Publication 911 Contents
Cat. No. 6003113
Important Changes for 2003 .....................
Important Reminders ................................
Internal Introduction................................................ 2
Service For use in preparing Who Is a Direct Seller? .............................. 2
2003 Returns Basic Tax Information ...........................
Business Income ......................................
Capital Expenses ......................................
Cost Recovery ...........................................
Business Expenses ..................................
Business Use of Your Home ..................... 10
Travel and Transportation .........................
Meals and Entertainment .......................... 11
Business Gifts ........................................... 12
Not-for-Profit Limit .................................... 13
Sample Filled-In Forms ..............................
How To Get Tax Help ................................
Standard mileage rate. The standard mileage
rate for the cost of operating your car in 2003
is 36 cents a mile for all business miles.
Increased section 179 deduction limit. The
maximum section 179 deduction you can elect
for property you placed in service in 2003 is
$100,000. For more information, see Chapter 2
in Publication 946.
Addition of 50% special depreciation allow-
ance. For qualified property you acquire after
May 5, 2003, and place in service in 2003, you
can take a special depreciation allowance that is
equal to 50% of the property's depreciable basis.
However, you can elect to claim an allowance at
the 30% rate for property that qualifies for the
50% rate, or elect to claim no special allowance.
For more information, see chapter 3 in
Depreciation limits on business cars. The
Get forms and other information total section 179 deduction and depreciation (in-
Internet • www.irs.gov or FTP • cluding the 30% or 50% special depreciation
allowance) you can take on a car you use in your
ftp.irs.gov FAX • 703-368-9694 (from business and first place in service in 2003 is
generally limited. For those limits and additional
your fax machine) information, including the maximum deprecia-
tion you can deduct in later years, see Passenger
automobiles under Listed Property, later.
You can write to us at the following address:
Important Reminders Internal Revenue Service
Who Is a Direct Seller?
Business Forms and Publications You are a direct seller if you meet all the follow-
Accounting methods. Certain small busi- SE:W:CAR:MP:T:B ing conditions.
ness taxpayers that are qualifying taxpayers 1111 Constitution Ave. NW
or qualifying small business taxpayers may Washington, DC 20224 1) You are engaged in one of the following
be eligible to adopt or change to the cash trades or businesses.
method of accounting and may not be required We respond to many letters by telephone.
to account for inventories. For more information, Therefore, it would be helpful if you would in- a) Selling or soliciting the sale of con-
including the definitions of a qualifying taxpayer clude your daytime phone number, including the sumer products, either-
and a qualifying small business taxpayer, see area code, in your correspondence.
Publication 538, Accounting Periods and Meth- i) In a home or other place that is not
ods. a permanent retail establishment, or
You may want to see: ii) To any buyer on a buy-sell basis or
Photographs of missing children. The Inter- a deposit-commission basis for re-
nal Revenue Service is a proud partner with the Publication sale in a home or other place that is
National Center for Missing and Exploited Chil- not a permanent retail establish-
1 Your Rights as a Taxpayer ment.
dren. Photographs of missing children selected
by the Center may appear in this publication on 15 Circular E, Employer's Tax Guide
pages that would otherwise be blank. You can b) Delivering or distributing newspapers or
15–A Employer's Supplemental Tax
help bring these children home by looking at the shopping news (including any services
directly related to that trade or busi-
photographs and calling 1-800–THE–LOST
15–B Employer's Tax Guide to Fringe ness).
(1-800-843– 5678) if you recognize a child.
2) Substantially all your pay (whether paid in
334 Tax Guide for Small Business
cash or not) for services described in (1) is
463 Travel, Entertainment, Gift, and Car directly related to sales or other output (in-
Introduction Expenses cluding the performance of services) rather
than to the number of hours worked.
This publication explains general tax information 505 Tax Withholding and Estimated Tax
of interest to direct sellers. It covers how to treat 3) Your services are performed under a writ-
income, expenses, and other items related to 525 Taxable and Nontaxable Income ten contract between you and the person
having a direct-sales business. It also illustrates 533 Self-Employment Tax for whom you perform the services, and
two filled-in tax forms that most direct sellers the contract provides that you will not be
must file along with Form 1040. They are Sched- 535 Business Expenses treated as an employee for federal tax pur-
ule C (Form 1040), Profit or Loss From Busi- 538 Accounting Periods and Methods poses.
n e s s , a n d S c h e d u l e S E (F o rm 1 0 4 0 ),
Self-Employment Tax. 583 Starting a Business and Keeping As a direct seller, you usually sign up with a
Records particular company to sell its product line. The
company may refer to you by one of the follow-
587 Business Use of Your Home ing titles.
Who is a direct seller? Some of the charac- 946 How To Depreciate Property
teristics that identify direct sellers are listed be- Consultant
low. A more complete discussion is contained Form (and Instructions) Coordinator
under the heading Who Is a Direct Seller, later.
SS-4 Application for Employer Dealer
How you sell. You sell consumer prod- Identification Number Demonstrator
ucts to others on a person-to-person ba-
Sch A (Form 1040) Itemized Deductions Designer
sis, usually working out of your home. Or,
you deliver or distribute newspapers or Sch C (Form 1040) Profit or Loss From Director
shopping news. Business
Distributor or direct distributor
Where you sell. You may sell Sch C–EZ (Form 1040) Net Profit From
door-to-door, through the sales party plan, Business
or by appointment in someone else's Manager or supervisor
Sch SE (Form 1040) Self-Employment
home. Tax Representative or sales representative
When you sell. You may sell on a regular LI 1040 U.S. Individual Income Tax Return
basis or only occasionally. You may sell LI 1040–ES Estimated Tax for Individuals Self-employed. Direct sellers are self-em-
full-time or part-time, such as a sideline to ployed. This generally means you have to pay
a regular job. LI 1099–MISC Miscellaneous Income self-employment tax (discussed later under
2210 Underpayment of Estimated Tax by
Who is not a direct seller? You are not a Individuals, Estates, and Trusts Employee. You are a direct seller only if you
direct seller if you are employed in a store, sell 4562 Depreciation and Amortization are in business for yourself. Selling consumer
through a retail sales outlet, or sell your products as a company employee does not
employer's product away from the employer's 8829 Expenses for Business Use of Your make you a direct seller.
place of business. The fact that you work under another direct
See How To Get Tax Help near the end of seller does not make you that person's em-
this publication for information about getting ployee.
Comments and suggestions. We welcome
publications and forms.
your comments about this publication and your Recruiting. You are engaged in the trade or
suggestions for future editions. business of selling or soliciting the sale of con-
You can email us at *firstname.lastname@example.org. sumer products if you attempt to increase the
Please put "Publications Comment" on the subject sales of direct sellers who work under you (your
line. downline group) and your earnings depend in
part on how much they sell. Recruiting, motivat- Employment taxes from direct selling.
ing, and training are examples of attempts to
increase sales. Your state, county, or city may impose other Estimated tax. If you do not pay tax
kinds of tax and licensing obligations. through withholding, or do not have
Host or hostess. You are not a direct seller if enough withheld, you may have to pay
you simply host a party at which sales are made. Income tax. All businesses except partner- estimated tax.
Nevertheless, some information in this publica- ships must file an annual income tax return. Estimated tax is used to pay both income and
tion may still apply to you. (Partnerships file an information return.) For ex- self-employment taxes.
The gift you receive for giving the party is a ample, if you operate your direct-selling busi-
payment for helping the direct seller make sales. ness as a sole proprietor, you must file
You must report it as income at its fair market General rule for making estimated tax pay-
Schedule C or Schedule C–EZ as part of your
value. See Other Income, later. ments. You must make estimated tax pay-
individual income tax return (Form 1040). You are
ments for 2004 if you expect to owe at least
Your out-of-pocket party expenses are sub- a sole proprietor if you are self-employed (work
$1,000 in tax, after subtracting your withholding
ject to the 50% limit for meal and entertainment for yourself) and are the only owner of your unin-
and credits, and you expect your withholding
expenses, discussed under Meals and Enter- corporated business.
and credits to be less than the smaller of the
tainment, later. These expenses are deductible following.
as miscellaneous itemized deductions subject to Self-employment tax. Self-employment tax is
the 2%-of-adjusted-gross-income limit on a social security and Medicare tax primarily for 90% of the tax to be shown on your 2004
Schedule A (Form 1040), but only up to the those who work for themselves. It is similar to tax return.
amount of income you receive for giving the the social security and Medicare taxes withheld
party. See Not-for-Profit Limit, later. from the pay of most wage earners. If you are a 100% of the tax shown on your 2003 tax
direct seller, you generally must pay this tax on return. Your 2003 tax return must cover all
your income from direct selling. You must pay it 12 months for this rule to apply.
whether you are a sole proprietor or a partner in
Basic Tax Information a partnership. Use Schedule SE (Form 1040) to
Paying estimated tax. You can use Form
figure your self-employment tax. For more infor-
1040–ES to figure your estimated tax and make
The following discussion gives basic tax infor- mation about self-employment tax, see Publica-
quarterly estimated tax payments. Or, you can
mation that may help if you have never been in tion 533.
make estimated tax payments by electronic
business for yourself. For more information funds withdrawal or by credit card. See the Form
about starting a business, see Publication 583. The Social Security Administration (SSA)
1040–ES instructions or How To Pay Estimated
time limit for posting self-employment in-
Tax in Publication 505.
Employer Identification come. Generally, the SSA will give you credit
for self-employment income reported on a tax
Number (EIN) return filed within 3 years, 3 months, and 15
Underpayment penalty. If you did not pay
days after the tax year you earned the income. If
EINs are used to identify the tax accounts of enough estimated tax or have enough income
you file your tax return or report a change in your
employers, certain sole proprietors, corpora- tax withheld, you may be subject to a penalty for
self-employment income after this time limit, the
tions, partnerships, estates, trusts, and other underpayment of tax. You can use Form 2210 to
SSA may change its records, but only to remove
entities. figure the penalty. In most cases, you can have
or reduce the amount. The SSA will not change
If you do not already have an EIN, you need the Internal Revenue Service figure the penalty
its records to increase the amount of your
to get one if any of the following apply to your for you. See Form 2210 to determine if you must
business. complete the form.
1) You have employees. Employment taxes. If you have employees in Exceptions. Generally, you do not have to
your business, you generally withhold and pay pay an underpayment penalty if you meet either
2) You have a qualified retirement plan. the following kinds of employment taxes. of the following exceptions.
3) You operate your business as a corporation The federal income tax you withhold from
or partnership. employees' wages. Your total tax is less than $1,000.
