us internal revenue service: p911--1997

8/14/2019 US Internal Revenue Service: p911--1997

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ContentsImportant Change for 1997 ............... 1

Introduction ........................................ 1

Who is a Direct Seller? ...................... 2

Basic Tax Information ....................... 2

Business Income ................................ 4

Capital Expenses ............................... 5

Cost Recovery .................................... 6

Business Expenses ........................... 6

Business Use of Your Home ............ 8

Travel and Transportation ................. 9

Meals and Entertainment .................. 9

Business Gifts .................................... 10

Not-for-Profit Limit ............................. 11

Recordkeeping ................................... 11

Sample Filled-In Forms ..................... 12

How To Get More Information .......... 17

Index .................................................... 18

Important Changefor 1997

Standard mileage rate. The standard mile-age rate for 1997 is 31.5 cents a mile for allbusiness miles on a passenger automobile(including vans, pickups, or panel trucks).

IntroductionThis publication explains general tax infor-mation of interest to direct sellers. For exam-ple, it covers how to treat income, expenses,and other items related to having a direct-sales business. It also illustrates two filled-intax forms that most direct sellers must filealong with Form 1040. They are Schedule C(Form 1040), Profit or Loss From Business,and Schedule SE (Form 1040), Self-Employment Tax.

Who is a direct seller? Here are somecharacteristics that identify direct sellers. A

more complete discussion of direct sellers iscontained under the heading Who is a DirectSeller, later.

How you sell. You sell consumer pro-ducts to others on a person-to-personbasis, usually working out of your home.Or, you deliver or distribute newspapersor shopping news.

Where you sell. You may sell door-to-door, through the sales party plan, or byappointment in someone else's home.

When you sell. You may sell on a regu-lar basis or only occasionally. You maysell full-time or part-time, such as asideline to a regular job.

Departmentof theTreasury

InternalRevenueService

Publication 911Cat. No. 60031B

Direct Sellers

For use in preparing

1997 Returns

Get f orms and other informat ion faster and easier by:COMPUTER

World Wide Web www.irs.ustreas.gov FTP ftp.irs.ustreas.gov IRIS at FedWorld (703) 321-8020

FAX From your FAX machine, dial (703) 368-9694See How To Get More Information in this publication.


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Who is not a direct seller? You are not adirect seller if you are employed in a store,sell through a retail sales outlet, or sell youremployer's product away from the employer'splace of business.

Useful ItemsYou may want to see:

Publication

15 Circular E, Employer's Tax Guide

15A Employer's Supplemental TaxGuide

334 Tax Guide for Small Business

463 Travel, Entertainment, Gift, andCar Expenses

505 Tax Withholding and EstimatedTax

525 Taxable and Nontaxable Income

533 Self-Employment Tax

535 Business Expenses

538 Accounting Periods and Methods

583 Starting a Business and KeepingRecords

587 Business Use of Your Home

946 How To Depreciate Property

Form (and Instructions)

SS4 Application for Employer Identifi-cation Number

Sch A (Form 1040) Itemized De-ductions

Sch C (Form 1040) Profit or Loss FromBusiness

Sch CEZ (Form 1040) Net Profit FromBusiness

Sch SE (Form 1040) Self-Employment

Tax 1040 U.S. Individual Income Tax Return

1040ES Estimated Tax for Individuals

1099MISC Miscellaneous Income

2210 Underpayment of Estimated Taxby Individuals, Estates, andTrusts

4562 Depreciation and Amortization

8829 Expenses for Business Use ofYour Home

See How To Get More Information nearthe end of this publication for informationabout getting publications and forms.

Who is a Direct Seller?You are a direct seller if you meet all of thefollowing conditions:

1) You are engaged in the trade or busi-ness of:

a) Selling or soliciting the sale of con-sumer products, either

i) In a home or other place thatis not a permanent retail es-tablishment, or

ii) To any buyer on a buy-sellbasis or a deposit-commission

basis for resale by the buyeror any other person in a homeor other place that is not apermanent retail establish-ment, or

b) Delivery or distribution of newspa-pers or shopping news (includingany services directly related to thetrade or business).

2) Substantially all your pay (whether paidin cash or not) for services described in(1) is directly related to sales or otheroutput (including the performance ofservices) rather than to the number ofhours worked.

3) Your services are performed under awritten contract between you and theperson for whom you perform the ser-vices, and the contract provides that youwill not be treated as an employee forfederal tax purposes.

As a direct seller, you usually sign up witha particular company to sell its product line.The company may refer to you by using oneof the following many titles:

Consultant

Coordinator Dealer

Demonstrator

Designer

Director

Distributor and direct distributor

Instructor

Manager or supervisor

Representative or sales representative

Self-employed. You are self-employed as adirect seller if you meet the three conditionslisted earlier in this section. This generallymeans you have to pay self-employment tax

(discussed later under Business Taxes).

Employee. You are a direct seller only if youare in business for yourself. Selling consumerproducts as a company employee does notmake you a direct seller.

The fact that you work under another di-rect seller does not make you that person'semployee.

Recruiting. You are engaged in the tradeor business of selling or soliciting if you at-tempt to increase the sales of direct sellerswho work under you and your pay dependson how much they sell. Recruiting, motivating,and training are examples of attempts to in-crease sales.

Host or hostess. You are not a direct sellerif you simply host a party at which sales aremade. Nevertheless, some information in thispublication may still apply to you:

The gift you receive for giving the partyis a payment for helping the direct seller makesales. You must report it as income at its fairmarket value. See Other Income, later.

Your out-of-pocket party expenses aresubject to the 50% limit for meal and enter-tainment expenses, discussed later. Theseexpenses are deductible as miscellaneousitemized deductions subject to the 2% limiton Schedule A (Form 1040), but only up tothe amount of income you receive for givingthe party. See Not-for-Profit Limit, later.

Basic Tax InformationThe following discussion gives basic tax in-formation that may help if you have neverbeen in business for yourself. For more in-formation about starting a business, get Pub-lication 583.

Employer IdentificationNumber (EIN)EINs are used to identify the tax accounts ofemployers, sole proprietors, corporations,partnerships, estates, trusts, and other enti-ties.

If you do not already have an EIN, youneed to get one if you:

1) Have employees,

2) Have a Keogh plan,

3) Operate your business as a corporationor partnership, or

4) File any of these returns:

a) Employment.

b) Excise.

c) Alcohol.

d) Tobacco.

e) Firearms.

Use Form SS4 to apply for an EIN.

Business TaxesFour kinds of business taxes may apply todirect sellers:

Income tax.

Self-employment tax.

Employment taxes.

Excise taxes.

Income tax. Each business must file an an-nual income tax return. For example, if youoperate your direct-selling business as a soleproprietor, you must file Schedule C (Form1040) or Schedule CEZ (Form 1040). Youare a sole proprietor if you are self-employed(work for yourself) and are the only owner ofyour unincorporated business.

Self-employment tax. Self-employment taxis the social security and Medicare tax forthose who work for themselves. It is like thesocial security and Medicare taxes withheldfrom the pay of wage earners. If you are adirect seller, you generally must pay this tax

on your income from direct selling. You mustpay it whether you are the sole proprietor ofyour business or a partner in a partnership.Use Schedule SE (Form 1040) to figure andreport self-employment tax. For more infor-mation about self-employment tax, see Pub-lication 533.

Employment taxes. If you have employeesin your business, you generally withhold andpay employment taxes. These taxes include:

The federal income tax you withhold fromemployees' wages,

Social security and Medicare taxesboththe amount you withhold from employees'

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wages and the amount you pay as em-ployer, and

Federal unemployment (FUTA) tax (noneof which is withheld from the employees'wages).

For more information, see Publication 15.

Other taxes. For information about deduct-ing personal property and other taxes, seeTaxesunder Business Expenses, later.

Estimated TaxThe federal income tax is a pay-as-you-gotax. You must pay it as you earn or receiveincome during the year. There are two waysto pay as you go:

Withholding. If you are an employee,your employer probably withholds incometax from your pay. You can ask youremployer to increase the amount withheldto cover the income both from your joband from direct selling.

Estimated tax. If you do not pay taxthrough withholding, or do not payenough tax that way, you may have to

pay estimated tax.Estimated tax is used to pay both income andself-employment taxes (and certain othertaxes and amounts reported on Form 1040).Estimated tax is discussed in Publication 505.

$1,000 minimum. You do not have to payestimated tax if:

You had zero tax liability last year, or

Your total expected taxes for 1998, minusany expected tax credits and withholdingwill be less than $1,000. (For 1997, thisamount was $500.)

Form 1040ES. Use Form 1040ES to figureyour estimated tax and make estimated taxpayments.

Form 2210. If you did not pay enough esti-mated tax or have enough income tax with-held, you may be subject to a penalty. Youcan use Form 2210 to figure the penalty. Or,in most cases, you can have the InternalRevenue Service figure the penalty for you.See the Form 2210 instructions to determineif you must complete the form.

