US Internal Revenue Service: p911--1998

8/14/2019 US Internal Revenue Service: p911--1998

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ContentsImportant Change for 1998 ............... 1

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

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

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

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

Capital Expenses ............................... 6

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

Business Expenses ........................... 7

Business Use of Your Home ............ 9

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

Meals and Entertainment .................. 10

Business Gifts .................................... 11

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

Recordkeeping ................................... 12

Sample Filled-In Forms ..................... 13

How To Get More Information .......... 18

Index .................................................... 19

Important Changefor 1998

Standard mileage rate. The standard mile-age rate for 1998 is 32.5 cents a mile for allbusiness miles on an owned or leased pas-senger 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

1998 Returns


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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

1 Your Rights as a Taxpayer

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-EmploymentTax

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 information

about 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 one of the followingtrades or businesses.

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, a deposit-commissionbasis 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 thattrade 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 one of thefollowing 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 conditions

listed 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 earnings de-pend in part on how much they sell. Recruit-ing, motivating, and training are examples ofattempts to increase 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 to

the 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 any one of the followingapplies to your business.

1) You have employees.

2) You have a Keogh plan.

3) You operate your business as a corpo-ration or partnership.

4) You file any of the following returns.

a) Employment.

b) Excise.

c) Alcohol, tobacco, and firearms.

Use Form SS4 to apply for an EIN.

Business TaxesFour kinds of federal business taxes mayapply to direct sellers.

Income tax.

Self-employment tax.

Employment taxes.

Excise taxes.

Your state, county, or city may impose otherkinds of tax and licensing obligations.

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 orSchedule CEZ as part of your individual in-come tax return (Form 1040). You are a soleproprietor if you are self-employed (work foryourself) and are the only owner of your un-incorporated business.

Self-employment tax. Self-employment taxis the social security and Medicare tax forthose who work for themselves. It is like the

social security and Medicare taxes withheldfrom the pay of wage earners. If you are adirect seller, you generally must pay this taxon 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 the following kinds of employment taxes.

The federal income tax you withhold fromemployees' wages.

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Social security and Medicare taxesboththe amount you withhold from employees'wages and the amount you pay as em-ployer.

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, see

Taxesunder 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 pay

enough tax that way, you may have topay 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.

Exceptions. You do not have to pay esti-mated tax if you meet either of these two ex-ceptions.

You had zero tax liability last year, youwere a U.S. citizen or resident for thewhole year, and your tax year coveredall 12 months.

Your total expected taxes for 1999, minus

any expected tax credits and withholding,will be less than $1,000.

Form 1040ES. Use Form 1040ES to figureyour estimated tax and make quarterly esti-mated tax payments.

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 (such as part of your downline group)and you sell $5,000 or more in goods duringthe year to any one of those sellers, you mustreport the sales on an information return. Theinformation return, Form 1099MISC, mustshow the name, address, and identificationnumber of the seller placing the orders.Check box 9 of Form 1099MISC to showthese sales. Do not enter a dollar amount.You must give Copy B or a qualified state-ment (such as a letter showing this informa-tion along with commissions, prizes, awards,etc.) to the seller by February 1, 1999.

You must file Copy A of Form 1099MISCwith the Internal Revenue Service by March

1, 1999. Use Form 1096 to summarize andtransmit Form 1099MISC. See the in-structions to Form 1096 for the addresswhere 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 taxesfor 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.

You may still have to pay a failure-to-paypenalty if you received an automatic exten-sion of time for filing. You will have to pay thepenalty in either of the following situations.

The amount of tax shown as due on theextended return is more than 10% of thetotal tax.

The amount due is not paid by the ex-tended due date.

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 either of the followingreasons.

A frivolous position on your part.

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 the following reasons.

Negligence or disregard of rules or regu-lations.

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 the followingamounts.

10% of the correct tax.

$5,000.

Information reporting penalties. A penaltyapplies if you do not file information returnsby the due date, if you do not include all re-quired information, or if you do not reportcorrect information. A penalty applies to in-formation 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 the following amounts.

$100 per statement.