4) You file returns for: Social security and Medicare taxes—both You had no tax liability last year.
the amount you withhold from employees'
a) Employment taxes, wages and the amount you pay as the For more information on estimated tax, see
employer. Publication 505.
b) Excise taxes, or
Federal unemployment (FUTA) tax (none Information Returns
c) Taxes on alcohol, tobacco, or firearms. of which is withheld from the employees'
You can apply for an EIN in the following wages). You must file an information return to report that
ways: For more information, see Publication 15. you made direct sales of at least $5,000 of
By going online—Click on the EIN link at consumer products to a buyer for resale any-
www.irs.gov/businesses/small. The EIN Other taxes. You can deduct personal property where other than a permanent retail establish-
is issued immediately once the application m ent. The i nf orm ati on return, F orm
and other taxes as a business expense if you
information is validated. 1099– MISC, must show the name, address,
incur them in the ordinary course of your
business. For information about deducting these and identification number of the buyer (recipi-
By telephone at 1-800-829-4933 from taxes, see Taxes under Business Expenses,
ent). Check box 9 of Form 1099–MISC to show
7:30 a.m. to 5:30 p.m. in the applicant's these sales. Do not enter a dollar amount.
local time zone.
By mailing or faxing Form SS-4, Applica- Estimated Tax You must also provide a statement to the
tion for Employer Identification Number. buyer by January 31 of the year following the
The federal income tax is a pay-as-you-go tax. calendar year for which the information return is
You must pay it as you earn or receive income filed, showing your name, address, phone num-
Business Taxes during the year. There are two ways to pay as ber for contacting you, and identifying number.
you go. The statement you give to the buyer for these
The following kinds of federal business taxes direct sales may be in the form of a letter show-
may apply to direct sellers. Withholding. If you are an employee, ing this information along with commissions,
your employer likely withholds income tax prizes, awards, etc. See the instructions for
from your pay. By revising your W-4, you Form 1099– MISC for more information.
Self-employment tax can increase your withholding to cover the
tax you owe on income from your job and
Penalties Negligence. Negligence includes a failure of any month except December.
to make a reasonable attempt to comply with
provisions of the Internal Revenue Code. You generally adopt a tax year by filing your first
The law imposes penalties for noncompliance income tax return using that tax year. If you filed
with tax laws. Some of these penalties are dis- Disregard. Disregard means the careless, your first return as a wage earner using the
cussed next. If you underpay your tax due to reckless, or intentional disregard of rules or reg- calendar year and you later start your own busi-
fraud, you could be subject to a civil fraud pen- ulations. ness, you must continue to use the calendar
alty. In certain cases, you could be subject to year as your business tax year. You generally
criminal prosecution. Substantial understatement of income tax.
cannot change your tax year without IRS ap-
For an individual, income tax is substantially
Failure-to-file penalty. If you do not file your proval.
understated if the understatement exceeds the
return by the due date (including extensions), greater of the following amounts. For more information, see Publication 538.
you may have to pay a failure-to-file penalty. The
penalty is usually 5% of the tax not paid by the 10% of the correct tax.
due date for each month or part of a month that $5,000. Accounting Methods
the return is late. This penalty cannot exceed
25% of your tax, and it is reduced by the An accounting method is a set of rules used to
Information reporting penalties. A penalty
failure-to-pay penalty (discussed next) for any determine when and how income and expenses
applies if you do not file information returns by
month both penalties apply. However, if you file are reported. You must use the same account-
the due date, do not include all required informa-
your return more than 60 days after the due date ing method from year to year. The two most
tion, or do not report correct information. The
or extended due date, the minimum penalty is common accounting methods are the cash
amount of the penalty is based on when you file
the lesser of $100 or 100% of the unpaid tax. method and an accrual method. A third method,
the correct information return, as follows.
You will not have to pay the penalty if you show called a hybrid method, is generally a combina-
that you failed to file on time because of reason- Correct information returns filed within 30 tion of cash and accrual.
able cause and not because of willful neglect. days after the due date, $15 each. The text and examples in this publication
Failure-to-pay penalty. You may have to pay Correct information returns filed after the generally assume you use the calendar year as
a penalty of 1/2 of 1% of your unpaid taxes for 30-day period but by August 1, $30 each. your tax year and either the cash or hybrid
each month or part of a month after the due date method as your accounting method. Generally,
Information returns filed after August 1 or if inventories are needed to account for your
that the tax is not paid. This penalty cannot be not filed, $50 each.
more than 25% of your unpaid tax. You will not income, you must use an accrual method, dis-
have to pay the penalty if you can show good Maximum limits apply to all these penalties. cussed later, for your sales and purchases.
However, if you are a qualifying taxpayer or a
reason for not paying the tax on time. This pen-
alty does not apply during the automatic Failure to furnish correct payee statements. qualifying small business taxpayer, you can use
4-month extension of time to file if you paid at If you do not provide a complete, correct, and the cash method of accounting, even if you
timely copy of an information return (payee purchase or sell merchandise. You also can
least 90% of your actual tax liability on or before
the due date of your return and you pay the statement), you may be subject to a penalty of account for inventoriable items as materials and
balance when you file the return. $50 for each statement. If the failure is due to supplies that are not incidental. For more infor-
intentional disregard of the requirements, the mation, including definitions of a qualifying tax-
The monthly rate of the failure-to-pay penalty payer, a qualifying small business taxpayer, and
is half the usual rate (.25% instead of .50%) if minimum penalty is $100 per statement with no
maximum penalty. an explanation of materials and supplies that are
an installment agreement is in effect for that not incidental, see Publication 538.
month. You must have filed your return by the
Failure to supply identification number. If
due date (including extensions) to qualify for this Cash method. Under the cash method, you
reduced penalty. you do not include your identification number
(SSN or EIN) or the identification number of report income in the year it is received, credited
Penalty for frivolous return. You may have another person where required on a return, to your account, or made available to you on
to pay a penalty of $500 if you file a return that statement, or other document, you may be subject demand. You need not have physical posses-
does not include enough information to figure to a penalty of $50 for each failure. You may also sion of it. You deduct expenses in the year you
be subject to the penalty if you do not give your pay them, even if they were incurred in an earlier
the correct tax or that contains information
clearly showing the tax you reported is substan- identification number to another person when it year.
tially incorrect. is required on a return, statement, or other
Check received. If you receive a check
You will have to pay the penalty if you filed before the end of the tax year, you must include
this kind of return for either of the following You will not have to pay the penalty if you it in income for the year you receive it even
reasons. can show the failure was due to reasonable though you do not cash or deposit it until the
cause and not willful neglect.
A frivolous position on your part. next year.
A desire to delay or interfere with the ad- Accounting Periods Accrual method. Under an accrual method,
you generally report income for the tax year
ministration of federal income tax laws.
and Methods when all events have occurred that fix your right
This penalty is in addition to any other penalty to receive the income and you can determine the
provided for by law. All income tax returns are prepared using an amount with reasonable accuracy. Generally,
accounting period (tax year) and an accounting you deduct or capitalize business expenses
Accuracy-related penalty. An accuracy-re- method. when all events have occurred that fix the fact of
lated penalty of 20% applies to any underpay- liability, the liability can be determined with rea-
ment due to the following reasons. sonable accuracy, and economic performance
Accounting Periods has occurred. See Publication 538 for an expla-
Negligence or disregard of rules or regula-
tions. nation of economic performance.
When preparing a statement of income and ex-
Substantial understatement of income tax. penses, you must use books and records for a
specific interval of time called an accounting Prepaid expenses. Expenses paid in ad-
This penalty also applies to conditions not dis- period. The annual accounting period for your vance generally can only be deducted in the
year to which they apply under either the cash
cussed here. tax return is called a tax year. You can generally
or an accrual method. (However, see Exception
Even though an underpayment was due to use one of the following tax years.
for recurring items under Accrual Method in Publi-
both negligence and substantial underpayment, A calendar year, which begins on January cation 538.) For example, suppose you have a
the total accuracy-related penalty cannot ex- 1 and ends on December 31. subscription to a direct-selling journal that runs
ceed 20% of the underpayment. The penalty is out at the end of 2003. It will cost you $30 to
not imposed if you can show reasonable cause A fiscal year (including a period of 52 or renew the subscription for one year or $54 for 2
and that you acted in good faith. 53 weeks). A regular fiscal year is 12
consecutive months ending on the last day
years. You decide to renew for 2 years and mail you work under). You either send the money bought for your own use.
your check at the end of November 2003. You directly to the company with your orders, or
cannot deduct the $54 on your 2003 return. you are billed later. In either case, you are able to 3) Subtract from this total the inventory on
However, you can deduct half of the $54 in 2004 charge your customers more than you pay for hand at the end of the year. The difference
and the other half in 2005. the goods. is your cost of goods sold during the year.
You are buying products wholesale and sell-
ing them retail. The full amount received from Example 1. Janet sells cookware on the
your customers is income from sales. sales-party plan. On December 31, 2002, she
Business Income did not have any cookware on hand to sell to
Example 4. You keep a supply of goods that customers. She does not have a beginning in-
You must report all income you receive as a your customers regularly buy from you. This ventory for 2003.
direct seller. This includes any of the following. allows you to fill their orders without delay. You During the year, Janet spent $5,270 on
Income from sales—payments you re- order and pay for the goods before your custom- goods in her product line. Of this amount, $130
ceive from customers for products they ers request them. was for cookware sets she gave for personal
buy from you. gifts and $40 was for a set for her own use. She
You have purchased goods to resell to cus- purchased $5,100 [$5,270 - ($130 + $40)] worth
Commissions, bonuses, or percentages tomers. The full amount received from your cus- of goods to sell to customers.
you receive for sales and the sales of tomers is income from sales.