Information ReturnsIf you have other direct sellers working underyou and you sell $5,000 or more in goodsduring the year to any one of those sellers,you must report the sales on an informationreturn. The information return, Form1099MISC, must show the name, address,and identification number of the seller placingthe orders. Check Box 9 of Form 1099MISCto show these sales. Do not enter a dollaramount. You must give Copy B or a qualifiedstatement (such as a letter showing this in-formation along with commissions, prizes,awards, etc.) to the seller by February 2,1998.

You must file Copy A of Form 1099MISCwith the Internal Revenue Service by March2, 1998. Use Form 1096 to summarize andtransmit Form 1099MISC. See the in-structions to Form 1096 for the address

where you must file Form 1096 and the ac-companying Forms 1099MISC.

PenaltiesThe law imposes penalties to ensure that alltaxpayers pay their taxes. Some of thesepenalties are discussed below. If you under-pay your tax due to fraud, you may be subjectto a civil fraud penalty. In certain cases, youmay be subject to criminal prosecution.

Failure-to-file penalty. If you do not file yourreturn by the due date (including extensions),you may have to pay a failure-to-file penalty.The penalty is 5% of the tax not paid by thedue date for each month or part of a monththat the return is late. This penalty cannot bemore than 25% of your tax, but it is reducedby the failure-to-pay penalty (discussed next)for any month both penalties apply. However,if your return is more than 60 days late, thepenalty will not be less than $100 or 100%of the tax balance, whichever is less. You willnot have to pay the penalty if you can showreasonable cause for not filing on time.

Failure-to-pay penalty. You may have topay a penalty of 1/2 of 1% of your unpaid taxes

for each month or part of a month after thedue date that the tax is not paid. This penaltycannot be more than 25% of your unpaid tax.You will not have to pay the penalty if you canshow good reason for not paying the tax ontime.

Penalty for frivolous return. You may haveto pay a penalty of $500 if you file a returnthat does not include enough information tofigure the correct tax or that shows an incor-rect tax amount due to:

A frivolous position on your part, or

A desire to delay or interfere with theadministration of federal income tax laws.

This penalty is in addition to any other penaltyprovided by law.

Accuracy-related penalty. An accuracy-related penalty of 20% applies to any under-payment due to:

Negligence or disregard of rules or regu-lations, or

Substantial understatement of incometax.

This penalty also applies to conditions notdiscussed here.

Even though an underpayment was dueto both negligence and substantial underpay-ment, the total accuracy-related penalty can-

not exceed 20% of the underpayment. Thepenalty is not imposed if there is reasonablecause accompanied by good faith.

Negligence. Negligence includes the lackof any reasonable attempt to comply withprovisions of the Internal Revenue Code.

Disregard. Disregard includes the care-less, reckless, or intentional disregard of rulesor regulations.

Substantial understatement of incometax. For an individual, income tax is sub-stantially understated if the understatementof tax exceeds the greater of:

10% of the correct tax, or

$5,000.

Information reporting penalties. Any per-son who does not file an information returnor a complete and correct information returnwith the IRS by the due date is subject to apenalty for each failure. A penalty applies toinformation returns as follows:

Correct information returns filed within 30days after the due date, $15 each.

Correct information returns filed after the30-day period but by August 1, $30 each.

Information returns not filed by August 1,$50 each.

Maximum limits apply to all these penalties.

Failure to furnish correct payee state-ments. Any person who does not provide ataxpayer with a complete and correct copy ofan information return (payee statement) bythe due date is subject to a penalty of $50 foreach statement. If the failure is due to inten-tional disregard of the requirement, the pen-alty is the greater of:

$100 per statement, or

10% or 5% (depending on the type ofstatement) of the amount to be shown on

the statement.

Identification numbers and other informa-tion. Any person who does not comply withother specified reporting requirements, in-cluding the use of correct identification num-bers (employer identification numbers andsocial security numbers), is subject to a pen-alty of $50 for each failure. This includes fail-ures to:

Use correct identification numbers foryourself, your spouse, and your depen-dents on returns and statements.

Use correct identification numbers forother taxpayers where required.

Supply correct identification numberswhen required by another taxpayer, suchas a bank.

Accounting Periodsand MethodsAll income tax returns are prepared using anaccounting period (tax year) and an account-ing method.

Accounting PeriodsYou must figure your taxable income and filea federal income tax return on the basis ofan annual accounting period called a taxyear. The accounting periods you may use

are:

A calendar year, which begins on Janu-ary 1 and ends on December 31, or

A fiscal year(including a period of 52or 53 weeks). A regular fiscal year is 12months in a row ending on the last dayof any month except December.

You establish a tax year when you file yourfirst income tax return. If you filed your firstreturn as a wage earner using the calendaryear, you must use the calendar year as yourbusiness tax year. You cannot change yourtax year without IRS approval. For more in-formation, get Publication 538.

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Accounting Methods

An accounting method is a set of rules usedto report income and deduct expenses. Thetwo most common accounting methods arethe cash method and an accrual method.

The text and examples in this publicationgenerally assume that you use the calendaryear as your tax year and either the cashmethod or a hybrid method (a combinationof cash and accrual) as your accountingmethod. If inventories are needed to accountfor your income, you must use an accrual

method, discussed later, for your sales andpurchases. If you use a fiscal year or an ac-crual method, you must make adjustments.For more information on accounting methods,get Publication 538.

Cash method. Under the cash method, youreport income in the year it is received, cred-ited to your account, or made available to youon demand. You need not have physicalpossession of it. You deduct expenses in theyear you pay them, even if you incurred themin an earlier year.

Checks. If you receive a check before theend of the tax year, you must include it in yourincome for the year you receive it even

though you do not cash or deposit it until thenext year.

Accrual method. Generally, you report anitem of income in the tax year when all eventshave happened that fix your right to receivethe income and you can determine theamount with reasonable accuracy. Generally,you deduct or capitalize business expenseswhen you become liable for them, whetheror not you pay them in the same year.

Prepaid expenses. Expenses paid in ad-vance can be deducted only in the year towhich they apply under either the cash or anaccrual method. For example, suppose you

have a subscription to a direct-selling journalthat runs out at the end of 1997. It will costyou $30 to renew the subscription for oneyear or $54 for 2 years. You decide to renewfor 2 years and mail your check at the endof November 1997. You cannot deduct the$54 on your 1997 return, even if you use thecash method of accounting. However, youcan deduct half of the $54 in 1998 and theother half in 1999.

Business IncomeYou must report on your tax return all income

you receive as a direct seller. This incomeincludes any of the following:

Income from salespayments you re-ceive from customers for products theybuy from you.

Commissions, bonuses, or percentagesyou receive for sales and the sales ofothers who work under you.

Prizes, awards, and gifts you receive forany reason from your selling business.

Report this income regardless of whether it isreported to you on an information return.

Income From SalesYou have income from sales if your custom-ers buy directly from you and you buy theproducts you sell from a company (or anotherdirect seller).

If your customers buy their products froma company, you, as the sales agent, do nothave any income from sales. You will gener-ally receive a commission for making the sale,but will have no direct income from the saleitself. In that case, the rules in this section donot apply to you. Report your commissions

as other business income. For more informa-tion, see Other Income, later.

Example 1. Your customers pay you theretail price for goods they order. You send theorders and payments to a company. Thecompany sends the merchandise to fill theorders. The company also sends your shareof the retail price.

You are acting as a sales agent for thecompany. You did not purchase the productsyou sold to your customers. Your paymentfrom the company is a commission, not in-come from sales. Include the commissions inthe gross receipts of your business. Do notinclude the full amount your customers payfor the goods they order.

Example 2. Your customers pay you adeposit when you take their orders. You sendthe orders to the company, but keep the de-posits for yourself. The company fills the or-ders by shipping the merchandise to custom-ers. The customers pay the company the restof the retail price (usually cash on delivery).

You are acting as a sales agent for thecompany. The deposit is your commission.You have no income from sales.

Example 3. Your customers pay you forthe goods you sell them, either when you taketheir orders or when you make deliveries. Af-ter your customers place orders, you orderthe goods from a company (or from a directseller you work under). You either send themoney for the goods with your orders or youare billed later. In either case, you are ableto charge your customers more than you payfor the goods.

You are buying products wholesale andselling them retail. The full amount receivedfrom your customers is income from sales.You have income from sales to report on yourreturn.

Example 4. You keep a supply of goodsyour customers regularly buy from you. Thisallows you to fill their orders without delay.You order and pay for the goods before yourcustomers specifically ask for them.

You have purchased goods to resell tocustomers. The full amount received from

your customers is income from sales. Youhave income from sales to report on your re-turn.

