, Depletion – This line relates to the extraction of natural resources from the earth. It’s probably not relevant to a self-employed digital nomad.

Line 13, Depreciation and section 179 expense deduction – Depreciation allows you to recover the cost of business property that wears out or is otherwise used up. Generally, the deduction is spread out over a number of years. Section 179 allows you to recover all of the cost of the property in the year you buy it. Personal property that you can touch, such as a computer or cell phone, qualify as section 179 property. In cases where the property is used for both personal and business use, you can depreciate or expense only the business portion.

Line 14, Employee benefit programs – If you have employees and contribute to their health or life insurance premiums, costs for child care, or similar benefits, you can deduct the costs on this line. You deduct the wages you pay your employees on Line 26.

Can I deduct my health care premiums?

Health insurance protects you from unexpected, high medical costs. (Patty Brito/Unsplash)

If you paid for health insurance for you and your family and the insurance plan was established under your business, you may be able to deduct the cost on Schedule 1, not Schedule C. This means the cost won’t reduce your business income, but it does reduce your overall income.

What does it mean that the insurance was “established under your business?” Neither the instructions to Schedule C nor Schedule 1 explain the concept, so I don’t know exactly, but I advise clients to use business profits, or a business-related credit card, to pay the plan premium as a reasonable means to show that the plan is provided by the business, and none of my clients have been audited.

Back to the Schedule C expenses

Line 15, Insurance – Premiums paid by attorneys, therapists, masseuses and other professionals for insurance to cover them if they get sued get deducted here. You may also have insurance on business vehicles, property, or equipment.

Line 16, Interest – If you have loans on business property you own, such as a building, vehicle, drone or other equipment, you may be able to deduct the interest.

Line 17 – Legal and professional services – This is where you put the fee charged by your attorney to prepare your tax return to resolve other business-related issues, or by your accountant to balance your books. Fees charged by the locksmith to make you a new set of office keys after you’ve lost them go on line 10.

Line 18, Office expense – If you still use stamps, you can lick and stick that cost here. You can also use this line for shipping fees and postage charged by platforms such as eBay and Amazon, and for anything you would get for your business at Staples or Office Depot, such as paper, paper clips, manila folders, white boards, dry erase markers, Sharpies and printer cartridges or toner.

Line 19, Pension and profit-sharing plans – Contributions you make on behalf of employees to retirement plans go here. Contributions you make to an IRA or other retirement plan for yourself go on Schedule 1.

Line 20, Rent or lease – You can deduct the rent you pay for an office, studio, or warehouse, or to lease vehicles, machinery, or other business equipment.

Line 21, Repairs and maintenance – You can deduct the cost of repairs you make to business property, or any required maintenance so long as they do not add to its value or significantly extend its useful life. For example, if you are a bike courier and you replace a pedal. For digital nomads, the cost to fix your laptop after you spill your morning coffee on the keyboard goes here.

Line 22, Supplies – Materials and equipment that you use up within the year can be deducted here. For example, an artist can deduct the cost of sketch pads, brushes and canvases. If the useful life of the item extends beyond the year, like a paint spray gun, it generally must be depreciated.

Line 23, Taxes and licenses – This line includes the cost to maintain state licenses or certifications — such as those required by a counselor, therapist, or attorney — as well as certain taxes required to be paid on behalf of employees, such as social security or unemployment tax, or for business property, such as real estate or property taxes.

Line 24, Travel and meals – The travel costs deductible on this line are for hotels and transportation — including airfare, and Ubers or rental cars — if you are required to be away overnight. I advise my clients to deduct same-day return airfare for business travel in Part V, Other Expenses. If they drove, it would go on line 9. To deduct the cost of meals, a business contact, such as a client or potential client, must be in attendance. If you paid for your client’s meal delivery while talking on Zoom, that would count as a business meal.

Line 25, Utilities – If you have an office outside of your home, all of the utilities would be deductible. If you have a home office, see the discussion below about the home office deduction.

What about my cell phone and internet costs?

The cost of a cell phone or for an internet connection used exclusively for business is fully deductible. However, keeping a separate cell phone or second Wi-Fi service is often too expensive, so many of us, especially those of us who work from home, have one phone and internet service for both business and personal use. In this case, an allocation of the cost is required because the personal use isn’t deductible. Here is how I determine how much I use my phone for work as compared to playing my dad in Words with Friends.

I divide my working hours — 40 hours per week, from 8 AM to 5 PM each weekday — by my waking hours — roughly 14 hours per day for a total of 98 hours per week. This equation gives me a percentage of about 41% business use to 59% personal use. Of course, I’m not playing Words with Friends every waking hour, but I could be, and this is a reasonable way to allocate business and personal use that would be difficult for the IRS to successfully challenge.

Back to the Schedule C expenses

Line 27, Other expenses – Schedule C, Part V

This catchall category is not a license for you to get creative. It is still required that the expense be ordinary and necessary to your business. But certain ordinary and necessary expenses aren’t necessarily common expenses, so they don’t get their own line. Each expense entered in this section is required to be specifically identified, and could include the cost of courses you are required to take to maintain a license, membership fees for trade associations, travel expenses not deductible elsewhere, the cost of an office holiday party, or any other business-related expense that didn’t make sense to put elsewhere. 

I also group fees paid for online subscription services that meet business needs here, such as Canva for graphic design, Dropbox for storage and Zoom for communications.

Finally, the Line 30 home office deduction

A home office is a space that you use regularly and exclusively for your business. You do not have a home office if you work at the kitchen table or with your laptop in bed because these spaces are also regularly used for other activities, so it is not an exclusive business space. You do have a home office if you have a spare room that you use as an office. You do not spoil the “exclusively” aspect of the office if you hide birthday presents in the closet, let your child do her homework at your desk, or let your mother-in-law sleep there occasionally.

There are two ways to calculate your home office deduction. The easiest way is called “the simplified method.” To use this method, multiply the square footage of your office by US $5. There are rules on how much you can deduct if both you and another person use the space as an office. A more complicated way, but with potentially larger deductions, is to use Form 8829, Expenses for Business Use of your Home, to prorate the actual expenses associated with your home office. Using actual expenses includes depreciation of the space, however, which you will need to recapture if you eventually sell your home.

Completing Schedule C requires you to be organized. You are not going to be able to recall each dollar you spent during the year on your business when you sit down at tax time, so it pays to take the time during the year to record your expenses as they happen. Consider the time you put in as an investment in your business. Not only does the time spent benefit you by saving money on your taxes, but handing over organized and complete expense logs will make you a favorite client of your tax return preparer.

Paul Carlino is an attorney living in San Miguel de Allende and the founder of Pickleball Mexico. He writes for Mexico News Daily. 

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