On December 31, 2003, Janet had several
others who work under you. sets of cookware in boxes for delivery to custom-
Example 5. You have recruited several
Prizes, awards, and gifts you receive from other direct sellers who order their products ers. The cost of these sets was $220. Her ending
your selling business. through you. Commissions or bonuses paid to inventory for the year is $220, and her cost of
you by the company are shared with the direct goods sold for 2003 is $4,880 ($0 beginning
You must report this income regardless of inventory + $5,100 purchases - $220 ending
sellers in your group based on sales,
whether it is reported to you on an information inventory).
purchases, or some other formula established
by the company whose products you sell. You
keep the portion of the commissions you are not Example 2. Lisa is a direct seller of cosmet-
Income From Sales required to distribute to the direct sellers in your ics. She has an established clientele and knows
group. what items are steady sellers. When the com-
You have income from sales if your customers pany has a special sale on these items, she
buy directly from you and you buy the products The bonuses you receive from the company buys extra quantities for future sales. She had
you sell from a company (or another direct are included in income as commissions, not as merchandise costing $200 on hand at the end of
seller). income from sales. 2002 (which would be her beginning inventory
If some of your customers buy their products for 2003) and merchandise costing $175 at the
directly from the company, you, as the sales Gross Profit end of 2003. During the year she purchased
agent, do not have any sales income from these $3,250 of merchandise. Purchase returns and
transactions. You will generally receive a com- Gross receipts minus cost of goods sold equals allowances were $50. She withdrew $200 of
mission or bonus for making the sale, but you gross profit. cosmetics for personal use. Lisa figures her cost
will have no direct income from the sale itself. If If you have income from sales and you are of goods sold for 2003 as follows:
all of your sales are handled this way, the rules filing Schedule C, Form 1040, figure your gross
in this section do not apply to you. Report your Beginning inventory .................. $200
profit and the income to report by following these Add: Merchandise
commissions as other business income. For steps.
more information, see Other Income, later. purchased during the
year ........................ $3,250
Depending on the company with which you 1) Figure the total your customers paid you Subtract: Purchase returns and
are affiliated and the nature of its marketing and during the year for goods you sold them. allowances ........... 50
compensation plan, you may have income from Include this in the gross receipts you re- Subtract: Goods withdrawn for
sales, commissions, bonuses, or all three. port on line 1 of Schedule C. personal use ........... 200 3,000
Goods available for sale ............ $3,200
Example 1. Your customers pay you the 2) Subtract the amount (if any) your custom- Subtract: Ending inventory ......... 175
retail price for goods they order. You forward the ers paid that you had to return in the form Cost of goods sold .................. $3,025
orders and payments to the company. The com- of refunds, rebates, or other allowances.
pany sends the merchandise to fill the orders. Show this on line 2 of Schedule C. Lisa figures her gross profit by subtracting the
The company also sends you a commission. cost of goods sold from her gross receipts
3) Finally, subtract the cost of the goods sold
You are acting as a sales agent for the com- (line 4 of Schedule C). To figure the cost of ($5,375) for the year as follows:
pany. You did not purchase the products to sell goods sold, you must know the value of
to your customers. Your payment from the com- the inventory at the beginning and end of Gross receipts ................................ $5,375
pany is commission income, not income from the year, and your purchases during the Minus: Cost of goods sold .........................
sales. Include the commission in your gross year. See Cost of Goods Sold, next, and ............................................................. 3,025
receipts. The amount your customers pay for the Inventory, later. Gross profit .................................. $2,350
goods they order is not included in income.
Purchases. When figuring cost of goods sold,
Example 2. Your customers pay you a de- include the full cost of all merchandise you buy
posit when you take their orders. You send the Cost of Goods Sold to sell to customers. This cost includes all post-
orders to the company, but keep the deposits for age and freight charges incurred.
yourself. The company fills the orders by ship- To figure your cost of goods sold, follow these
Figure your purchases at the actual price you
ping the merchandise to your customers. Your steps.
pay. Deduct a cash discount or a trade dis-
customers pay the company the remainder of count in figuring the cost of your purchases. A
the retail price (usually cash on delivery). 1) Start with the value of your inventory at the
cash discount or a trade discount is the differ-
You are acting as a sales agent for the com- beginning of the tax year. This is usually
ence between the invoice price and the actual
pany. The deposit is your commission income. the same as the value of your inventory at
price you have to pay.
You have no income from sales. the end of the previous year. Valuing in-
ventory is discussed later under Inventory.
Purchase returns and allowances. Subtract
Example 3. Your customers pay you for the 2) Add to your beginning inventory the cost of purchase returns and allowances from your total
goods you sell them, either when you take their merchandise you bought during the year purchases for the year when figuring cost of
orders or when you make deliveries. After your to sell to customers. This does not goods sold. This includes any rebates or refunds
customers place orders, you order the include the cost of merchandise you you received off the purchase price. It also in-
goodsfrom the company (or from a direct seller
cludes any credit you received for returned mer- customer. Prizes, awards, and gifts. If you receive
chandise. prizes, awards, or gifts in your role as a direct
Identifying the cost. The second step in figuring seller, report their full value as business income.
Personal withdrawals. Subtract from your your inventory is to identify the cost of inventory The following are examples of items that must
purchases for the year the cost of goods in your items. Use the specific identification be included in income.
product line that you bought for personal use method when you can identify and match the
and the cost of goods you withdrew from inven- actual cost to the items in inventory. Most direct Cash.
tory. Merchandise is considered withdrawn from sellers will be able to use this method. Free merchandise.
inventory when it is no longer available for sale If you cannot identify specific items with their
to customers. For example, if you sell a particu- Expense-paid trips.
invoices, you must make an assumption about
lar kind of soap and give some as a gift or use which items were sold during the year and which Use of a car.
some yourself, you must withdraw the soap from remain. Make this assumption using either the
inventory because it is no longer available for Jewelry signifying your level of achieve-
first-in first-out (FIFO) method or the last-in
sale. Follow this procedure for all products with- ment as a direct seller.
first-out (LIFO) method.
drawn for personal use, even if you are using the
The FIFO method assumes that the first Membership in organizations or clubs.
product only to familiarize yourself with its char-
acteristics or to demonstrate loyalty to the com- items you purchased or produced are the first Tickets to sporting events, shows, or con-
pany whose products you sell. items you sold, consumed, or otherwise dis- certs.
The LIFO method assumes that the last
items that you purchased are sold, consumed, Value of goods or services received. Report
Inventory or otherwise disposed of first. income received in the form of goods or services
at their fair market value. Fair market value is
Many direct sellers have little or no inventory. Valuing the inventory. The third step in figur- the price agreed on between a willing buyer and
Others keep a considerable inventory on hand. ing your inventory is to value the items you have a willing seller when both have reasonable
If you must account for an inventory in your in inventory. The value of your inventory is a knowledge of the facts and neither is forced to
business, you must use an accrual method of major factor in figuring your taxable income. The buy or sell.
accounting for your purchases and sales. How- method you use is very important.
ever, see Qualifying taxpayer and Qualifying small
The two most common methods to value Value of use of property. If you receive the
business taxpayer in the discussion on exceptions
non-LIFO inventory are the cost method and free use of property through your direct-sales
under Inventories in Publication 538. the lower of cost or market method. LIFO performance, you must include the fair market
If you have income from sales, you need to inventory may only be valued at cost. value of the use of the property in your business
know how to figure your inventory at the end of income. There are special rules for the free use
each tax year. Your inventory practices must be Cost method. If you use the cost method to of an automobile and certain other property. For
consistent from year to year. value your inventory items, the value of each
more information, see Valuation of Fringe Bene-
Figuring inventory involves: item is usually its invoice price. Add transporta-
tion, shipping, and other necessary costs to ac- fits in Publication 525.
1) Taking inventory, quire the items. Subtract appropriate discounts
2) Identifying the cost, and
3) Valuing the inventory. Lower of cost or market method. See
Publication 538 for a discussion of the lower of
You need to know your inventory at the begin- cost or market method. You must capitalize some costs rather than de-
ning and end of each tax year to figure your cost
New business. For a new business not us- duct them. These costs are a part of your invest-
of goods sold. Beginning inventory will usually
ing LIFO, you may choose either method to ment in your business and are called capital
be the same as the prior year's ending inventory.
value your inventory. You must use the same expenses. When you capitalize a cost, you add
Any differences must be explained in a schedule
method to value your entire inventory, and you it to the basis of the property to which it relates.
attached to your return.
cannot change the method without first ob- Although you generally cannot take a current
Taking inventory. The first step is to identify taining IRS approval. deduction for a capital expense, you may be
and count all merchandise in your inventory. able to take deductions for these costs over a
Include all goods to which you have title at the Other Income period of years as explained later under Cost
end of the year. This generally will be any goods Recovery.
you have on hand and have not yet sold to You must report on your tax return all income
customers. you receive from your business unless it is ex- Kinds of Capital Expenses
cluded by law. In most cases, your business
Include merchandise you have purchased, if
income will be in the form of cash, checks, and You must capitalize the following costs.
title has passed to you even if you have not yet
credit card charges. But business income can
physically received the goods. You may have Going into business. The costs of getting
be in other forms, such as property or services.
title to goods that were shipped to you but are started in business, before you are author-
These and other types of income are explained
still in transit and not yet received. If the risk of ized to start selling your company's prod-
loss during shipment is yours, you will probably ucts, are capital expenses. These start-up
have title to the goods during shipment. If you costs include the cost of exploring different
buy merchandise that is sent C.O.D., title Commissions, bonuses, and percentages.
Many direct sellers receive a commission on direct-selling opportunities, the cost of any
passes when payment and delivery occur. training you must have before becoming a
their sales or purchases. Your commission
might be called a bonus or percentage, and it direct seller for your product line, any fees
Goods not yet paid for. You may have title
might be based on both your own sales and the you must pay to the company to become a
to goods purchased but not yet paid for. If you
sales of other direct sellers working under you, direct seller, and similar costs. See
are billed for merchandise, you must usually pay
or on purchases from the company with which chapter 9 of Publication 535 for information
the bill within a certain time. In this case, you
you are affiliated. on how to treat these costs.
have title to the goods and must include them in
inventory, provided they are not sold by the end Report the full amount of any commissions Business assets. The cost of any asset
of the year. you receive as business income, even if you pay (property) that will last substantially be-
part of it to other direct sellers working under yond the tax year it is placed in service is
Consignments. Merchandise you receive you. You can usually deduct the part you pay to a capital expense. Examples of business
on consignment is not purchased by you and is others as a business expense. For more infor- assets include office furniture, business
never included in your inventory. You have mer- mation, see Commissions under Other Ex- vehicles, and storage shelves. See Cost
chandise on consignment if you do not have to penses, later. Recovery, later.
pay for what you have in stock until the time you
sell it and collect the retail price from the
Improvements. The costs of making im- The demonstrator kits last less than one year Dollar limit. The maximum section 179 cost
provements to a business asset are capital and are not sold to customers. Some are ruined you can choose to deduct for 2003 is generally
expenses if the improvements add to and thrown away. Their cost is a business ex- $100,000.
the value of the asset, appreciably pense. Certain benefits, including an increased sec-
lengthen the time you can use it, or adapt tion 179 deduction, are available for certain
it to a different use. However, normal re- More than one year of use. If you use a property you place in service in the New York
pair expenses are deducted as current demonstrator for more than one year, its cost is Liberty Zone or in an empowerment zone.
business expenses and are not capital- a capital expense. However, if you expect to
ized. For example, if you have a car you Business income limit. The total cost you
eventually sell the demonstrator, include it in can deduct each year after you apply the dollar
use only for business, you can deduct as your inventory of goods for sale.
business expenses, maintenance and re- limit is further limited to the taxable income from
pair costs such as tune-ups, new head- the active conduct of any trade or business dur-
Example 1. Mike sells educational books ing the year.
lights, or brake repairs. The cost of door-to-door. He carries copies of the books to
overhauling the engine, however, would show potential customers. If someone wants a Any cost not deductible in one year because
be a capital expense. book, he takes a deposit and delivers the book of this limit can be carried to the next tax year.
at a later time. More information. For more information, see
His product line changes little from year to chapter 2 in Publication 946.