Gross Profit on SalesGross receipts minus cost of goods soldequals gross profit for the year.

If you have income from sales, figure yourgross profit and the income to report by fol-lowing these steps:

1) Figure the total your customers paid youduring the year for goods you sold them.Include this in the gross business re-ceipts you report on your return.

2) Next, subtract the amount (if any) yourcustomers paid that you had to return inthe form of refunds, rebates, or other al-lowances. Show this on your tax return.

3) Finally, subtract the cost of the goodsyou sold. To figure the cost of goodssold, you must know the value of the in-ventory of goods you had at the begin-ning and end of the year, and your pur-chases during the year. See Cost ofGoods Sold, next, and Inventory, later.

Cost of Goods SoldTo figure the cost of goods sold during theyear, follow these steps:

1) Start with the value of your inventory atthe beginning of your tax year. Thisshould be the same as the value of yourinventory at the end of the previous year.Valuing inventory is discussed later un-der Inventory.

2) Add to your beginning inventory the costof merchandise you bought during theyear to sell to customers. This does notinclude the cost of merchandise youbought for your own use, but it can in-clude the cost of merchandise you useto demonstrate your product line. SeeDemonstratorsunder Capital Expenses,later.

3) Subtract from this total your inventory atthe end of the year. The difference isyour cost of goods sold during the year.

Example 1. Janet Smith sells cookwareon the sales-party plan. On December 31,1996, she did not have any cookware on handthat she would sell, or had sold, to customers.However, she did have items of cookwarethat she used in demonstrations. The cost ofthese demonstrators was $80. She does nothave a beginning inventory for 1997.

During the year, Janet spent $5,270 ongoods in her product line. Of this amount,$130 was for cookware sets she gave forpersonal gifts and $40 was for a set for per-sonal use. She purchased $5,100 [$5,270 ($130 + $40)] worth of goods to sell to cus-tomers.

On December 31, 1997, Janet had onlyone demonstrator set on hand. She also hadseveral sets of cookware in boxes awaitingdelivery to customers. The cost of these setswas $220. Her ending inventory for the yearis $220, and her cost of goods sold for 1997is $4,880 ($0 beginning inventory + $5,100purchases $220 ending inventory).

Example 2. Lisa Marie is a direct sellerof cosmetics. She has an establishedclientele and knows what items are steadysellers. When the company has a special sale

on these items, she buys an extra quantity forfuture sales. She had merchandise costing$200 on hand at the end of 1996 (whichwould be her beginning inventory for 1997)and merchandise costing $175 at the end of1997. She figures her cost of goods sold for1997 as follows:

Beginning inventory ..................................... $200Add: Merchandise purchased

during the year ................ $3,250Subtract: Purchase returns and al-

lowances .......................... 50Subtract: Goods withdrawn for per-

sonal use ......................... 200 3,000Goods available for sale .............................. $3,200Subtract: Ending inventory .......................... 175Cost of goods sold $3,025

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Lisa figures her gross profit by subtractingthe cost of goods sold from her gross receiptsfor the year as follows:

Purchases. When figuring cost of goodssold, include the full costof all merchandiseyou buy to sell to customers. This cost in-cludes any postage or freight charges to getthe merchandise.

Figure your purchases at the actual priceyou pay. If you receive a trade discount, useit to figure your purchases, not the statedselling price. A trade discount is the differencebetween the stated selling price and the ac-tual price you have to pay.

Purchase returns and allowances. Youmust subtract purchase returns and allow-ances from your total purchases for the yearwhen figuring cost of goods sold. This in-cludes any rebates or refunds you receivedoff the selling price. It also includes any credityou received for merchandise you returned.

Personal withdrawals. Subtract from yourpurchases for the year the cost of goods inyour product line that you bought for personaluse and the cost of goods you withdrew frominventory. Merchandise is considered with-drawn from inventory when it is no longer forsale to customers. For example, if you sell aparticular kind of soap and give some as agift or use some yourself, you must withdrawthe soap from inventory because it is nolonger available for sale.

InventoryMany direct sellers have little or no inventory.Others keep a considerable inventory ofgoods on hand. In either case, if you haveincome from sales, you should know how tofigure your inventory at the end of each tax

year. Figuring inventory involves:

1) Taking inventory,

2) Identifying the cost, and

3) Valuing the inventory.

You need to know your inventory at the be-ginning and end of each tax year to figureyour cost of goods sold. Beginning inventorywill usually be the same as ending inventoryof the year before. Any differences must beexplained in a schedule attached to your re-turn.

Taking inventory. The first step is to identifyand count all merchandise in your inventory.Include all goods you have title to at the endof the year. This will generally be any goodsyou have on hand and have not yet sold tocustomers.

Include merchandise you have purchased,even if you have not yet physically receivedit. You may also have title to goods that wereshipped to you but not yet received. If the riskof loss during shipment is yours, you probablyhave title to the goods during shipment. If youbuy merchandise that is sent C.O.D., titlepasses when payment and delivery occur.

Goods not yet paid for. You may havetitle to goods not yet paid for. If you are billedfor merchandise that is sent to you, you mustusually pay the bill within a certain time,whether or not you sell the goods. In this

case, you have title to the goods and mustinclude them in inventory if they are unsoldor undelivered at the end of the year.

Consignments. Merchandise you re-ceive on consignment is not purchased byyou and is never included in your inventory.You have merchandise on consignment if youdo not have to pay for what you have in stockuntil the time you sell it and collect the retailprice from the customer.

Identifying the cost. The second step in

figuring your inventory is to identify the in-ventory items with their costs. The specificidentification method is used when you canidentify and match the actual cost of the itemsin inventory. Most direct sellers will be ableto use this method.

If you cannot identify specific items withtheir invoices, you must make an assumptionabout which items were sold during the yearand which remain. Make this assumption us-ing either the first-in first-out (FIFO) methodor the last-in first-out (LIFO) method.

The FIFO method assumes that the firstitems you purchased or produced are the firstitems you sold, consumed, or otherwise dis-posed of.

The LIFO method assumes that the lastitems that you purchased are sold or removedfrom inventory first.

Valuing the inventory. The third step infiguring your inventory is to value the itemsyou have in inventory.

The two common methods to valuenon-LIFO inventory are the cost methodandthe lower of cost or market method.

Cost method. If you use the cost methodto value your inventory items, the value ofeach item is usually its invoice price. Addtransportation, shipping, or other necessarycharges in getting the items. Subtract dis-counts you received from the invoice price.

If any of the goods you have on hand atthe end of the year were also in your inven-tory at the beginning of the year, they have

the same value at the end of the year as theyhad at the beginning.

Lower of cost or market method. SeePublication 538 for a discussion of the lowerof cost or market method.

New business. For a new business notusing LIFO, you may choose either methodto value your inventory. You must use thesame method to value your entire inventory,and you cannot change the method withoutIRS approval.

Other IncomeThe full amount of everything you receive inyour selling business is business income. Youmust report all business income on your tax

return. Take no deduction from your incomebefore entering it on the return.

Commissions, bonuses, and percentages.Many direct sellers receive a commission ontheir sales. Your commission might be calleda bonus or percentage, and it might bebased on both your own sales and the salesof other direct sellers working under you.

Report the full amount of any commissionsyou receive as business income, even if youpay part of it to other direct sellers workingunder you. You usually can deduct the partyou pay as a business expense. For moreinformation, see Commissions under OtherExpenses, later.

Prizes, awards, and gifts. If you receiveprizes, awards, or gifts in your role as a di-rect seller, you must report their full value asbusiness income. Examples include:

Cash.

Free merchandise.

Expense-paid trips.

Use of a car.

Jewelry signifying your level of achieve-ment as a direct seller.

Memberships in organizations or clubs.

Tickets to sports events, shows, or con-certs.

Value of goods or services received. Youmust report income received in the form ofgoods or services at their fair market valueon your tax return. Fair market value is theprice agreed on between a buyer and a sellerwhen both have all the necessary informationand neither is forced to buy or sell.

Value of use of property. If you receive thefree use of property through your direct-salesperformance, you must include the fair marketvalue of the use of the property in your busi-

ness income. There are special rules for thefree use of an automobile and certain otherproperty. For more information, get Publica-tion 463, Travel, Entertainment, Gift, and CarExpenses, and Publication 525, Taxable andNontaxable Income.

Capital ExpensesYou must capitalize (treat as an asset), somecosts rather than deduct them. These costsare a part of your investment in your businessand are called capital expenses.

Although you generally cannot imme-diately deduct a capital expense, you may beable to take deductions for these costs over

a period of years as explained later underCost Recovery.