10% or 5% (depending on the type ofstatement) of the amount to be shown onthe 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. The following areexamples of information you must provide.

Correct identification numbers for your-self, your spouse, and your dependentson returns and statements.

Correct identification numbers for othertaxpayers where required.

Correct identification numbers when re-quired by another taxpayer, such as 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. There are two accounting periods youmay use.

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

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 your

tax year without IRS approval. For more in-formation, get Publication 538.

Accounting MethodsAn 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 accrualmethod, discussed later, for your sales and

purchases. 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 eventhough 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 youhave a subscription to a direct-selling journalthat runs out at the end of 1998. It will cost

you $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 1998. You cannot deduct the$54 on your 1998 return, even if you use thecash method of accounting. However, youcan deduct half of the $54 in 1999 and theother half in 2000.

Business IncomeYou must report on your tax return all incomeyou 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 at least someof your customers buy directly from you andyou buy the products you sell to them from acompany (or another direct seller).

If some of your customers buy their pro-ducts from a company, you, as the salesagent, do not have any sales income fromthese transactions. You will generally receivea commission or bonus for making the sale,but will have no direct income from the saleitself. If all of your sales are handled in thisway, the rules in this section do not apply toyou. Report your commissions as otherbusiness income. For more information, seeOther Income, later.

Depending on the company with whichyou are affiliated and the nature of its mar-keting and compensation plan, you may havesome sales which produce income from salesand some which produce only commissionsor bonuses.

Example 1. Your customers pay you theretail price for goods they order. You sendthe orders 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 take

their orders or when you make deliveries.After 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 fromyour customers is income from sales. Youhave income from sales to report on your re-turn.

Example 5. You have recruited severalother direct sellers who order the productsthey sell through you. Commissions or bo-nuses paid to you by the company are sharedwith the direct sellers in your group based

on sales, purchases, or some other formulaestablished by the company whose productsyou sell. You are able to keep the portion ofthe commissions you are not required to dis-tribute to the direct sellers in your group.

The bonuses you receive from the com-pany on these sales are included in grossreceipts as commissions, and not as incomefrom sales.

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 31,1997, 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 costof these demonstrators was $80. She doesnot have a beginning inventory for 1998.

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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, 1998, 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 1998is $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 saleon these items, she buys an extra quantity forfuture sales. She had merchandise costing$200 on hand at the end of 1997 (whichwould be her beginning inventory for 1998)and merchandise costing $175 at the end of1998. During the year she purchased $3,250of merchandise. Purchase returns and allow-ances were $50. She withdrew $200 of cos-metics for personal use. Lisa figures her costof goods sold for 1998 as follows:

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

Purchases. When figuring cost of goods sold,include the full cost of all merchandise youbuy to sell to customers. This cost includesany postage or freight charges to get themerchandise.

Figure your purchases at the actual priceyou pay. Deduct a cash discountor a tradediscount in figuring your purchases, not thestated purchase price. A cash discount or atrade discount is the difference between thestated purchase price and the actual priceyou 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 purchase price. It also includes anycredit you received for merchandise you re-turned.

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. Follow this proce-

dure for all products withdrawn for personaluse, even if you are using the product only tofamiliarize yourself with its characteristics orto demonstrate loyalty to the companywhose products you sell.

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 to which you have title at the

end of the year. This will generally be anygoods you have on hand and have not yetsold to customers.

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 thiscase, you have title to the goods and must

include 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 infiguring 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. LIFOinventory must only be valued at cost.

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 anydiscounts 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 havethe 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, oron your purchases from the company withwhich you are affiliated.

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 to others as a business expense. Formore information, see Commissions under

Other Expenses, 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. The following are exam-ples of items that must be included in income.

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 the

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

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

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free 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 some costs rather thandeduct them. These costs are a part of your

investment in your business and are calledcapital expenses.Although you generally cannot take a

current deduction for a capital expense, youmay be able to take deductions for thesecosts over a period of years as explained laterunder Cost 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 different

direct-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. See chapter 12 of Publication535 for information on how to treat thesecosts.

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.See Cost Recoverylater.

