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IRS Publication


									             Publication 911                            Contents
             Cat. No. 6003113

             Direct Sellers
Department                                                                                                                1
                                                        Important Changes for 2003 .....................
of the
Treasury                                                                                                                  2
                                                        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

                                                        Recordkeeping ..........................................
                                                        Sample Filled-In Forms ..............................
                                                        How To Get Tax Help ................................
                                                        Index........................................................... 20

                                                        Important Changes
                                                        for 2003
                                                        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
                                                        Publication 946.

                                                        Depreciation limits on business cars. The
                 Get forms and other information        total section 179 deduction and depreciation (in-
                 Internet • or FTP •        cluding the 30% or 50% special depreciation
                                                        allowance) you can take on a car you use in your
        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
                                                         Useful Items
                                                         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
                                                                                                              Instructor
    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
                                                                                                            Business Taxes).
                                                           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 *                                                                  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

Page 2
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
                                                     self-employment income.
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- 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
   Income tax
                                                         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
Page 3
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

Page 4
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

                                                                                                                                                                           Page 5
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.
                                                        posed of.
                                                            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
                                                        you received.
 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
                                                                                                               Capital Expenses
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
Page 6
  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

                                                                                                                                                      Page 7
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-
                                                      tion 535.
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
                                                      fringe benefits.
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.
   in 2003.
                                                      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

                                                                                                            personal expense.
                                                      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.
Page 8
                                                      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

                                                                                                                                                     Page 9
  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
                                                          b) Regular,
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
                                                             fined later),
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.

Page 10
                                                      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.

                                                                                                                                                       Page 11
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-
Page 12
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
Not-for-Profit Limit
                                                        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
                                                                                                                                          Transaction date.
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
                                                        business.                                                A
                                                                                                                           discussed in Proving Your De-
                                                                                                                           ductions, next.
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.
                                                                                                                 Travel Expenses
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

                                                                                                                                                           Page 13
        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
Entertainment Expenses
                                                         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-

Page 14
                                                       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.

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