Kinds of Capital ExpensesYou must capitalize the following costs:

Going into business. The costs of get-ting started in business, before you areauthorized to start selling your company'sproducts, are all capital expenses. Theseinclude the cost of exploring differentdirect-selling opportunities, the cost ofany training you must have before be-coming a direct seller for your productline, any fees you must pay to the com-pany to become a direct seller, and simi-

lar costs. Business assets. The cost of any asset

(property) that will last for more than 1year is a capital expense. Examples ofbusiness assets include: office furniture,business vehicles, and storage shelves.

Improvements. The costs of making im-provements to a business asset are cap-ital expenses if the improvements add tothe value of the asset, appreciablylengthen the time you can use it, or adaptit to a different use. However, normal re-pair expenses are deducted as currentbusiness expenses and are not capital-ized. For example, if you have a car youuse only for business, maintenance and

Gross receipts .............................................. $5,375Minus: Cost of goods sold ........................... 3,025Gross profit $2,350

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repair costs, such as tune-ups, newheadlights, or brake repairs, are businessexpenses. The cost of overhauling theengine, however, is a capital expense.

DemonstratorsIf you keep your company's products on handto show to potential customers, their cost maybe part of the cost of goods sold, a capitalexpense, a business expense, or a personalexpense, depending on the circumstances.The cost of a product you use yourself is apersonal expense, even if you occasionallyshow it to prospective customers.

Example. Sheila is a direct seller whouses many of her products in her own home.When potential customers come to her house,she can show them drapes she bought fromthe company, as well as the lawn chairs,toaster, grill, tea set, and spice cabinet. Byshowing these items in her own home, shehopes to interest people in buying from hercompany or in becoming direct sellers them-selves.

Sheila cannot take deductions for the costof any of these products. Because she usesthem in her own home for personal reasons,

their cost is not a cost of doing business.

One year or less of use. If you have aproduct that you use as a demonstrator for 1year or less and the demonstrator itself is notavailable for purchase by your customers, itscost is a business expense. See BusinessExpenses, later.

If the demonstrator itself can be boughtby your customers, include it in your inventoryof goods for sale.

Example 1. Constance is a direct sellerof kitchenware. Customers must order itemsfrom a catalog, but she keeps at least one ofeach type on hand to show buyers. When her

product line changes and an item is discont-inued, she either starts using the demonstra-tor in her own kitchen or tries to sell it. Whenshe had a garage sale, she sold a numberof unused demonstrators.

Constance includes her demonstrators,including those for discontinued products, inher inventory of goods for sale. When shesells a demonstrator, including those she soldat the garage sale, she includes the incomein her gross business receipts.

When Constance starts using a demon-strator in her own kitchen, it is a withdrawalof inventory for her personal use. She sub-tracts the cost of the item from her purchasesfor the year, as discussed under Cost ofGoods Sold, earlier.

Example 2. Lydia sells needlework kitsat sales parties. She has catalogs and anumber of kits to show customers. She usesthese kits to demonstrate various needleworktechniques.

The demonstrator kits last less than 1 yearand are not sold to customers. Some are ru-ined and thrown away. Their cost is a busi-ness expense.

More than 1 year of use. If you use ademonstrator for more than one year, its costis a capital expense. However, if you expectto eventually sell the demonstrator, include itin your inventory of goods for sale.

Example 1. Mike sells educational booksdoor-to-door. He carries copies of the booksto show. If someone wants a book, he takesa deposit and delivers the book at a later time.

Because his product line changes littlefrom year to year, Mike can use a book as ademonstrator for a long time. Although heperiodically replaces his demonstrators withnew ones and sells the old ones at a discount,he has kept some books as demonstrators forup to 3 years.

Because Mike eventually sells his dem-onstrators, they remain part of his inventoryof goods for sale.

Example 2. Janet sells the same line ofeducational books as Mike in Example 1.Unlike him, she tries to use her demonstratorsas long as possible. She puts the books inplastic jackets to protect them, and ordinarilyonly stops using them as demonstrators whenthe company comes out with a new edition.Janet never sells the old demonstrators. Shecan recover the cost of the books she usesas demonstrators as discussed under CostRecovery, next.

Cost RecoveryYou can usually recover your cost for capitalexpensessubtract them from incomeovera number of years. This is done by deductingeach year a part of the basis (usually yourcost) using depreciation or amortization. Usedepreciation to recover capital expenses formost tangible business assets. Use amorti-zation to recover only certain kinds of capitalexpenses, including business start-up costs.Amortization is discussed in chapter 12 ofPublication 535, Business Expenses.

If you choose, you can treat a limitedamount of the cost of certain qualifying prop-erty as a current expense rather than a capitalexpense. This is called the section 179 de-duction.

Form 4562. Generally, use Form 4562 toreport depreciation, amortization, and thesection 179 deduction. Form 4562 is illus-trated in an example in Publication 946, HowTo Depreciate Property.

Section 179 DeductionYou can choose to treat all or part of the costof certain qualifying property as a current ex-pense rather than as a capital expense. If youmake the choice, you can deduct a limitedamount of the cost of qualifying property youbuy for use in your direct-selling businessonly in the first year you place the property inservice.

Placed in service. Property is placed inservice when it is first ready and available fora specific use. To claim the section 179 de-duction or depreciation, you must know whenthe property was placed in service.

Qualifying property. Qualifying property in-cludes tangible personal property for whichdepreciation is allowable. However, seechapter 2 in Publication 946 for more infor-mation.

Maximum dollar limit. The total cost youcan choose to deduct for the tax year cannotexceed $18,000.

If the total cost of qualifying property isless than $18,000, your section 179 deductionis limited to the cost of the qualifying propertyplaced in service in the tax year.

TIP

The maximum amount you can takeas a section 179 deduction increasesto $18,500 for tax year 1998. This

amount increases further for each later yearuntil it reaches $25,000 for tax year 2003.

Taxable income limit. The total cost you candeduct in each year is limited to the taxable

income from the active conduct of any tradeor business during the tax year.

For more information, get Publication 946,How To Depreciate Property.

DepreciationIf you do not choose a section 179 deductionor you choose a section 179 deduction anddo not deduct all of your cost, you can takea depreciation deduction for part or all of thecost you did not deduct as a section 179 de-duction.

Property for which you can recover thecost through depreciation is called deprecia-ble property. Depreciable property may betangible or intangible.

1) Tangible property is any property thatcan be seen or touched and includesboth real and personal property.

a) Real property is land and generallyanything that is built on, growing on,or attached to land. However, landitself is never depreciable.

b) Personal property is property thatis not real estate, such as a car,truck, or office equipment.

2) Intangible property generally is propertythat has value but that you cannot seeor touch. It includes items such ascopyrights, franchises, trademarks, andtrade names.

Property is depreciable if it meets theserequirements:

It is used in business or held for the pro-duction of income for more than 1 year.

It is something that wears out, decays,gets used up, becomes obsolete, or losesvalue from natural causes.

It has a determinable useful life longerthan 1 year.

In general, if property does not meet all ofthese requirements, it is not depreciable.

The modified accelerated cost recoverysystem (MACRS) is the depreciation systemthat you must use for most tangible depre-

ciable assets placed in service after 1986.For more information about depreciationof property placed in service after 1986, getPublication 946. It contains a detailed dis-cussion of MACRS and its depreciationmethods.

For more information about propertyplaced in service before 1987, get Publication534, Depreciating Property Placed in ServiceBefore 1987.

Business ExpensesThe current operating costs of running yourbusiness are known as business expenses.

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These are costs you do not have to capitalizeor include in the cost of goods sold.

You must keep business expenses sepa-rate from personal expenses. If you have anexpense that is partly for business and partlypersonal, you can deduct only the businesspart.

To be deductible, a business expensemust be both ordinary and necessary. An or-dinary expense is one that is common andaccepted in your field of business, directselling. A necessaryexpense is one that isappropriate and helpful for your direct-sellingbusiness. An expense does not have to beindispensable to be considered necessary.

This section discusses some businessexpenses you might have as a direct seller.For more information on business expenses,see Publication 535.

Salaries and WagesThe reasonable salaries, wages, and otherforms of compensation you pay to your em-ployees for their services are deductiblebusiness expenses.

If you are a sole proprietor, you cannotdeduct your own salary or any personal with-drawals you make from your business. Youare not an employee of the business.

For detailed discussions of salaries,wages, and other payments to employees,get Publications 15 and 535.

TaxesYou can deduct as business expenses vari-ous federal, state, local, and foreign taxesdirectly attributable to your direct-sellingbusiness. Some of these taxes are discussedunder Business Taxes, earlier, and others arediscussed below.

Income taxes. You cannot deduct any in-come taxes as business expenses. However,you can deduct state and local income taxesas personal expenses if you itemize de-ductions on Schedule A (Form 1040). Youcannot deduct federal income taxes at all.

Personal property tax. You can deduct asa business expense any tax imposed by astate or local government on personal prop-erty used in your direct-selling business.

You also may deduct as a business ex-pense registration fees for the right to useproperty within a state or local area.