Demonstrators year, so Mike can use a book as a demonstrator
If you keep your company's products on hand to
for a long time. Although he periodically re- Depreciation
places his demonstrators with new ones and
show to potential customers, their cost may be
sells the old ones at a discount, he has kept If you do not choose a section 179 deduction or
part of the cost of goods sold, a capital expense,
some books as demonstrators for up to 3 years. you choose a section 179 deduction and do not
a business expense, or a personal expense,
Because Mike eventually sells his demon- recover all your cost, you can take a deprecia-
depending on the circumstances. The cost of a
strators, they remain part of his inventory of tion deduction (which may include a special de-
product you use yourself is a personal expense,
goods for sale. preciation allowance for qualified property) for
even if you occasionally show it to prospective
part or all of the cost you did not claim as a
Example 2. Janet sells the same line of ed- section 179 deduction.
ucational books as Mike in Example 1. She Property whose cost can be recovered
Example. Sheila is a direct seller who uses
tries to use her demonstrators as long as through depreciation is depreciable property.
many of the products in her own home. When
possible. She puts the books in plastic jackets to Depreciable property includes most types of tan-
potential customers come to her house, she can
protect them, and ordinarily only stops using gible property (except land), such as buildings,
show them drapes she bought from the com-
them as demonstrators when the company machinery, vehicles, furniture, and equipment.
pany, as well as her lawn chairs, toaster, grill,
comes out with a new edition. Janet never sells Depreciable property also includes certain in-
tea set, and spice cabinet. By showing these
the old demonstrators. She can recover the cost tangible property.
items in her own home, she hopes to interest
people in buying from her company or in becom- of the books she uses as demonstrators as You can depreciate property if it meets the
ing direct sellers themselves. discussed under Cost Recovery, next. following requirements.
Sheila cannot take a deduction for the cost of It must be property you own.
any of these products. Because she uses them
in her own home for personal reasons, their cost It must be used in your business or
is not a cost of doing business. Cost Recovery income-producing activity.
It must have a determinable useful life.
Used one year or less. If you have a product You can usually recover (subtract from income) This means it is something that wears out,
you use as a demonstrator for one year or less your cost for capital expenses over a number of decays, gets used up, becomes obsolete,
and the demonstrator itself is not available for years. Each year a part of your basis is recov- or loses value from natural causes.
purchase by your customers, its cost is a busi- ered through depreciation or amortization. Use
ness expense. depreciation to recover capital expenses for It must be expected to last more than one
If the demonstrator itself can be bought by most tangible business assets. Use amortiza- year.
your customers, include it in your inventory. tion to recover the cost of intangible assets, such It must not be excepted property, such as
as start-up costs. Amortization is discussed in property placed in service and disposed of
Example 1. Constance is a direct seller of chapter 9 of Publication 535. in the same year.
kitchenware. Customers must order items from
Under certain circumstances, you may be
a catalog, but she keeps at least one of each
able to recover a limited amount of the cost of You must use the modified accelerated cost
type on hand to show buyers. When her product
qualifying property as a current expense by recovery system (MACRS) to depreciate most
line changes and an item is discontinued, she
electing the section 179 deduction rather than property placed in service after 1986.
either starts using the demonstrator in her own
recover the cost as a capital expense. The sec- For information about the depreciation of
kitchen or tries to sell it. When she had a garage
tion 179 deduction is discussed later. property placed in service after 1986, see Publi-
sale, she sold a number of unused demonstra-
tors. cation 946. Chapter 4 contains a detailed dis-
Form 4562. Generally, use Form 4562 to report cussion on figuring depreciation under MACRS.
Constance includes her demonstrators, in-
depreciation, amortization, and the section 179 For information about the depreciation of
cluding those for discontinued products, in her
deduction. A filled-in Form 4562 is illustrated in property placed in service before 1987, see
inventory of goods for sale. When she sells a
an example in Publication 946. Publication 534, Depreciating Property Placed
demonstrator, including those she sold at the
garage sale, she includes the income in her in Service Before 1987.
gross business receipts. Section 179 Deduction Special depreciation allowance. You can
When Constance starts using a demonstrator take a special depreciation allowance to recover
You can elect to deduct all or part of the cost of
in her own kitchen, it is a withdrawal of part of the cost of qualified property placed in
inventory for personal use. She subtracts the certain qualifying property in the year you place
it in service. Property is placed in service when it service during the tax year. An allowance ap-
cost of the item from her purchases for the year. plies for the first year you place the property in
is first made ready and available for a specific
See Personal withdrawals under Cost of Goods service. For qualified property acquired before
Sold, earlier. May 6, 2003, it is an additional 30% deduction.
For qualified property acquired after May 5,
Example 2. Lydia sells needlework kits at Qualifying property. Qualifying property in- 2003, it is an additional 50% deduction, or you
sales parties. She has catalogs and a number of cludes tangible personal property for which de- can elect to take an additional deduction deter-
kits to show customers. She uses these kits to preciation is allowable. See chapter 2 in mined at the 30% rate. You can take the addi-
demonstrate various needlework techniques. Publication 946 for more information. tional 30% or 50% deduction after any section
179 deduction and before you figure regular If your business/investment use of the You can also deduct registration fees for the
depreciation under MACRS for the year you
place the property in service. For more informa-
automobile is less than 100%, you
must reduce the maximum deduction
right to use property within a state or local area.
tion, see chapter 3 in Publication 946. amount proportionately. Example. May and Julius Winter drove their
car 7,000 business miles out of a total of 10,000
miles during the tax year. They had to pay $25
Listed Property Example. Peter purchases a used car this for their annual state license tags and $20 for
year for $4,500 and he uses it 60% for business. their city registration sticker. They also paid
Listed property includes property which lends The car is not qualified property for the 30% or
itself to personal use such as property used for $235 in city personal property tax on the car, for
50% special depreciation allowance. He a total of $280. They are claiming their actual car
transportation, entertainment equipment, cer- chooses to take a section 179 deduction for the
tain computers, and cellular phones. In addition, expenses for the year. Because they used the
car. The cost of Peter's car that qualifies for the car 70% for business, they can deduct 70% of
there are recordkeeping requirements and rules section 179 deduction is $2,700 ($4,500 x 60%).
you must follow when depreciating listed prop- the $280, or $196, as a business expense.
However, Peter's section 179 deduction is lim-
erty. If listed property is not used more than ited to $1,836 ($3,060 x 60%).
50% for a qualified business use during any tax Sales tax. Treat any sales tax you pay on a
year, you cannot claim the section 179 deduction service or on the purchase or use of property as
or a special depreciation allowance and special part of the cost of the service or property. If the
rules apply to the depreciation deduction. See
chapter 5 in Publication 946.
Business Expenses service or the cost or use of the property is a
deductible business expense, you can deduct
The operating costs of running your business the tax as part of that service or cost. If the
are called business expenses. These are costs property is merchandise bought for resale, the
Passenger automobiles. For most passen- sales tax is part of the cost of the merchandise. If
you do not have to capitalize or include in the
ger automobiles, the section 179 deduction and cost of goods sold. the property is depreciable, add the sales tax to
depreciation deduction (including the special Keep business expenses separate from per- the basis for depreciation. See Publication 551,
depreciation allowance) you can claim is limited. Basis of Assets, for information about the basis
sonal expenses. If you have an expense that is
See Publication 946 for limits that apply for partly for business and partly personal, deduct of property.
trucks, vans and electric passenger automobiles only the business part on your business return. Do not deduct state and local sales
placed in service in 2003. To be deductible, a business expense
must be both ordinary and necessary. An
taxes imposed on the buyer that
you must collect and pay over to the
For a passenger automobile that is qualified state or local government. Do not
ordinary expense is one that is common and
property for a special depreciation allowance include these taxes in gross receipts or sales.
accepted in your trade or business. A necessary
(see definitions below) placed in service during
expense is one that is appropriate and helpful for
2003, the total of your section 179 deduction and
your trade or business. An expense does not Fuel taxes. Taxes on gasoline, diesel fuel,
depreciation deduction (including the special
have to be indispensable to be considered and other motor fuels that you use in your busi-
depreciation allowance) cannot be more than
necessary. ness usually are included as part of the cost of
$10,710 for a car acquired after May 5, 2003
($7,660 for a car acquired before May 6, 2003). This section discusses business expenses the fuel. Do not deduct these taxes as a sepa-
If you elected not to claim the special deprecia- you might have as a direct seller. For more rate item.
tion allowance for the automobile or if the auto- information on business expenses, see Publica-
mobile is not qualified property, the limit is Interest
generally $3,060. For 2004 and 2005, the maxi-
mum deduction amounts for a passenger auto- Salaries and Wages Interest is the amount charged for the use of
mobile placed in service in 2003 are $4,900 and borrowed money. You can generally deduct as a
$2,950 respectively. The maximum deduction You can generally deduct the pay you give your business expense all interest you pay or accrue
for each year after 2005 is $1,775. employees for the services they perform for your during the tax year on debts related to your trade
business. The pay may be in cash, property, or or business.
services. It may include wages, salaries, vaca- You can deduct interest on a debt only if you
Qualified property for the 30% special depre-
tion allowances, bonuses, commissions, and meet all the following requirements.
ciation allowance includes a car that meets all
the following requirements. You are legally liable for that debt.
If you are a sole proprietor, you cannot de-
You bought the car new after September duct your own salary or any personal withdraw- Both you and the lender intend that the
10, 2001. als you make from your business. You are not debt be repaid.
an employee of the business.