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 andrepair 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 may

be 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 bought

by 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 herproduct 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 income

in 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 1 year, its cost isa capital expense. However, if you expect toeventually sell the demonstrator, include it inyour 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.Under certain circumstances, you may be

able to treat a limited amount of the cost ofcertain qualifying property as a current ex-pense rather than a capital expense. This iscalled the section 179 deduction.

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 DeductionIf you make the choice, you can deduct alimited amount of the cost of qualifying prop-erty you buy for use in your direct-sellingbusiness only in the first year you place theproperty in service.

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 $18,500 for 1998.

If the total cost of qualifying property isless than $18,500, 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 $19,000 for tax year 1999. 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.

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.

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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 property

that 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 of

these requirements, it is not depreciable.The modified accelerated cost recovery

system (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.

Listed Property

Listed property includes property used fortransportation or entertainment and certaincomputers and cellular phones. There areadditional rules and recordkeeping require-ments you must follow when depreciatinglisted property. If listed property is not usedmore than 50% for qualified business useduring any tax year, special rules apply to thesection 179 deduction and the depreciationdeduction. See chapter 4 in Publication 946.

Passenger automobiles. For passengerautomobiles, the total depreciation deduction(including the section 179 deduction) that youcan claim is limited.

For automobiles you place in service dur-ing 1998, your depreciation, including the

section 179 deduction, cannot be more than$3,160 for 1998 (the first tax year of the re-covery period). For 1999 and 2000 (secondand third years), you are limited to a depre-ciation deduction of $5,000 and $2,950, re-spectively. The maximum depreciation ineach succeeding tax year will be $1,775.

You must reduce these limits further ifyour business/investment use is less than100%.

Example. Peter purchased a car this yearfor $4,500 and he used it 60% for business.The total cost of Peter's car that qualifies forthe section 179 deduction is $2,700 ($4,500cost 60% business use). However, Peter islimited to a total section 179 deduction plus

depreciation deduction of $1,896 ($3,160 limit 60% business use).

Additional rules apply if your business/in-vestment use is 50% or less. For more infor-mation, see chapter 4 in Publication 946.

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

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 business expensesyou might have as a direct seller. For moreinformation on business expenses, see Pub-lication 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. Most income taxes cannotbe deducted as business expenses. You cannot deduct federal income taxes. In general,an individual can deduct state and local in-come taxes only as an itemized deduction onSchedule A (1040). However, you can deducta state income tax on gross income (as dis-tinguished from net income) directly attribut-able to a trade or business as a business

expense.

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 taxon the car, for a total of $280. They are

claiming 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 thesetaxes as a separate item.

InterestInterest is the amount charged for the use ofborrowed money. You generally can deductas a business expense all interest you payor accrue 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 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-

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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 if you claim ac-tual expenses for the use of the car.

When to deduct. Under the cash methodof accounting, premiums are not deductibleuntil paid. If you wait until a later tax year topay 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 June1998, you pay $1,200 in premiums for mer-chandise insurance effective July 1998through June 2000 ($50 per month). You candeduct $300 in 1998 ($50 6 months), $600in 1999 ($50 12 months), and $300 in 2000.

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 the following expenses.

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 his

direct-selling business. He had this phonenumber 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-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. Some licenses and fees mayhave to be amortized. See chapter 12 ofPublication 535 for information on amorti-zation.

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 your di-rect 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, ListedProperty, in Publication 946.

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

The expenses of entertaining businessassociates in your home are deductibleonly if they meet the tests discussed un-der Meals and Entertainment, later, andonly if you can prove your expenses asdiscussed under Recordkeeping, later.

The expenses of maintaining your homeas a place of business are deductible onlyif you meet the tests discussed underBusiness 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 Meals andEntertainment. They keep a copy of theirgrocery receipts for these refreshments, andrecord the date, time, and business nature ofeach meeting. Because the meetings are heldin their living room rather than in a specialarea set aside only for business, they cannotdeduct any of their home expenses for themeetings.

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

Exception. Generally, membership feesfor the following types of organizations aredeductible unless one of the main purposesis to conduct entertainment activities formembers or their guests or to provide mem-bers or their guests with access to enter-tainment facilities.

Boards of trade.