Example. May and Julius Winter drovetheir car 7,000 business miles out of a totalof 10,000 miles during the tax year. They hadto pay $25 for their annual state license tagsand $20 for their city registration sticker. Theyalso paid $235 in city personal property tax

on the car, for a total of $280. They areclaiming their actual car expenses for theyear. Because they used the car 70% forbusiness, they can deduct 70% of the $280,or $196, as a business expense.

Sales tax. Treat any sales tax you pay on aservice or on the purchase or use of propertyas part of the cost of the service or property.If the service or the cost or use of the propertyis a deductible business expense, you candeduct the tax as part of that service or cost.If the property is merchandise bought for re-sale, the sales tax is part of the cost of themerchandise. If the property is depreciable,add the sales tax to the basis for depreciation.

Get Publication 551 for information about thebasis of property.

CAUTION

!Do not deduct state and local salestaxes imposed on the buyer that youmust collect and pay over to the state

or local government. Do not include thesetaxes in gross receipts or sales.

Fuel taxes. Taxes on gasoline, diesel fuel,and other motor fuels that you use in yourbusiness usually are included as part of thecost of the fuel itself. Do not deduct these

taxes as a separate item.

InterestInterest is the amount you pay to use bor-rowed money. You generally can deduct asa business expense all interest you pay oraccrue in the tax year on a debt related toyour business. To take the deduction, youmust have a true obligation to pay a fixed ordeterminable sum of money.

No deduction is allowed for interest paidor accrued on personal loans. If a loan is partbusiness and part personal, you must dividethe interest between the personal part and thebusiness part. For more information, seechapter 8 in Publication 535.

Example. During the tax year, you paid$600 interest on a car loan and used the car60% for business and 40% for personal pur-poses. You are claiming actual expenses onthe car. You can deduct only $360 (60% of$600) as a business expense on yourSchedule C (Form 1040) or Schedule CEZ(Form 1040). The remaining interest of $240is a nondeductible personal expense.

InsuranceYou generally can deduct premiums you payfor the following kinds of insurance related toyour trade or business:

Fire, theft, flood, or similar insurance.

Merchandise and inventory insurance.

Car and truck insurance that covers ve-hicles used in your business if you do notuse the standard mileage rate to figureyour car expenses.

Credit insurance to cover losses fromunpaid debts.

Liability insurance.

Use and occupancy and business inter-ruption insurance. This insurance paysyou for lost profits if your business is shutdown due to a fire or other cause. Reportthe proceeds as ordinary income.

You generally cannot deduct the cost of lifeinsurance paid on your own life. However,see chapter 10 in Publication 535 for infor-mation on when life insurance premiums aredeductible.

Business and personal. If you pay premi-ums for insurance coverage that is bothbusiness and personal, you can deduct onlythe part that pays for business coverage. Forexample, if you use your car 25% in yourdirect-selling business and 75% for personaltransportation, you can deduct only 25% ofyour car insurance premiums.

When to deduct. Under the cash methodof accounting, premiums are not deductibleuntil paid. If you wait until a later tax year to

pay an insurance premium due in an earlieryear, you cannot deduct the premium until theyear you pay it.

If you make an advance payment on aninsurance policy that covers more than onetax year, you can only deduct the part thatbuys insurance for the current tax year. Youmust wait until the next year to deduct the partthat buys insurance for that year, and so on.

Example. You are a direct seller. In June1997, you pay $1,200 in premiums for mer-chandise insurance effective July 1997

through June 1999 ($50 per month). You candeduct $300 in 1997 ($50 6 months), $600in 1998 ($50 12 months), and $300 in 1999.

Dividends. An insurance dividend is a returnof part of the premiums you paid. If you re-ceive dividends from business insurancepremiums you deducted in an earlier year,you must report all or part of the dividend asbusiness income on your return. For moreinformation, see Recovery of amount de-ductedin chapter 1 of Publication 535.

TelephoneYou can deduct the cost of business tele-phone calls made on your own phone, in-

cluding:

Business calls on a second line.

Long-distance business calls on anyphone.

A pro-rata portion (the business part) ofspecial services on any line.

A pro-rata portion (the business part) ofbasic local services on a second line.

You cannot deduct any charges (includingtaxes) for basic local services on the firsttelephone line in your home.

Example 1. Leo had a separate tele-phone line installed in his home for hisdirect-selling business. He had this phone

number printed on his business cards andalways uses it only for business calls.

Leo can deduct the full amount of hisbusiness phone bill because the phone isused exclusively for business.

Example 2. Mary and George run anactive direct-selling business out of theirhome. For February, their phone bill was$65$20 for basic telephone service, federalexcise tax, etc., and $45 for long-distancecalls.

The total charge for long-distance busi-ness calls on their bill is $31. Mary andGeorge can deduct $31 as a business ex-pense.

Away from home. If you travel away fromhome and make a business phone call, youcan deduct the cost of the call, whether or notthe rest of your travel expenses are deduct-ible.

Business and personal calls. You can de-duct telephone expenses only for businesscalls. Personal calls do not become businesscalls because some business is discussed.

Example. Lydia is interested in sponsor-ing others as direct sellers for her productline. She often talks by phone with her sisterwho lives 50 miles away. They talk aboutpersonal matters. When Lydia mentions herdirect-selling work, she usually says some-

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thing to encourage her sister to become adirect seller too.

Lydia's phone calls to her sister are per-sonal and nondeductible. Their primary pur-pose is not to recruit her sister as a directseller, but to continue their personal relation-ship.

Other ExpensesDiscussed next are other expenses you mayhave as a direct seller.

Business licenses. License fees and regu-latory fees paid each year to state and localgovernments are generally deductible busi-ness expenses.

Catalogs. The cost of catalogs you keep anduse in your selling business for more than 1year must be capitalized. The cost can thenbe recovered as explained under Cost Re-covery, earlier. If the catalogs are useful inyour selling business for a year or less, youcan deduct their full cost in the tax year youpay for them.

Commissions. If you must pay a bonus,percentage, or other type of commission todirect sellers working under you, you can de-

duct the amount you pay. Report the fullamount of any commissions you receive asbusiness income, and deduct the commis-sions you pay out as ordinary and necessarybusiness expenses.

Example. Freda has her own direct-selling business and sponsors two other di-rect sellers. These direct sellers report theirsales to her each month. She in turn addstheir sales to hers and reports the total to thedirect seller who sponsored her. In March, thepeople working under her each had $400 insales and she had $500 in sales of her own.She reports to the company (or her sponsor)$1,300 ($400 + $400 + $500) in monthly salesfor her group even though her income is only$500.

Freda received a commission or per-formance bonus for March equal to 10% ofthe $1,300, or $130, in sales. She reports theentire $130 as business income on her taxreturn.

Freda must pay the direct sellers workingunder her a commission of 7% on theirmonthly sales of $400. She paid each of them$28 (7% of $400) for their March sales. Shededucts the total, $56, as a business expenseon her tax return.

Computer. If you use a computer in yourdirect sales business, you can take a section179 deduction, depreciation, or both, if morethan 50% of its use is in your business. Formore information, see chapter 4, Listed

Property, in Publication 946.

Home meetings. If you have businessmeetings in your home, you can deduct yourexpenses for the meeting only when theymeet certain tests:

1) The expenses of entertaining businessassociates in your home are deductibleonly if they meet the tests discussedunder Meals and Entertainment, later,and only if you can prove your expensesas discussed under Recordkeeping,later.

2) The expenses of maintaining your homeas a place of business are deductible

only if you meet the tests discussed un-der Business Use of Your Home, later.

Example. Barbara and Bill hold biweeklymeetings in their home for the direct sellerswho work under them. They discuss sellingtechniques, solve business problems, andlisten to presentations by company represen-tatives.

Because the meetings are for business,Barbara and Bill can deduct 50% of the costof the food and beverages they provide. The50% limit is explained later under Limit, under

the section, Meals and Entertainment. Theykeep a copy of their grocery receipts for theserefreshments, and record the date, time, andbusiness nature of each meeting. Becausethe meetings are held in their living roomrather than in a special area set aside only forbusiness, they cannot deduct any of theirhome expenses for the meetings.

Journal subscriptions. If you subscribe toa journal for direct sellers, you can deduct theannual subscription fee as a business ex-pense.

Membership fees or club dues. Generally,you cannot deduct amounts you pay or incurfor membership in any club organized for

business, pleasure, recreation, or any othersocial purpose. This includes country clubs,athletic clubs, luncheon clubs, sporting clubs,airline clubs, and hotel clubs.

Exception. Unless one of its main pur-poses is to conduct entertainment activitiesfor members or their guests or to providemembers or their guests with access toentertainment facilities, the following organ-izations will not be treated as clubs organizedfor business, pleasure, recreation, or othersocial purpose:

Boards of trade,

Business leagues,

Chambers of commerce,

Civic or public service organizations,

Professional associations, and

Trade associations.