You placed the car in service for business You and the lender have a true
For detailed discussions of salaries, wages, debtor-creditor relationship.
and other payments to employees, see Publica-
You used the car more than 50% in a tions 15 and 15–A, and chapter 2 in Publication
No deduction is allowed for interest paid or
qualified business use. 535.
accrued on personal loans. If a loan is part
business and part personal, allocate the interest
Qualified property for the 50% special depre- Taxes between the two. For more information, see
ciation allowance includes a car that meets all chapter 5 in Publication 535.
the following requirements. You can deduct as a business expense various
federal, state, local, and foreign taxes directly Example. During the tax year, you paid
You bought the car new after May 5, 2003. attributable to your direct-selling business. $600 interest on a car loan. You used the car
You placed the car in service for business Some of these taxes were discussed earlier 60% for business and 40% for personal pur-
after May 5, 2003. under Business Taxes and others are discussed poses. You can deduct $360 (60% x $600) as a
next. business expense on your Schedule C (Form
You used the car more than 50% in a 1040) or Schedule C–EZ (Form 1040). The
qualified business use. Income taxes. Most income taxes, including
remaining interest ($240) is a nondeductible
federal income taxes, cannot be deducted as a
business expense. You can generally deduct
You can elect to claim the 30% personal state and local income taxes as an
special depreciation allowance itemized deduction on Schedule A (Form 1040). Insurance
instead of the 50% special depreciation
allowance for property that qualifies for the 50% Personal property tax. You can deduct as a You can generally deduct premiums you pay for
allowance. This election applies to all property in business expense any tax imposed by a state or the following kinds of insurance related to your
the same property class placed in service during local government on personal property used in trade or business. This list is not all inclusive.
the year. your direct-selling business.
Example 2. Mary and George run an active total, $56, as a business expense on her tax
Fire, theft, flood, or similar insurance. direct-selling business out of their home. For return.
Car and other vehicle insurance on vehi- February, their phone bill was $65 ($20 for basic
cles used in your business if you do not telephone service and $45 for long-distance Computer. If you use a computer in your direct
use the standard mileage rate to figure calls). sales business, you can depreciate it. However, if
your car expenses. The total charge for long-distance business you use it 50% or less in your business, you
calls on their bill is $31. Mary and George can must use the Alternative Depreciation System
Credit insurance to cover losses from (ADS) under MACRS to figure your depreciation
deduct $31 as a business expense.
business bad debts. deduction. For more information, see chapter 5
Liability insurance. Away from home. If you travel away from in Publication 946.
home and make a business phone call, you can
Use and occupancy and business inter- deduct the cost of the call, whether or not the Home meetings. If you have business meet-
ruption insurance. This insurance pays for rest of your travel expenses are deductible. ings in your home, you can deduct expenses for
lost profits if your business is shut down the meetings as entertainment expenses and as
due to a fire or other cause. Report the Business and personal calls. You can deduct expenses related to the business use of your
proceeds as ordinary income. telephone expenses only for business calls. home only when they meet certain tests.
Personal calls do not become business calls
You generally cannot deduct the cost of life because some business is discussed. The expenses of entertaining business as-
insurance paid on your own life. However, see sociates in your home are deductible as
chapter 7 in Publication 535 for information on Example. Lydia is interested in sponsoring entertainment expenses if they meet the
when life insurance premiums are deductible. others as direct sellers for her product line. She rules discussed under Meals and Enter-
often talks by phone with her sister who lives 50 tainment, later, and you can prove your
Business and personal. If you pay premiums miles away. They talk about personal matters. expenses as discussed later under Re-
for insurance coverage that is both business and When Lydia mentions her direct-selling work, cordkeeping.
personal, deduct only the part that is for busi- she usually says something to encourage her The expenses of maintaining your home
ness coverage. For example, if you use your car sister to become a direct seller. as a place of business are deductible if
25% in your direct-selling business and 75% for Lydia's phone calls to her sister are personal you meet the tests discussed under Busi-
personal transportation, you can deduct 25% of and nondeductible. Their primary purpose is
your car insurance premiums if you claim actual ness Use of Your Home, later.
not to recruit her sister as a direct seller, but to
expenses for the use of the car. continue their personal relationship.
Example. Barbara and Bill hold biweekly
When to deduct. You generally cannot de- meetings in their home for the direct sellers who
duct expenses in advance, even if you pay them Other Expenses work under them. They discuss selling tech-
in advance. This rule applies to both the cash niques, solve business problems, and listen to
and accrual methods. If you make an advance Discussed next are other expenses you may presentations by company representatives.
payment on an insurance policy that provides have as a direct seller. Because the meetings are for business, Bar-
coverage substantially beyond the end of the bara and Bill can deduct 50% of the cost of the
current tax year, deduct only the part for the Licenses and regulatory fees. License and food and beverages they provide. The 50% limit
current tax year. You must wait until the follow- regulatory fees for your business paid each year is explained later under Meals and Entertain-
ing tax year to deduct the part for that year, and to state or local governments are generally de- ment. They keep a copy of their grocery receipts
so on. ductible business expenses. Some licenses and for these refreshments, and record the date,
fees may have to be amortized. See chapter 9 of time, and business nature of each meeting. Be-
Publication 535 for information on amortization. cause the meetings are held in their living room
Example. You are a direct seller. In June
2003, you pay $1,200 in premiums for theft in- rather than in a special area set aside only for
Catalogs. The cost of catalogs you use in your
surance effective July 2003 through June 2005 business, they cannot deduct any of their home
selling business for more than one year must be
($50 per month). You can deduct $300 in 2003 expenses for the meetings.
capitalized. The cost can then be recovered as
($50 x 6 months), $600 in 2004 ($50 x 12 explained under Cost Recovery, earlier. If the
months), and $300 in 2005. Journal subscriptions. If you subscribe to a
catalogs are used in your selling business for journal for direct sellers, you can deduct the
one year or less, you can deduct their full cost in annual subscription fee as a business expense.
Dividends. An insurance dividend is a return the tax year you pay for them.
of part of the premiums you paid. If you receive Club dues and membership fees. Generally,
dividends from business insurance premiums Commissions. If you must pay a bonus, per- you cannot deduct amounts you pay or incur for
you deducted in an earlier year, report all or centage, or other type of commission to direct membership in any club organized for business,
part of the dividend as business income. For more sellers working under you, you can deduct it. pleasure, recreation, or any other social pur-
information on recovery of prior deductions, see Report the full amount of any commissions you pose. This includes country clubs, golf and ath-
Publication 525. receive as business income, and deduct the letic clubs, hotel clubs, sporting clubs, airline
commissions you pay as ordinary and neces- clubs, and clubs operated to provide meals
sary business expenses. under circumstances generally considered to be
Telephone conducive to business discussions. The pur-
Example. Freda has her own direct-selling pose and activities of a club, not its name, will
You cannot deduct the cost of basic local tele- business and sponsors two other direct sellers. determine whether or not you can deduct the
phone service (including any taxes) for the first These direct sellers report their sales to her dues.
telephone line you have in your home, even if each month. She in turn adds their sales to hers
you have an office in your home. However, and reports the total to the direct seller who Exception. None of the following organiza-
charges for business long distance phone calls sponsored her. In March, the people working tions will be treated as a club organized for
on that line, as well as the cost of a second line under her each had $400 in sales and she had business, pleasure, recreation, or other social
into your home used exclusively for business, $500 in sales of her own. She reports to the purpose, unless one of its main purposes is to
are deductible business expenses. company (or her sponsor) $1,300 ($400 + $400 conduct entertainment activities for members or
+ $500) in monthly sales for her group even their guests or to provide members or their
Example 1. Leo had a separate telephone though her income is only $500. guests with access to entertainment facilities.
line installed in his home for his direct-selling Freda received a commission or perform- Boards of trade.
business. He had this phone number printed on ance bonus for March equal to 10% of the
his business cards and always uses it only for $1,300, or $130, in sales. She reports the entire Business leagues.
business calls. $130 as business income on her tax return. Chambers of commerce.
Leo can deduct the full amount of his busi- Freda must pay the direct sellers working
under her a commission of 7% on their monthly Civic or public service organizations.
ness phone bill because the phone is used ex-
clusively for business. sales of $400. She paid each of them $28 (7%
of$400) for their March sales. She deducts the
Professional associations. Qualifying for a Deduction Principal place of business. Your home office
will qualify as a principal place of business if you
Trade associations. meet both the following requirements.
To deduct expenses related to the business use
of part of your home, you must meet the follow- You use it exclusively and regularly for the
Legal and professional fees. Legal and pro- ing tests. Even if you meet the tests, your deduc- administrative or management activities of
fessional fees, such as fees charged by ac- tion may be limited. See Deduction limit, later. your trade or business.
countants, that are ordinary and necessary
expenses directly related to operating your busi- 1) Your use of the business part of your You have no other fixed location where
ness are deductible as business expenses. home must be: you conduct substantial administrative or
However, you usually cannot deduct legal fees management activities of your trade or
paid to acquire business assets. Those are ad- a) Exclusive (however, see Exception business.
ded to the basis of the property. under Exclusive use, later),
If the fees include payments for work of a Alternatively, if you do business at more than
personal nature (such as making a will), you can one location and your home office does not
take a business deduction only for the part of the c) For your trade or business, AND qualify as your principal place of business based
fee related to your business. The personal por- on these rules, you determine your principal
tion of legal fees for producing or collecting tax- 2) The business part of your home must be place of business based on the following factors.
able income, doing or keeping your job, or for tax one of the following:
advice may be deductible on Schedule A (Form 1) The relative importance of the activities
a) Your principal place of business (de- performed at each location.
1040) if you itemize deductions. See Publication
529, Miscellaneous Deductions. 2) The time spent at each location if the rela-
b) A place where you meet or deal with tive importance factor does not determine
Tax preparation fees. You can deduct as a clients or customers in the normal your principal place of business.
trade or business expense the cost of preparing course of your trade or business, or
that part of your tax return relating to your busi-
ness as a sole proprietor. The remaining cost c) A separate structure (not attached to Place to meet clients or customers. If you
may be deductible on Schedule A (Form 1040) if your home) used in connection with meet with clients or customers in your home in
you itemize deductions. your trade or business. the normal course of your direct selling busi-
You can also take a business deduction for ness, even though you also carry on business at
the amount you pay or incur in resolving as- another location, you can deduct your expenses
serted tax deficiencies against your business as Exclusive use. Exclusive use means you use for the part of your home used exclusively and
a sole proprietor. a specific part of your home solely for carrying regularly for business if both the following apply.
on your direct-selling business. You do not meet
Samples and promotional items. You can the exclusive use test if you use the area in You physically meet with clients or cus-
deduct the cost of samples you give to your question for your direct-selling business and that tomers on your premises.
customers and the cost of promotional items same part for personal purposes. Their use of your home is substantial and
such as posters. You cannot deduct the cost of integral to the conduct of your business.
any samples you use personally. Example. You use a den in your home to
write orders and do the paperwork for your busi- You do not qualify to deduct expenses for the
Service charges. You can deduct service ness. The den also is used by your children to do
charges you pay on orders for goods. The serv- business use of your home if you have only
their homework. You cannot claim any business occasional meetings or telephone calls.
ice charge can be a flat charge or it can be deduction for the use of the room.
based on other criteria.