Business leagues.

Chambers of commerce.

Civic or public service organizations.

Professional associations.

Trade associations.

Legal and professional fees. You can de-duct as a business expense professionalfees, such as fees charged by accountantsor lawyers, that are directly related to yourbusiness and are ordinary and necessary inthe operation of your business. However, ifthe charges include payments for work of apersonal nature (such as making out a willor the personal portion of your tax return), you

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can deduct only the part of the fee related toyour business 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 itemssuch 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 either the amount you order or 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 the

amount on hand at the beginning and endof the tax year.

Your taxable income is clearly reflectedby this method.

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 certain tests.

Qualifying for a DeductionTo qualify to claim expenses for the businessuse of your home, you must meet the follow-ing tests.

1) Your use of the business part of yourhome must be:

a) Exclusive (however, see Exceptionsto Exclusive Use),

b) Regular,

c) For your trade or business, AND

2) The business part of your home must beone of the following:

a) Your principal place of business,

b) A place where you meet or dealwith clients or customers in thenormal course of your trade orbusiness, or

c) A separate structure (not attachedto your home) you use in con-nection with your trade or business.

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 usepart 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. You do not have to meet theexclusive use test if you use part of yourhome for storing inventory or product sam-ples. You can deduct expenses from usingpart 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, itdoes not matter whether you use it exclu-sively for business.

Example. Your home is the sole fixed

location 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.

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.

Principal place of business. You may havemore than one business location, includingyour home for your business. To determinewhich is your principal place of business, youmust consider all of the facts and circum-stances. If, after considering your businesslocation, one cannot be identified as yourprincipal place of business, you cannot de-duct home office expenses. There are twoprimary factors to consider.

The relative importance of the activitiesperformed at each location.

The time spent at each location.

New rules for 1999. Beginning in 1999,your home office generally will qualify as aprincipal place of business if both of the fol-lowing are met.

You use it exclusively and regularly forthe administrative or management activ-ities of your trade or business.

You have no other fixed location whereyou conduct substantial administrative ormanagement activities of your trade orbusiness.

If you qualify for the deduction in 1999,you will claim it on your tax return due April17, 2000.

Place to meet clients or customers. If youmeet with clients or customers in your homein the normal course of your direct sellingbusiness, even though you also carry onbusiness at another location, you can deductyour expenses for the part of your home usedexclusively and regularly for business if bothof the following apply.

You physically meet with clients or cus-tomers on your premises.

Their use of your home is substantial andintegral to the conduct of your business.Occasional meetings and telephone callsdo not qualify you to deduct expenses forthe business use of your home.

Separate structure. 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.

Where to deduct. If you qualify to deductexpenses for the business use of part of yourhome, you must figure your deduction onForm 8829 and attach it to Form 1040. Youdeduct the expenses on Schedule C (Form1040). For more information, including how tofigure 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 business related function or con-vention. Transportation refers to trips youmake in the area where you live andworkfor example, transportation to call oncustomers or make deliveries in your city andits suburbs.

You must be able to prove your expensesfor travel and transportation. Deductions fortravel and transportation are looked at closelywhen the IRS examines returns. For more

information, see Recordkeeping, later.

TravelIf you temporarily travel away from your taxhome on business, you can deduct your or-dinary and necessary travel expenses.However, you cannot deduct lavish or ex-travagant expenses or those for personal orvacation purposes.

You can deduct all of your travel expensesif your trip was entirely business related. Thisincludes expenses incurred when you attenda seminar, meeting, convention, or otherfunction if you can show that your attendancebenefits your direct selling business. If yourtrip was primarily for business and, while at

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your business destination, you extended yourstay for a vacation, made a nonbusiness sidetrip, or had other nonbusiness activities, youcan deduct your business-related travel ex-penses. These expenses include the travelcosts of getting to and from your businessdestination and any business-related ex-penses at your business destination.

Example. You live in and conduct yourdirect selling business from Atlanta and takea business trip to New Orleans. On your wayhome, you stop in Mobile to visit your parents.