Legal and professional fees. You can de-duct as a business expense professionalfees, such as fees charged by accountants,that are directly related to your business andare ordinary and necessary in the operationof your business. However, if the charges in-clude payments for work of a personal nature(such as making out a will), you can deductonly the part of the fee related to your busi-ness as a business expense.

Tax return preparation fees. You can de-duct as a business expense on Schedule C(Form 1040) or Schedule CEZ (Form 1040)the cost of preparing that part of your tax re-turn relating to your business as a sole pro-prietor. You can deduct the remaining coston Schedule A (Form 1040) if you itemizeyour deductions.

You also can take a business deductionon Schedule C or Schedule CEZ for theamount you pay or incur in resolving assertedtax deficiencies for your business as a soleproprietor.

Samples and promotional items. You candeduct the cost of samples you give to yourcustomers and the cost of promotional items

such as posters. You cannot deduct the costof any samples you use personally.

Service charges. You can deduct servicecharges you pay on orders for goods. Theservice charge can be a flat charge, or basedon the amount you order or on the numberof customers for whom you order.

Supplies. You can deduct the cost of orderforms, bags, business cards, and other sup-plies you use in your business. However, ifyou stock supplies to be used largely in latertax years, you can deduct only the cost ofsupplies you use during the current year. Youmust wait until the years you actually use thesupplies to deduct the rest of their cost.

If you keep incidental materials and sup-plies on hand, you can deduct the cost of theincidental materials and supplies you boughtduring the tax year if all three of the followingrequirements are met:

You do not keep a record of when theyare used,

You do not take an inventory of theamount on hand at the beginning and endof the tax year, and

This method does not distort your in-

come.

Business Useof Your HomeMany direct sellers work out of their ownhomes and have business expenses for usingtheir homes. However, you cannot deduct anyexpenses for using your home in businessunless you meet the use tests discussed inthis section.

If you use part of your home for your tradeor business and can deduct the expenses onSchedule C (Form 1040) or Schedule CEZ

(Form 1040), you must figure your deductionon Form 8829 and attach it to Form 1040. Formore information, get Publication 587.

Use TestsYou can take a limited deduction for thebusiness use of your home only if you use aspecific part of it both exclusivelyand regu-larly:

As the principal place of business for yourdirect-selling business,

As a place of business where you meetor deal with customers or clients in thenormal course of your direct-selling busi-ness, or

In connection with your direct-sellingbusiness, if you are using a separatestructure that is not attached to yourhome.

Regular use. Regular use means that youuse a specific part of your home for businesson a continuing basis. Occasional or inci-dental business use of part of your homedoes not meet the regular use test even if youdo not use that part for any other purpose.

Exclusive use. Exclusive use means thatyou use a specific part of your home only forcarrying on your direct-selling business. Youdo not meet the exclusive use test if you use

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part of your home as your business office andalso for personal purposes.

Example. You use a den in your hometo write orders and do the paperwork for yourbusiness. The den is also used by your chil-dren to do their homework. You cannot claimany business deduction for the use of theroom.

Exception. There is an exception to theexclusive use test if you use part of yourhome for storing inventory or product samples

(or both). You can deduct expenses from us-ing part of your home for storing inventory orproduct samples if you meet all the followingtests.

You keep the inventory or product sam-ples for use in your direct-selling busi-ness.

Your home is the onlyfixed location ofyour business.

You use the storage space on a regularbasis.

The space you use is separately identifi-able and suitable for storage.

If your storage space meets these tests, it

does not matter whether you use it exclu-sively for business.

Example. Your home is the sole fixedlocation for your business of selling cookware.You regularly use half your basement forstoring inventory and occasionally for per-sonal purposes. You can deduct your ex-penses for the storage space even thoughthis part of your basement is not used exclu-sively for business.

Separate structures. You can deduct theexpenses for a separate free-standing struc-ture, such as a studio, garage, or barn, if youuse it exclusively and regularly for business.This structure does not have to be your prin-

cipal place of business or a place where youmeet clients or customers.For more information, including how to

figure your deduction, see Publication 587.

Travel andTransportationTravel refers to trips you take to places whereyou need to spend the night away fromhomefor example, travel to a distant city toattend a convention. Transportation refers totrips you make in the area where you live andworkfor example, transportation to call oncustomers or make deliveries in your city and

its suburbs.You must be able to prove your expenses

for travel and transportation. Deductions fortravel and transportation are looked at closelywhen the IRS examines returns. For moreinformation, see Recordkeeping, later.

TravelIf you temporarily travel away from your taxhome on business, you can deduct your or-dinary and necessary travel expenses. How-ever, you cannot deduct lavish or extravagantexpenses or those for personal or vacationpurposes. For more information, get Publica-tion 463.

TransportationYou can deduct transportation expenses foryour business. Generally, business transpor-tation is traveling between two or moreworkplaces in the same day or between yourhome and a temporary work location. It in-cludes trips you make in the area where youlive and work to:

Call on customers.

Make deliveries.

Pick up goods.

Attend business meetings.

Transportation expenses can include train,bus, and cab fares, car rental fees, and thecost of driving and maintaining your car forbusiness transportation. Meals and lodgingare not included in transportation expenses.

Commuting expenses. You cannot deductthe cost of transportation between your homeand your main or regular place of work. Thecost of commuting is a nondeductible per-sonal expense, regardless of the distance orwhether work is performed during the trip.

Example. Elaine Eden works full time asa bank teller. She also sells cosmetics parttime to her coworkers at the bank. After hercustomers select items from a catalog, shesends the orders to the cosmetics company.She delivers the items to the bank when shereceives them from the company.

Elaine's expense of delivering items is notdeductible. Her cost of getting to the bank isa commuting expense. The fact that she car-ries cosmetics does not make her commutingexpense a deductible business expense.

Two places of work. If you work at twoplaces in a day, you can deduct the expenseof getting from one to the other. However, iffor some personal reason you do not go di-

rectly from one location to the other, you candeduct only the amount it would have costyou to go directly from the first location to thesecond.

Deductible expenses. If you use your vehi-cle in your business, get Publication 463 forinformation on how to figure your expensesfor business transportation.

Meals andEntertainmentBecause you are in the selling business, you

may take business associates to lunch orentertain them. The cost can be a deductiblebusiness expense. However, there are certainconditions that must be met before you cantake a deduction for business meals andentertainment, and you generally can deductonly 50% of your cost. This section discussesthese rules. There are also certain recordsyou must keep. For more information, seeRecordkeeping, later.

Meals. Include as meals amounts spent onfood, beverages, and the taxes and tips onthose meals. Generally, no deduction is al-lowed unless you or your employee is presentwhen the food or beverages are provided.

Entertainment. Include as entertainmentany activity generally considered to provideentertainment, amusement, or recreation.This includes entertaining guests at night-clubs; social, athletic, and sporting clubs;theaters; sporting events; on yachts; and onhunting, fishing, and vacation trips or on sim-ilar outings. It can also include meeting per-sonal, living, or family needs, such as fur-nishing a hotel suite or a car to businesscustomers or their families. However, see Notdirectly related, later, for more information.

Directly Relatedor AssociatedTo be deductible, meal and entertainmentexpenses must be ordinary and necessaryexpenses of carrying on your direct-sellingbusiness, and you must be able to prove themas explained later under Proving Your De-ductions. Unless certain exceptions apply,you must be able to show that they are:

Directly related to the active conduct ofyour business, or

Associated with the active conduct ofyour business.

For more information, see chapter 2 of Publi-cation 463.

Directly related. For meal and entertainmentexpenses to meet the directly related test, allof the following must apply:

You had more than a general expectationof getting income or some other specificbusiness benefit from the expense.

You engaged in business with the personduring the meal or entertainment period.

The main purpose of the combined busi-ness and meal or entertainment was theactive conduct of business.

You do not have to show that business in-

come or another business benefit actuallyresulted.It is not necessary to devote more time to

business than to the meal or entertainment.However, if the business discussion is onlyincidental to the meal or entertainment, itdoes not qualify as directly related.

Example. You are a direct seller ofwomen's cosmetics. A state women's organ-ization is holding its annual convention in alocal hotel and you decide to display yourproducts in a hospitality room in the hotel.You also provide entertainment and give outproduct samples. You can deduct the cost ofthe hospitality room and entertainment pro-vided.

Not directly related. Generally, expensesare not directly related if there is little or nopossibility that you will actively conduct busi-ness. Examples are:

Meetings at nightclubs, theaters, orsporting events.

Meetings at essentially social gatherings,such as cocktail parties.

Meetings with a group that includes peo-ple who are not business associates ata place such as a cocktail lounge, countryclub, athletic club, or resort.

You may prove that the meal or entertainmentis directly related by showing that you did

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have a substantial business discussion duringthe meal or entertainment.