Exception. If you use part of your home for Separate structure. You can deduct the ex-
Supplies. Unless you have deducted the cost the storage of inventory or product samples, you penses for a separate free-standing structure,
in any earlier year, you generally can deduct the can claim expenses for the business use of your such as a studio, garage, or barn, if you use it
cost of materials and supplies actually con- home without meeting the exclusive use test. exclusively and regularly for your business. This
sumed and used during the tax year. However, you must meet all the following tests. structure does not have to be your principal
If you keep incidental materials and supplies place of business or a place where you meet
on hand, you can deduct the cost of the incidental You keep the inventory or product sam- clients or customers.
materials and supplies you bought during the tax ples in your home for use in your
year if all three of the following requirements are direct-selling business. Deduction limit. If the gross income from the
met. Your home is the only fixed location of business use of your home equals or exceeds
your business. your total business expenses (including depreci-
You do not keep a record of when they are ation), you can deduct all your business ex-
used. You use the storage space on a regular penses related to the use of your home. If your
You do not take an inventory of the basis. gross income from the business use of your
amount on hand at the beginning and end The space you use is separately identifi- home is less than your total business expenses,
of the tax year. able and suitable for storage. your deduction for certain expenses for the busi-
ness use of your home is limited.
Your taxable income is clearly reflected by
this method. Example. Your home is the only fixed location
Where to deduct. If you qualify to deduct ex-
of your business. You regularly use half your
penses for the business use of your home, you
basement for storing inventory as well as for
must figure your deduction on Form 8829 and
personal purposes. You can deduct the ex-
attach it to Form 1040. You deduct the
penses for the storage space even though this
Business Use part of your basement is not used exclusively for
expenses on Schedule C (Form 1040).
of Your Home business.
More information. For more information, in-
cluding how to figure the deduction, see Publica-
Regular use. Regular use means you use a tion 587.
Many direct sellers work out of their homes and
specific part of your home for business on a
have business expenses for using their homes.
continuing basis. Occasional or incidental busi-
You can deduct expenses for using your home if
ness use of part of your home does not meet the
you meet certain tests.
regular use test even if you do not use that part
for any other purpose.
Transportation Entertainment. Include as entertainment any
activity generally considered to provide enter-
Travel and tainment, amusement, or recreation. This in-
You can deduct transportation expenses for cludes entertaining guests at nightclubs; at
Transportation your business when you are not traveling away social, athletic, and sporting clubs; at theaters;
from home. Transportation expenses include at sporting events; on yachts; and on hunting,
Travel expenses generally are those the costs of getting from one workplace to an- fishing, and vacation trips or on similar outings. It
business-related expenses for trips that require other in the course of your business when travel- can also include meeting your customers' per-
you to sleep or rest while traveling away from ing within the city or general area that is your tax sonal, living, or family needs, such as providing
your tax home, explained later, for substantially home, and of getting from your home to a tem- meals, a hotel suite, or a car. However, see Not
longer than an ordinary day's work—for example, porary work location. They also include the fol- directly related, later.
the cost of travel to a distant city to attend a lowing kinds of trips you make in the area where
business-related function or convention. Trans- you live and work.
portation expenses generally are those Directly Related
Visiting clients or customers.
business-related expenses for trips you make in or Associated
the area of your tax home—for example, the Attending business meetings away from
cost of transportation to call on customers or your workplace. To be deductible, meal and entertainment ex-
make deliveries in the city where you work and penses must be ordinary and necessary ex-
its suburbs. Transportation expenses include train, bus, and penses of carrying on your direct-selling
cab fares, car rental fees, and the cost of driving business and you must be able to prove them as
You must be able to prove your expenses for and maintaining your car for business transpor- explained later under Proving Your Deductions.
travel and transportation. Deductions for travel tation. Meals and lodging are not included in Unless certain exceptions apply, you must be
and transportation are looked at closely when transportation expenses. able to show that entertainment expenses (in-
the IRS examines returns. For more information, cluding expenses for entertainment-related
see Recordkeeping, later. Commuting expenses. You cannot deduct
meals) are directly related to or associated
the cost of transportation between your home
with the active conduct of your business.
and your main or regular place of work. The cost
Travel of commuting is a nondeductible personal ex- For more information, see chapter 2 of Publi-
pense, regardless of the distance or whether cation 463.
Generally, your tax home is your regular place work is performed during the trip.
of business or post of duty, regardless of where
Directly related. For entertainment expenses
you maintain your family home.
Example. Elaine works full time as a bank to meet the directly-related test, all the following
If you temporarily travel away from your tax teller. She also sells cosmetics part time to her must apply.
home on business, you generally can deduct co-workers at the bank. After her customers
your ordinary and necessary travel expenses. select items from a catalog, she sends the or- You had more than a general expectation
You cannot deduct lavish or extravagant ex- ders to the cosmetics company. She delivers the of getting income or some other specific
penses or those for personal or vacation pur- items to the bank when she receives them from business benefit from the expense.
poses. the company. You engaged in business with the person
You can deduct all your ordinary and neces- Elaine's expense of delivering items is not during the entertainment period.
sary travel expenses, subject to certain limits, deductible. Her cost of getting to the bank is a
commuting expense. The fact that she carries The main purpose of the combined busi-
discussed later, if your trip was entirely business
cosmetics does not make her commuting ex- ness and entertainment was the active
related. This includes expenses for attending a
pense a deductible business expense. conduct of business.
seminar, meeting, convention, or other function
if you can show that your attendance benefits
your business. If your trip was primarily for busi- Two places of work. If you work at two places
in one day, you can deduct the expense of You do not have to show that business income
ness and, while at your business destination, or another business benefit actually resulted from
you extended your stay for a vacation, made a getting from one workplace to the other. How-
ever, if you do not go directly from one location each entertainment expense.
nonbusiness side trip, or had other nonbusiness
activities, you can deduct only your business-re- to the other, deduct only the amount it would It is not necessary to devote more time to
lated travel expenses. These expenses include have cost you to go directly from the first location business than to the entertainment. However, if
the travel costs of getting to and from your busi- to the second. the business discussion is only incidental to the
ness destination and any business-related ex- entertainment, it does not qualify as directly re-
Deductible expenses. If you use your vehicle lated.
penses at your business destination.
in your business, see Publication 463 for infor-
mation on how to figure your expenses for busi- Example. You are a direct seller of women's
Example. You live in and conduct your di- ness transportation. cosmetics. A state women's organization is
rect selling business from Atlanta and take a holding its annual convention in a local hotel and
business trip to New Orleans. On your way you decide to display your products in a
home, you stop in Mobile to visit your parents. hospitality room in the hotel. You also provide
You spend $830 for the 9 days you are away
from home for transportation, meals, lodging, Meals and entertainment and give out product samples.
You can deduct the cost of the hospitality room
and other travel expenses. If you had not
stopped in Mobile, you would have been gone Entertainment and entertainment provided.
only 6 days, and your total cost would have been
Because you are in the selling business, you Not directly related. Generally, expenses are
$730. You can deduct $730 for your trip, includ-
may take business associates to lunch or other- not directly related if you are not there, or there
ing the cost of round-trip transportation to and
wise entertain them. The cost can be a deducti- are substantial distractions that prevent you
from New Orleans. The cost of your meals is
ble business expense. However, certain from actively conducting business. The follow-
subject to the 50% limit on meals explained
conditions must be met before you can take a ing are situations where there are substantial
deduction for business meals and entertain- distractions.
ment, and you generally can deduct only 50% of
If your trip was primarily for personal reasons,
the cost. This section discusses those rules.
such as a vacation, the entire cost of the trip is 1) A meeting or discussion at a nightclub,
a nondeductible personal expense. However, Meals. Include as meals the amounts spent on theater, or sporting event.
you can deduct any expenses you have while food and beverages and the taxes and tips on
at your destination that are directly related to 2) A meeting or discussion during what is es-
those amounts. Generally, no deduction is al- sentially a social gathering, such as a
your business. lowed for an entertainment-related meal unless cocktail party.
For more information, see Publication 463. you or your employee is present when the food
or beverages are provided.
3) A meeting with a group that includes persons pense. Furthermore, if your spouse joins the
who are not business associates at places party because the customer's spouse is present,
such as cocktail lounges, country clubs, golf the cost of the entertainment for your spouse Business Gifts
clubs, athletic clubs, or vacation resorts. also is deductible as an ordinary and necessary
business expense. Giving prizes, awards, and gifts may be an ordi-
You may prove the entertainment is directly nary and necessary part of doing business as a
related by clearly establishing you had a sub- direct seller. In each of the following situations
stantial business discussion during the enter- Lavish or extravagant expenses. You can- you can deduct the cost as a business expense.
tainment. not deduct expenses for meals and entertain-
When entertainment takes place on a hunt- m e n t t o t h e e xt e n t t h e y a r e l a v i s h o r Situation 1. You do your direct selling on the
ing or fishing trip, or on a yacht or pleasure boat, extravagant. An expense is not considered lavish sales party plan. As an incentive for people to
the conduct of business is not considered the or extravagant if it is reasonable considering the host your parties, you offer them a variety of
main reason for the combined business and facts and circumstances. Expenses will not be gifts. The choice of gift depends on the success
entertainment unless you clearly show other- disallowed merely because they are more than of the party—the higher the volume of sales, the
wise. a fixed dollar amount or take place at a deluxe more valuable the gift.
restaurant, hotel, nightclub, or resort. In this situation, your gift to the host or host-
Associated. You can deduct entertainment ess is actually payment for hosting the party,
e xp e n s e s ( i n c l u d i n g e x p e n s e s f o r and the host or hostess must report the fair
entertainment-related meals) that do not meet Your meals. Generally, you can deduct your market value of the gift as income.
the directly-related test if both the following business meal expenses while traveling away You can deduct the cost of the gift. If you give
apply. from home for business (other than lavish or hosts and hostesses items from your inventory
extravagant amounts). However, if you entertain or items you purchase from the company at the
The expenses are associated with your a business customer locally and the conditions same time you purchase goods you sell, their
direct-selling business. discussed earlier are met, the cost of your own cost will be included in the cost of goods sold.
meal is deductible only to the extent the cost You cannot deduct their cost again as a busi-
The entertainment is directly before or exceeds the amount you would normally have ness expense. However, if you purchase the
after a substantial business discussion. spent for personal purposes. gifts separately from the goods you sell, deduct
An ordinary and necessary entertainment ex- their cost as an ordinary and necessary busi-
pense is generally associated with your ness expense.
direct-selling business if you can show you had
a clear business purpose for the expense. The Situation 2. You have several direct sellers
You usually can deduct only 50% of your un- working under you. Because your income de-
purpose may be to get new business or to en-
reimbursed business-related meal and enter- pends in part on their sales, you regularly meet
courage the continuation of an existing business
tainment expenses. The 50% limit applies, for with them, encourage them, and provide them
example, to expenses you incur while traveling with incentives and support. As an incentive to
away from home on business (whether eating make sales, you sometimes offer a prize, such
Substantial business discussion. Whether alone or with others), entertaining business cus- as an evening on the town or tickets to a sporting
a business discussion is substantial depends tomers at your place of business or a event, to the person who sells the most during
upon the facts and circumstances in each case. restaurant, or attending a business function, the month.