You spend $630 for the 9 days you are awayfrom home for travel, meals, lodging, andother travel expenses. If you had not stoppedin Mobile, you would have been gone only 6days, and your total cost would have been$580. You can deduct $580 for your trip, in-cluding the cost of round-trip transportation toand from New Orleans. The cost of yourmeals is subject to the 50% limit on mealsmentioned later.

If your trip was primarily for personal rea-sons, such as a vacation, the entire cost ofthe trip is a nondeductible personal expense.However, you can deduct any expenses youhave while at your destination that are directlyrelated to your business.

For more information, get Publication 463.

TransportationYou can deduct transportation expenses foryour business. Generally, business trans-portation is traveling between two or moreworkplaces in the same day or between yourhome and a temporary work location. It in-cludes the following kinds of trips you makein the area where you live and work.

Calling on customers.

Making deliveries.

Picking up goods.

Attending 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 shecarries cosmetics does not make her com-muting expense a deductible business ex-pense.

Two places of work. If you work at twoplaces in one day, you can deduct the ex-pense of getting from one to the other. How-ever, if for some personal reason you do notgo directly from one location to the other, youcannot deduct more than the amount it would

have cost you to go directly from the first lo-cation to the second.

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

Meals and

EntertainmentBecause you are in the selling business, youmay 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 present

when 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 Related

or 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 di-rectly related to or associated with the ac-tive conduct of your business.

For more information, see chapter 2 ofPublication 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.

TIP

You do not have to show that busi-ness income or another businessbenefit actually resulted.

It is not necessary to devote more time tobusiness than to the meal or entertainment.However, if the business discussion is only

incidental 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. The following expenses are usually notdirectly related to the conduct of business.

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

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 both of the followingapply.

The expenses are associated with yourdirect-selling business.

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.

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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 generally can-not deduct the cost of entertainment for yourspouse or for the spouse of a business cus-tomer. However, you can deduct these costsif you can show that you had a clear businesspurpose, rather than a personal or social

purpose, for providing the entertainment.

Example. You entertain a business cus-tomer. The cost is an ordinary and necessarybusiness expense and is allowed under theentertainment rules. The customer's spouse

joins you because it is impractical to entertainthe customer without the spouse. You candeduct the cost of entertaining the customer'sspouse as an ordinary and necessary busi-ness expense. Furthermore, if your spouse

joins the party because the customer'sspouse is present, the cost of the enter-tainment for your spouse is also an ordinaryand necessary business expense.

Lavish or extravagant expenses. You

cannot 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. Generally, you can deduct yourbusiness meal expenses while traveling awayfrom home for business (other than amountswhich are lavish or extravagant). However, ifyou entertain a business customer locally andthe conditions discussed earlier are met, thecost of your own meal is deductible only to theextent the cost exceeds the amount youwould normally have spent for personal pur-poses.

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 businessfunction, convention, or reception. Exceptionsto the 50% limit are discussed in Publication463.

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 must

make an allocation if a hotel includes one ormore 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 theparty, 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 necessary

business expense.

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

at 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 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. It

will, 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 promotional

material to be used on the businesspremises of the recipient.

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

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. If the not-for-profitlimits apply, you cannot use a loss from directselling to offset any other income 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 you

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and 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. The following aresome of the factors to consider.

Whether you carry on your direct sellingin a businesslike manner and maintaincomplete and accurate books and rec-ords.

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 are

normal 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.

If the IRS inquires about your tax return, youmay be asked to provide proof that your directselling activity is carried on for profit. How-ever, your direct selling is presumed carriedon for profit if it produced a profit in at least3 of the last 5 tax years, including the currentyear, unless the IRS establishes to the con-trary.

If you are starting a business and do nothave 3 years showing a profit, you may wantto take advantage of this presumption later,after you have the 5 years of experience al-lowed by the test. For more information onpostponing any determination that your directselling is not carried on for profit, see Using

the presumption later under Not-for-ProfitActivitiesin chapter 1 of Publication 535.

Recordkeeping

RECORDS

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

certain 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 at

all times for inspection by the IRS. Youmust keep the records as long as theymay be needed in the administration ofany Internal Revenue law. You sh

Documents

US Internal Revenue Service: p911--1998