When meals and entertainment take placeon a hunting or fishing trip, or on a yacht orpleasure boat, the conduct of business is notconsidered the main reason for the combinedbusiness and entertainment unless you showotherwise. Even if you show that businesswas the main reason, you generally cannotdeduct expenses for the use of an enter-tainment facility. For more information, seeEntertainment facilitiesin Publication 463.

Associated. You can deduct meal andentertainment expenses that do not meet thedirectly related test if they are:

Associated with your direct-selling busi-ness, and

The meal or entertainment is directly be-fore or after a substantial business dis-cussion.

A meal or entertainment expense is generallyassociated with your direct-selling business ifyou can show that you had a clear businesspurpose for the expense. The purpose maybe to get new business or to encourage thecontinuation of an existing business relation-

ship.

Substantial business discussion. Whethera business discussion is substantial dependson all the facts in each case. You must showthat you actively engaged in a discussion,meeting, negotiation, or other businesstransaction to get income for your businessor other specific business benefit.

The meeting does not have to be for aspecified length of time. However, you mustshow that the business discussion was sub-stantial in relation to the meal or enter-tainment. It is not necessary to devote moretime to business than to the meal or enter-tainment, and you do not have to discussbusiness during the meal or entertainment.

Business and nonbusiness guests. Youmust divide your entertainment expenses be-tween business and nonbusiness expenses.You can deduct only the business part. Forexample, if you entertain a group of 11 (in-cluding yourself)three business prospectsand seven social guestsyou can deductonly four-elevenths of the expense.

Expenses for spouses. You cannot deductthe cost of meals or entertainment for yourspouse or the spouse of a business associateunless you can show a clear business pur-pose for providing the meal or entertainment.

Lavish or extravagant expenses. Youcannot deduct expenses for meals andentertainment to the extent they are lavish orextravagant. An expense is not consideredlavish or extravagant if it is reasonable con-sidering the facts and circumstances. Ex-penses will not be disallowed merely becausethey are more than a fixed dollar amount ortake place at a deluxe restaurant, hotel,nightclub, or resort.

Your meals. You generally can deduct thecost of your own meals while entertaining forbusiness purposes, if you do not claim de-ductions for substantial personal living ex-penses.

LimitYou usually can deduct only 50% of your un-reimbursed business-related meal and enter-tainment expenses. The 50% limit applies, forexample, to expenses you incur while travel-ing away from home on business (whethereating alone or with others), entertainingbusiness customers at your place of businessor a restaurant, or attending a business con-vention or reception. Exceptions to the 50%limit are discussed in Publication 463.

Taxes and tips related to a meal or enter-

tainment activity are included in the amountsubject to the 50% limit. Expenses such ascover charges to a nightclub, rent for a roomwhere you hold a dinner or cocktail party, orthe amount paid for parking at a sports arenaare subject to the 50% limit. However, thecost of transportation to and from a businessmeal or entertainment activity that is other-wise allowable is not subject to the 50% limit.

If you pay or have an expense for goodsand services consisting of meals, enter-tainment, and other services (such as lodgingor transportation), you must make a reason-able allocation of that expense between thecost of meals and entertainment and the costof other services. For example, you mustmake an allocation if a hotel includes one or

more meals in its room charge.Apply the 50% limit after figuring theamount that would otherwise qualify for adeduction. First determine the amount of mealand entertainment expenses that would bedeductible under the rules discussed earlier.Then apply the 50% limit to figure thedeductible amount.

Example. You spend $100 for abusiness-related meal. If $40 of that amountis not allowable because it is lavish and ex-travagant, the remaining $60 is subject to the50% limit. You cannot deduct more than $30(50% of $60).

Business GiftsGiving prizes, awards, and gifts may be anordinary and necessary part of doing busi-ness as a direct seller. In each of the threesituations illustrated below, you can deductthe cost as a business expense.

Situation 1. You do your direct selling on thesales party plan. As an incentive for peopleto host your parties, you offer them a varietyof gifts. The choice of gift depends on thesuccess of the partythe higher the volumeof sales, the more valuable the gift.

In this situation, your gift to the host orhostess is actually payment for hosting the

party, and the host or hostess should reportthe fair market value of the gift as income.

You can deduct the cost of the gift. If yougive hosts and hostesses items from your in-ventory or items you purchase from the com-pany along with goods you sell, their cost willbe included in the cost of goods sold. Youcannot deduct their cost again as a businessexpense. However, if you purchase the giftsseparately from the goods you sell, deducttheir cost as an ordinary and necessarybusiness expense.

Situation 2. You have several direct sellersworking under you. Because your incomedepends in part on their sales, you regularly

meet with them, encourage them, and providethem with incentives and support. As an in-centive to make sales, you sometimes offera prizesuch as an evening on the town ortickets to a sports eventto the person whosells the most during the month.

In this situation, the prizes you give areactually payments for the winners' selling ef-forts. You can deduct the cost of the prizesas ordinary and necessary business ex-penses. The direct sellers who receive yourincentive prizes must report them as incomeat their fair market value. For more informa-tion, see Other Income, earlier.

Situation 3. You sell cosmetics door-to-door.To spur sales, you often give away smallsamples.

In this situation, you can deduct the costof the samples. If you purchase samplesseparately from the products you sell, you candeduct their cost as an ordinary and neces-sary business expense.

Do not deduct the cost of the same itemtwice. If the item was included in inventory,you cannot deduct it as a business expense.The item will already be a part of the cost ofgoods sold.

Gift limit. Do not deduct more than $25 forbusiness gifts to any one person during theyear (see the exceptions discussed later).You can deduct only business gifts. Personalgifts are not deductible.

Figuring the limit. A gift to the spouse of aperson with whom you are doing business isconsidered a gift to that person. However, ifyou have independent business connectionswith both spouses, a gift to one spouse isgenerally not considered a gift to the other. Itwill, however, be considered an indirect giftto the other spouse if it is intended for thatspouse's eventual use or benefit. These rulesalso apply to gifts you give to any other familymember of a person with whom you have abusiness connection.

If you and your spouse both give gifts,both of you are treated as one taxpayer. Itdoes not matter whether you have separatebusinesses or independent connections withthe recipient.

Incidental cost. Costs that do not add sub-stantial value to a gift, such as engraving on

jewelry, packaging, insuring, and mailing, aregenerally not included in determining the costof a gift for purposes of the $25 limit. For ex-ample, the cost of gift wrapping is consideredan incidental cost. However, the purchase ofan ornamental basket for packaging fruit isnot considered an incidental cost if the bas-ket's value is substantial in relation to thevalue of the fruit.

Exceptions. The following items are not in-cluded in the $25 limit for business gifts:

Items that cost $4 or less, on which yourbusiness name is clearly and perma-nently imprinted, and which are part of anumber of identical items you widely dis-tribute. This includes such items as pens,desk sets, and plastic bags and cases.

Signs, display racks, or other promotionalmaterial to be used on the businesspremises of the recipient.

Gifts that must be included in the in-come of the recipient.

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Gift or entertainment. Any item that mightbe considered either a gift or entertainmentwill generally be considered entertainmentand not subject to the $25 limit. However, ifyou give a customer packaged food orbeverages to be used later, they are gifts.

If you provide business associates withtickets to a theater performance or a sportingevent and you do not accompany them, youmay treat the tickets as either a gift or enter-tainment, whichever is to your advantage.However, if you go to the event with them,you must treat the cost of the tickets as anentertainment expense.

Not-for-Profit LimitIf you do not carry on your direct-selling ac-tivity to make a profit, there is a limit on thedeductions you can take. You cannot use aloss from direct selling to offset any other in-come you have.

This limit applies, for example, if you gointo direct selling primarily for the businesstax deductions you can take. It also appliesif you become a direct seller only to allow youand your friends to buy products at reducedrates.

If the not-for-profit limit applies, you musttake the deductions allowed on Schedule A(Form 1040). See Limit on Deductions andLosses under Not-for-Profit Activities inchapter 1 of Publication 535 for informationon how to figure your allowable deductions.Do not use a business tax return, such asSchedule C (Form 1040).

Not for profit. In deciding whether your di-rect selling is carried on for profit, take intoaccount all of the facts about the activity. Noone factor alone is decisive. Among the fac-tors to consider are:

Whether you carry on your direct sellingin a businesslike manner.

Whether the time and effort you put intodirect selling indicate that you intend tomake it profitable.

Whether you are depending on incomefrom direct selling for your livelihood.

Whether your losses are due to circum-stances beyond your control (or arenormal in the start-up phase of directselling).

Whether you change your methods ofoperation in an attempt to improve profit-ability.

Whether you, or your advisors, have theknowledge needed to carry on directselling as a successful business.

Whether you were successful in makinga profit in similar activities in the past.