You must show that you actively engaged in a convention, or reception.
discussion, meeting, negotiation, or other busi- In this situation, the prizes you give are actu-
ness transaction to get income for your business Taxes and tips related to a business meal or ally payments for the winners' selling efforts.
or another specific business benefit. entertainment activity are included in the You can deduct the cost of the prizes as ordinary
The meeting does not have to be for a speci- amount subject to the 50% limit. Expenses such and necessary business expenses. The direct
fied length of time. However, you must show that as cover charges to a nightclub, rent for a room sellers who receive your incentive prizes must
the business discussion was substantial in rela- where you hold a dinner or cocktail party, or the report them as income at their fair market value.
tion to the entertainment. It is not necessary to amount paid for parking at a sports arena are For more information, see Other Income, earlier.
devote more time to business than to the enter- subject to the 50% limit. However, the cost of
transportation to and from an otherwise allowa- Situation 3. You sell cosmetics door-to-door.
tainment and you do not have to discuss busi-
ble business meal or entertainment activity is To spur sales, you often give away small sam-
ness during the meal or entertainment.
not subject to the 50% limit. ples.
Business and nonbusiness guests. You In this situation, you can deduct the cost of
If you have one expense that includes the the samples. If you purchase samples sepa-
must divide your entertainment expenses be-
costs of meals, entertainment, and other serv- rately from the products you sell, you can deduct
tween business and nonbusiness expenses.
ices (such as lodging or transportation), you their cost as an ordinary and necessary busi-
You can deduct only the business part. If you
must reasonably allocate the expense between ness expense.
cannot establish the part of the expense for each
person participating, you can allocate the ex- the cost of meals and entertainment and the Do not deduct the cost of the same item
pense to each participant on a pro rata basis. cost of other services. For example, you must twice. If the item was included in inventory, you
For example, if you entertain a group of 11 make an allocation if a hotel includes one or cannot later deduct it as a business expense.
(including yourself)—three business prospects more meals in its room charge. The item will already be part of the cost of goods
and seven social guests —deduct only sold.
Apply the 50% limit after figuring the amount
four-elevenths of the expense. that would otherwise qualify for a deduction. Gift limit. You cannot deduct more than $25
First determine the amount of meal and enter- for business gifts you give directly or indirectly to
Expenses for spouses. You generally cannot tainment expenses that would be deductible any one person during the year (see the excep-
deduct the cost of entertainment for your spouse under the rules discussed earlier. Then apply tions discussed later). Personal gifts are not
or for the spouse of a business customer. How- the 50% limit to figure the deductible amount. deductible.
ever, you can deduct these costs if you can
show that you had a clear business purpose, Figuring the limit. A gift to the spouse (or
Example. You spend $100 for a
rather than a personal or social purpose, for family member) of a customer is generally con-
business-related meal. If $40 of that amount is
providing the entertainment. sidered an indirect gift to the customer. How-
not allowable because it is lavish and extrava-
gant, the remaining $60 is subject to the 50% ever, if you have bona fide independent
Example. You entertain a business cus- limit. You cannot deduct more than $30 (50% of business connections with the spouse (or family
tomer. The cost is an ordinary and necessary $60). member) and the gift is not intended for the
business expense and is allowed under the en- customer's eventual use, this rule does not
tertainment rules. The customer's spouse joins Exceptions to the 50% limit are discussed in apply.
you because it is impractical to entertain the Publication 463. If you and your spouse both give gifts, you
customer without the spouse. You can deduct are treated as one taxpayer for the $25 limit. It
the cost of entertaining the customer's spouse does not matter whether you have separate
as an ordinary and necessary business ex-
businesses or independent connections with the from direct selling for your livelihood. business books and records available at
recipient. all times for inspection by the IRS. You
Whether your losses are due to circum-
must keep the records as long as they
Incidental cost. Costs that do not add sub- stances beyond your control (or are normal
may be needed in the administration of
stantial value to a gift, such as engraving on in the start-up phase of direct selling).
any Internal Revenue law. You should
jewelry, packaging, insuring, and mailing, are
Whether you change your methods of op- also keep copies of your tax returns to
generally not included in determining the cost of help prepare future returns or file claims
eration in an attempt to improve profitabil-
a gift for purposes of the $25 limit. For for refunds.
example, the cost of gift wrapping is considered
an incidental cost. However, the purchase of an Whether you, or your advisors, have the Support your entries. File cancelled
ornamental basket for packaging fruit is not knowledge needed to carry on direct sell- checks, paid bills, duplicate deposit slips,
considered an incidental cost if the basket's ing as a successful business. and other items that support entries in
value is substantial in relation to the value of the your books and on your tax return in an
fruit. Whether you were successful in making a orderly manner and store them in a safe
profit in similar activities in the past. place. For instance, organize them by year
Exceptions. The following items are not in- and type of expense.
Whether your direct selling makes a profit
cluded in the $25 limit for business gifts.
in some years, and how much profit it
Items that cost $4 or less, on which your makes. If you cannot provide a cancelled check to
business name is clearly and permanently prove payment of an expense item, you may be
imprinted, and which are part of a number Whether you can expect to make a future
able to prove it with certain financial account
of identical items you widely distribute. profit from the appreciation of the assets
statements prepared by financial institutions.
This includes such items as pens, desk used in your direct-selling business.
These include account statements prepared for
sets, and plastic bags and cases. the financial institutions by a third party. These
If the IRS inquires about your tax return, you account statements must be highly legible. The
Signs, display racks, or other promotional may be asked to provide proof that your following table lists acceptable account state-
material to be used on the business prem- direct-selling activity is carried on for profit. How- ments.
ises of the recipient. ever, your direct selling is presumed to be car-
ried on for profit if it produced a profit in at least IF payment is THEN the statement
3 of the last 5 tax years, including the current year,
Gift or entertainment. Any item that might be by... must show the...
unless the IRS establishes otherwise.
considered either a gift or entertainment will
generally be considered entertainment and not Check Check number.
If you are starting a business and do not
subject to the $25 limit. However, if you give a have 3 years showing a profit, you may want to Amount.
customer packaged food or beverages to be elect to have the presumption made after you Payee’s name.
used later, they are gifts. have the 5 years of experience allowed by the Date the check
If you provide business associates with tickets test. For more information on postponing any amount was posted to
to a theater performance or a sporting event and determination that your direct selling is not car- the account by the
you do not accompany them, you may treat the ried on for profit, see Using the presumption financial institution.
tickets as either a gift or entertainment, later under Not-for-Profit Activities in chapter 1
whichever is to your advantage. However, if you of Publication 535. Electronic funds • Amount transferred.
go to the event with them, you must treat the transfer • Payee's name.
cost of the tickets as an entertainment expense.
Date the transfer was
posted to the account
Recordkeeping by the financial
You must keep records to correctly figure your Credit card •Amount charged.
If you do not carry on your direct-selling activity taxes. Your records must be Payee's name.
to make a profit, there is a limit on the deduc- permanent, accurate, complete, and
tions you can take. If the not-for-profit limits clearly establish your income,
apply, you cannot use a loss from direct selling deductions, and credits. The law does
to offset any other income. not require you to keep records in any Proof of payment alone does not establish that
This limit applies, for example, if you go into particular way. But if you have more than one you are entitled to a tax deduction. You
direct selling primarily for the business deduc- business, you should keep a complete and should also keep other documents as
tions you can take. It also applies if you become
a direct seller only so you and your friends can
separate set of books and records for each
discussed in Proving Your De-
buy products at reduced rates.
Publication 583 provides information about
If the not-for-profit limit applies, you can take
the deductions allowed only if you itemize them
setting up a record keeping system, the types of Proving Your Deductions
books and records included in a typical system
on Schedule A (Form 1040). See Limit on De- for a small business, and sample records. The IRS may ask you to prove your deductions
ductions and Losses under Not-for-Profit Activi- for business expenses.
ties in chapter 1 of Publication 535 for Publication 463 provides information on the
information on how to figure your allowable de- records to keep if you use your car in your
ductions. Do not use a business tax return, such business.
as Schedule C (Form 1040). The following are suggestions for keeping
adequate business records. For travel expenses, you must be able to prove
Not for profit. In deciding whether your direct the following items.
selling is carried on for profit, take into account Keep a business bank account. Deposit
all facts about the activity. No one factor alone is all business receipts in a separate bank Each separate amount you spent for travel
decisive. The following are factors to consider. account. Make all payments by check, if away from home, such as the cost of your
possible. Then business income and busi- transportation or lodging. A receipt, bill, or
Whether you carry on your direct selling in
ness expenses will be well documented. other documentary evidence generally is
a businesslike manner and maintain com-
plete and accurate books and records. required for all lodging expenses. You can
Make a record. Record all your business total the daily cost of your breakfast,
Whether the time and effort you put into transactions in separate account books lunch, dinner, and other incidental travel
direct selling indicates you intend to make and keep a monthly summary of your busi-
it profitable. ness income and expenses.
Whether you are depending on income Keep your records. You must keep your
costs if they are listed in reasonable cate- have to record the name of each person. It is rately for each serving of refreshments, treat the
gories, such as meals, gas and oil, and enough to designate the group. For example, if total expense for the refreshments as a single
taxi fares. you entertain all the members of a garden club, expense.
an entry such as "members of the Hillcrest Gar-
• The dates you left and returned home for den Club" is enough. Some items can be totaled in categories.
each trip, and the number of days spent You can make one daily entry for such catego-
on business while traveling away from ries as taxi fares, telephone calls away from
home. home, gas and oil, and other incidental travel
Gift Expenses costs. Meals should be a separate category.