Whether your direct selling makes a profitin some years, and how much profit itmakes.

Whether you can expect to make a futureprofit from the appreciation of the assetsused in your direct-selling business.

Your direct selling is presumed carried on forprofit if it produced a profit in at least 3 of thelast 5 tax years, including the current year,unless the IRS establishes to the contrary.

If you are starting a business and do nothave 3 years showing a profit, you may want

to take advantage of this presumption later,such as after you have the 5 years of experi-ence allowed by the test. For more informa-tion, see Publication 535.

Recordkeeping

RECORDS

You must keep records to correctlyfigure your taxes. Your records must

be permanent, accurate, complete,and clearly establish your income, de-ductions, and credits. The law does not re-quire you to keep records in any particularway. But if you have more than one business,you should keep a complete and separate setof books and records for each business.

Publication 583 provides informationabout setting up a recordkeeping system, thetypes of books and records included in atypical system for a small business, andsample records.

Publication 463 provides information onthe records to keep if you use your car in yourbusiness.

The following are suggestions for keepingadequate business records.

Keep a business bank account. De-posit all business receipts in a separatebank account. Make all payments bycheck, if possible. Then both businessincome and business expenses will bewell documented.

Make a record. Record all your businesstransactions in separate account books,and keep a monthly summary of yourbusiness income and expenses.

Support your entries. File canceledchecks, paid bills, duplicate deposit slips,and other items that support entries inyour books in an orderly manner andstore them in a safe place.

If you cannot provide a canceledcheck to prove payment of an expenseitem, you may be able to prove it withcertain financial account statements.These statements must show either acheck clearing, a credit card charge, oran electronic funds transfer. If the ac-count statement shows a check clearing,it must indicate the check number,amount, payee's name, and the date thecheck amount was posted to the account.If the account statement shows a creditcard charge, it must indicate the amountcharged, payee's name, and the datecharged. If the account statement showsan electronic funds transfer, it must indi-cate the amount transferred, the payee'sname, and the date of transfer.

Keep your records. You must keep yourbusiness books and records available atall times for inspection by the IRS. Youmust keep the records as long as theymay be needed in the administration ofany Internal Revenue law. You shouldalso keep copies of your tax returns tohelp prepare future returns or file claimsfor refunds.

CAUTION

!Proof of payment alone does not es-tablish that you are entitled to a taxdeduction. You should also keep

other documents as discussed in ProvingYour Deductions, next.

Proving Your DeductionsThe IRS may ask you to prove your de-ductions for business expenses.

Travel ExpensesFor travel expenses, you must be able toprove:

Each separate amount you spent fortravel away from home, such as the costof your transportation or lodging. A re-

ceipt, bill, or other documentary evidencegenerally is required for all lodging ex-penses. You can total the daily cost ofyour breakfast, lunch, dinner, and otherincidental travel costs if they are listed inreasonable categories, such as meals,gas and oil, and taxi fares.

The dates you left and returned home foreach trip, and the number of days spenton business while traveling away fromhome.

The destination or area of your travel,described by the name of the city or town.

The business reasons for your travel orthe business benefit you gained or ex-pected to gain from it.

Entertainment ExpensesFor entertainment expenses, includingentertainment-related meals, you must beable to prove:

1) The amount of each separate enter-tainment expense. You may total inci-dental expenses, such as taxi fares andtelephone calls, on a daily basis.

2) The date the entertainment took place.

3) The name and address or location of theplace you went. Include the type ofentertainment, such as dinner or theater,if the information is not clear from thename or designation of the place.

4) The occupation or other informationabout the people for whom you areclaiming a meal or entertainment ex-pense. Include their names, titles, orother information sufficient to establishtheir business relationship to you.

5) The business reason for the enter-tainment or the business benefit yougained or expected to gain from it andthe nature of any business discussionor activity that took place.

6) The presence of you or your employeeat a business meal given for a client.

Business discussion. If the entertainment

took place before or after a substantial andbona fide business discussion, in addition tothe information in (1), (2), (3), (4), and (6)above, you must be able to prove:

The date, place, and duration of thebusiness discussion.

The nature of the business discussion.

The business reason for the meal orentertainment or the business benefit yougained or expected to gain from enter-taining.

The identification of the people who par-ticipated in both the business discussionand the entertainment activity.

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Business relationship. If you entertain areadily identifiable group of people, you donot have to record the name of each person.It is enough to designate the group. For ex-ample, if you entertain all the members of agarden club, an entry such as members ofthe Hillcrest Garden Club is enough.

Gift ExpensesFor gift expenses, you must be able to prove:

The cost of the gift. The date you gave the gift.

A description of the gift.

Your reason for giving the gift or anybusiness benefit you gained (or expectedto gain) from giving it.

The occupation or other informationabout the person receiving the gift, in-cluding name, title, or other informationestablishing a business relationship toyou.

The name of the recipient of a business giftdoes not always have to be recorded. Ageneral listing will be enough if it is evident

that you are not trying to avoid the $25 annuallimit on the amount you can deduct for giftsto any one person. For example, if you buya large number of tickets to local high schoolbasketball games and give one or two ticketsto each of a number of customers, it is usuallyenough to record a general description of therecipients.

RecordsYou should keep the proof you need for yourtravel, meal, entertainment, and gift expensesin an account book, diary, statement of ex-pense, or similar record supported by ade-quate documentary evidence that togetherwill support each element of an expense.

You do not have to record information inyour account book that duplicates informationshown on a receipt if your records and re-ceipts complement each other in an orderlymanner.

Keep your records up to date. Record yourexpenses in your account book at or near thetime of the expense. Entries made later, whenyou may not remember them accurately, donot have as much value as entries made ator near the time of the expense.

Separating expenses. Usually, each sepa-rate payment you make must be recorded asa separate expense. For example, if you en-tertain someone at dinner and then go to thetheater, the dinner expense and the cost ofthe theater tickets are separate expenses.You must record them separately in your re-cords.

Expenses of a similar nature occurringduring the course of a single event will beconsidered a single expense. For example, ifduring entertainment at a cocktail lounge youpay separately for each serving ofrefreshments, treat the total expense for therefreshments as a single expense.

Some items can be totaled in categories.You can make one daily entry for such cate-gories as taxi fares, telephone calls awayfrom home, gas and oil, and other incidentaltravel costs. Meals should be a separate cat-egory. Include tips with the costs of the ser-vices you received.

Documentary evidence. A receipt is oftenthe best evidence to prove the amount of anexpense. A receipt, bill, or other documentaryevidence is needed for all your lodging ex-penses unless, under an accountable plan,your employer pays you a per diem re-imbursement of no more than the governmentrate in effect at that time and in that area. Itis also generally needed for any other ex-pense of $75 or more.

Documentary evidence will ordinarily beconsidered adequate if it shows the amount,date, place, and essential character of theexpense. For example, a hotel receipt isenough to support expenses for businesstravel if it has the name and location of thehotel, the dates you stayed there, and sepa-rate amounts for charges such as lodging,meals, and telephone. A restaurant receipt isenough to prove an expense for a businessmeal if it has the name and location of therestaurant, the number of people served, andthe date and amount of the expense. If acharge is made for items other than mealsand beverages, the receipt must show thatthis is the case.

Canceled check. A canceled check, to-gether with a bill from the payee, usually es-tablishes the cost. However, a canceledcheck by itself does not prove a business

expense without other evidence to show thatit was for a business purpose.

Incomplete records. If you do not have ad-equate records to prove an element of anexpense, you must prove the element by:

Your own statement, whether written ororal, containing specific information aboutthe element, and

Other supporting evidence that is suffi-cient to establish the element.

Additional proof. You may have to provideto the IRS additional information to clarify orestablish the accuracy or reliability of infor-mation contained in your records, statements,

testimony, or documentary evidence.

SampleFilled-In FormsThis section will familiarize you with ScheduleC (Form 1040), used to report business in-come or loss, and Schedule SE (Form 1040),used to figure self-employment tax. The linenumbers in bold type, below, follow the linenumbers on the form being discussed.

Schedule CIf you are the sole owner of an unincorporatedtrade or business, you must report businessincome and expenses on Schedule C (Form1040) or Schedule CEZ (Form 1040). If youown more than one business, or if you andyour spouse have separate businesses, youmust file a separate Schedule C or ScheduleCEZ for each business.

Samples of Schedule C and Schedule SEfor Kathleen Woods are illustrated on the fol-lowing pages. (Amounts have been roundedto the nearest dollar.)

Kathleen Woods is a secretary for a smallfirm. She reports her salary of $15,000 on line7 of Form 1040.

Kathleen is also a direct seller of house-hold cleaning products manufactured and

distributed by Spotless, Inc. She reports theincome and expenses of her selling businesson Schedule C because she is self-employed.

Kathleen uses the cash

us internal revenue service: p911--1997

Documents