• The destination or area of your travel, de-
For gift expenses, you must be able to prove the
Include tips for meal-related services with the
scribed by the name of the city or town. costs of the meals.
• The business reasons for your travel or
the business benefit you gained or ex- The cost of the gift. Documentary evidence. A receipt or bill is
pected to gain from it. The date you gave the gift. often the best evidence to prove the amount of
an expense. Documentary evidence is needed
A description of the gift. for all your lodging expenses unless, under an
Your reason for giving the gift or any busi- accountable plan, your employer pays you a per
For entertainment expenses, including ex- ness benefit you gained (or expected to diem reimbursement of no more than the gov-
penses for entertainment-related meals, you gain) from giving it. ernment rate in effect at that time and in that
must be able to prove the following. area. It is also generally needed for any other
The occupation or other information about expense of $75 or more.
1) The amount of each separate entertain- the person receiving the gift, including
name, title, or other information establish- Documentary evidence will ordinarily be con-
ment expense. You can total incidental ex-
ing a business relationship to you. sidered adequate if it shows the amount, date,
penses, such as taxi fares and telephone
place, and essential character of the expense.
calls, on a daily basis.
The name of each recipient of a business gift For example, a hotel receipt is enough to sup-
2) The date the entertainment took place. does not always have to be recorded. A general port expenses for business travel if it has the
listing will be enough if it is evident that you are name and location of the hotel, the dates you
3) The name and address or location of the stayed there, and separate amounts for charges
place of entertainment. Include the type of not trying to avoid the $25 annual limit on the
deduction for gifts to any one person. For exam- such as lodging, meals, and telephone calls. A
entertainment, such as dinner or the thea- restaurant receipt is enough to prove an ex-
ter, if the information is not clear from the ple, if you buy a large number of tickets to local
high school basketball games and give one or pense for a business meal if it has the name and
name or designation of the place. location of the restaurant, the number of people
two tickets to each of many customers, it is
4) The occupation or other information about usually enough to record a general description served, and the date and amount of the ex-
the persons for whom you are claiming an of the recipients. pense. If a charge is made for items other than
entertainment expense. Include their meals and beverages, the receipt must show
names, titles, or other information suffi- that this is the case.
cient to establish their business relation- Records
ship to you. Canceled check. A canceled check, to-
You should keep proof of travel, meal, entertain- gether with a bill from the payee, usually estab-
5) The business reason for the entertainment ment, and gift expenses in an account book, lishes the cost. However, a canceled check by
or the business benefit you gained or ex- diary, statement of expense, or similar record. itself does not prove a business expense without
pected to gain from it and the nature of You should also keep adequate documentary other evidence to show a business purpose.
any business discussion or activity that evidence to support each element of an ex-
took place. pense. Incomplete records. If you do not have ade-
6) The presence of you or your employee if You do not have to record information shown quate records to prove an element of an ex-
the entertainment was a business meal on a receipt if your records and receipts comple- pense, you must prove the element by providing
given for a client. ment each other in an orderly manner. both of the following.
Keep your records up to date. Record your Your own statement, whether written or
Business discussion. If the entertainment expenses in your account book at or near the oral, containing specific information about
took place before or after a substantial and bona time of the expense. Entries made later, when the element.
fide business discussion, in addition to the infor- you may not remember them accurately, do not
mation in (1), (2), (3), (4), and (6) above, you have as much value as entries made at or near Other supporting evidence sufficient to es-
must be able to prove the following. the time of the expense. tablish the element.
The date, place, and duration of the busi-
ness discussion. Separating expenses. Usually, each sepa- Additional proof. You may be required to pro-
rate payment you make must be recorded as a vide additional information to the IRS to clarify or
The nature of the business discussion.
separate expense. For example, if you entertain establish the accuracy or reliability of the infor-
The business reason for the entertainment someone at dinner and then go to the theater, mation in your records, statements, testimony,
or the business benefit you gained or ex- the dinner expense and the cost of the theater or documentary evidence.
pected to gain from entertaining. tickets are separate expenses. You must record
them separately in your records.
The identification of the persons who par-
ticipated in both the business discussion Expenses of a similar nature occurring dur-
and the entertainment activity. ing the course of a single event will be consid-
Business relationship. If you entertain a ered a single expense. For example, if during
readily identifiable group of people, you do not entertainment at a cocktail lounge you pay sepa-
at the beginning or end of the year. Therefore, Kathleen paid $35 to her bank for check printing
S a m p l e Filled- she has no entry on line 35 or line 41 of Part III. and account charges for her separate business
She purchased $10,000 worth of household bank account. She paid membership dues of
In Forms products during 2003 for $9,490. (She received $30 to a local business association and $38 for a
trade discounts of $510.) She enters her net 1-year subscription to a retail sales magazine.
This section will familiarize you with Schedule C cost of $9,490 ($10,000 - $510) on line 36. She She enters these expenses, along with the $199
(Form 1040), used to report business income or
also enters this amount on lines 40 and 42 of Part she paid for catalogs, in Part V. She totals the
loss, and Schedule SE (Form 1040), used to III and on line 4 of Part I. expenses, $302, on line 48 and enters the total
figure self-employment tax. The line numbers in on line 27.
bold type follow the line numbers on the form Line 5. Gross profit, $5,110, is the difference
being discussed. between Kathleen's net receipts of $14,600 on Line 28. Kathleen adds all her business de-
line 3 and the cost of goods sold of $9,490 on ductions listed on lines 8 through 27 and enters
Schedule C line 4. the total of $3,147 on this line.
Line 6. Kathleen reports the $200 received as
If you are the sole owner of an unincorporated Line 29. Kathleen subtracts her total deduc-
a bonus on line 6. She does not include on
trade or business, report business income and tions on line 28 from her Schedule C gross
Schedule C any income not related to her
expenses on Schedule C (Form 1040) or Sched- income on line 7. Because her gross business
direct-selling business, such as income from
ule C-EZ (Form 1040). If you and your spouse income is greater than her total deductions, she
investments or her salary. She reports such in-
each own one separate business, file a separate has a tentative profit of $2,163.
come on other lines of Form 1040.
Schedule C or C-EZ for each business. If a
person, as a sole owner, has more than one Line 7. Kathleen's gross income from direct Line 30. Kathleen did not use any part of her
business, that person must file a Schedule C for selling is $5,310, the sum of her gross profit of home for business, so she does not make an
each separate business. $5,110 on line 5 and the bonus of $200 on line 6. entry here.
Samples of Schedule C and Schedule SE for
Kathleen Woods are illustrated on the following Line 8. Kathleen gave her customers samples Line 31. Kathleen has a net profit of $2,163
pages. (Amounts have been rounded to the that cost $48. This amount was not included in (line 29 - line 30). She enters her net profit
nearest dollar.) the cost of goods sold on line 4. here, on line 12 of Form 1040, and on line 2,
Kathleen Woods is a secretary for a small Line 9. Kathleen's business mileage was Section A of Schedule SE (Form 1040).
firm. She reports her salary of $25,000 on line 7 2,100 miles, and her total 2003 mileage was
of Form 1040. 6,000 miles. She used her car 35% for business. Line 32. Kathleen does not have a loss, so she
Kathleen is also a direct seller of household She uses the standard mileage rate to figure the skips this line. If she had a loss and was not at
cleaning products manufactured and distributed deduction of $756 (2,100 x .36). risk for all her investment in the business, she
by Spotless, Inc. She reports the income and Kathleen must also complete Part IV of would have to attach Form 6198. See the
expenses of her selling business on Schedule C Schedule C. Schedule C instructions for the meaning of at
because she is self-employed. risk.
Kathleen uses the cash method of account- Line 16b. $280 is 35% of the total interest of
$800 paid during the year on Kathleen's car
ing and files her return on a calendar-year basis.
loan. Short Schedule SE
She has no employees and does not keep an
inventory of the products she sells. Any products Line 18. Kathleen spent $260 for various office Kathleen uses Short Schedule SE (Form 1040),
ordered for personal use are not shown in supplies and postage for her direct-selling because her net earnings from self-employment
purchases, sales, cost of goods sold, or inven- business. are more than $400 and the total of her net
tory. earnings plus her wages subject to social
Kathleen's customers select the products Line 22. Kathleen paid $392 in 2003 for order security and Medicare taxes (FICA) are not more
they want from a catalog listing retail prices for blanks, bags, and miscellaneous selling sup- than $87,000.
each item. She places an order with Spotless plies.
every 10 days, at which time she also pays for Line 23. $168 is 35% of the personal property Line 2. Kathleen enters $2,163, the amount
her prior order. She receives the items ordered tax of $480 Kathleen paid on her car in 2003. from line 31 of Schedule C (Form 1040).
with an invoice payable within 10 days or, if
sooner, with the next order. When she delivers Line 24. Kathleen attended two direct-selling Line 3. Kathleen enters the amount from line
the merchandise, she collects the retail (catalog) seminars during 2003. Her travel expenses, in- 2, $2,163.
price for each item. She can get full credit for any cluding lodging, were $515, which she entered
items returned to Spotless within 10 days. on line 24a. Her meals and entertainment, sub- Line 4. Kathleen multiplies her net profit by
ject to the 50% limit, were $200 and were en- .9235 and enters the result, $1,998.
Kathleen's cost for each item is 65% of the
retail price. During 2003, she had total retail tered on line 24b. The nondeductible amount of
$100 is shown on line 24c and the net deduction Line 5. Kathleen multiplies $1,998 (line 4) by
sales of $14,600. She paid Spotless $9,490 for
of $100 is shown on line 24d. .153 and enters $306 as her self-employment
the merchandise she received in 2003. She also
tax. She also enters this amount on line 55 of
received an award of $200 in January for having Line 25. Kathleen uses her second telephone Form 1040.
over $20,000 in total sales in 2002. 100% for business purposes. She paid $264 for
Lines 1-3. Kathleen reports $14,600 as her local service on her second phone and $62 for Line 6. Kathleen enters one-half of the amount
gross sales on line 1. On line 2, she would enter long-distance calls. She enters the total of $326 from line 5. She also enters this amount on line
any refunds she had to give on merchandise, as on this line. She has no deduction for other 28 of Form 1040 as an adjustment to income.
well as adjustments made to customers' utilities because she does not use any part of
purchases. Since she has no entry on line 2, she her home exclusively for business.
enters $14,600 on line 3. Line 27. This line is for other direct-selling
Line 4. Kathleen uses Part III to figure her cost expenses not listed separately on the schedule.
of goods sold for the year. She has no inventory These expenses are listed in Part V on page 2.