US Internal Revenue Service: p911--2000

8/14/2019 US Internal Revenue Service: p911--2000

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ContentsImportant Changes for 2000 ............. 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 Local Transportation ...... 9

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

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

Not-for-Profit Limit ............................. 12

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

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

How To Get Tax Help ......................... 18

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

Important Changesfor 2000

Standard mileage rate. The standard mile-age rate for the cost of operating your car in2000 is 321/2 cents a mile for all businessmiles.

Accounting methods. Certain small busi-ness taxpayers may be eligible to adopt orchange to the cash method of accounting andmay not be required to account for invento-ries. For more information, including the defi-nition of a small business taxpayer, see Pub-lication 553, Highlights of 2000 TaxChanges.

Photographs of missing children. TheInternal Revenue Service is a proud partnerwith the National Center for Missing and Ex-ploited Children. Photographs of missingchildren selected by the Center may appearin this publication on pages that would other-wise be blank. You can help bring thesechildren home by looking at the photographs

and calling 1800THELOST (18008435678) if you recognize a child.

IntroductionThis publication explains general tax infor-mation of interest to direct sellers. It covershow to treat income, expenses, and otheritems related to having a direct-sales busi-ness. It also illustrates two filled-in tax formsthat most direct sellers must file along withForm 1040. They are Schedule C (Form1040), Profit or Loss From Business, andSchedule SE (Form 1040), Self-EmploymentTax.

Departmentof theTreasury

InternalRevenueService

Publication 911Cat. No. 60031B

Direct Sellers

For use in preparing

2000 Returns


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Who is a direct seller? Some of the char-acteristics that identify direct sellers are listedbelow. A more complete discussion is con-tained 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.

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.

Comments and suggestions. We welcomeyour comments about this publication andyour suggestions for future editions.

You can e-mail us while visiting our web

site at www.irs.gov/help/email2.html.You can write to us at the following ad-

dress:

Internal Revenue ServiceTechnical Publications BranchW:CAR:MP:FP:P1111 Constitution Ave. NWWashington, DC 20224

We respond to many letters by telephone.Therefore, it would be helpful if you wouldinclude your daytime phone number, includ-ing the area code, in your correspondence.

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

15B Employer's Tax Guide to FringeBenefits

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 Tax Help near the endof this publication for information about get-ting publications and forms.

Who Is a Direct Seller?

You are a direct seller if you meet allthe fol-lowing 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 in a home orother place that is not a per-manent retail establishment,or

b) Delivering or distributing 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 or 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 not

make 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 (your downline group)and your earnings depend in part on howmuch they sell. Recruiting, motivating, andtraining are examples of attempts to increasesales.

Host or hostess. You are not a direct sellerif you simply host a party at which sales aremade. Nevertheless, some information in this

publication may still apply to you.The gift you receive for giving the party

is 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 under Mealsand Entertainment, later. These expenses aredeductible as miscellaneous itemized de-ductions subject to the 2% limit on ScheduleA (Form 1040), but only up to the amount ofincome you receive for giving the party. SeeNot-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, seePublication 583.

Employer IdentificationNumber (EIN)EINs are used to identify the tax accounts ofemployers, certain sole proprietors, corpo-rations, partnerships, estates, trusts, andother entities.

If you do not already have an EIN, youneed to get one if any of the following apply

to your business.1) You have employees.

2) You have a Keogh or other qualified re-tirement plan.

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

4) You file returns for:

a) Employment taxes,

b) Excise taxes, or

c) Taxes on alcohol, tobacco, orfirearms.

Use Form SS4 to apply for an EIN.

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Business TaxesThe following kinds of federal business taxesmay apply to direct sellers.

Income tax

Self-employment tax

Employment taxes

Your state, county, or city may imposeother kinds of tax and licensing obligations.

Income tax. All businesses except partner-ships must file an annual income tax return.(Partnerships file an information return.) Forexample, if you operate your direct-sellingbusiness as a sole proprietor, you must fileSchedule C or Schedule CEZ as part of yourindividual income tax return (Form 1040).You are a sole proprietor if you are self-employed (work for yourself) and are the onlyowner of your unincorporated business.

Self-employment tax. Self-employment taxis the social security and Medicare tax forthose who work for themselves. It is similarto the social security and Medicare taxeswithheld from the pay of wage earners. If youare a direct seller, you generally must pay this

tax on your income from direct selling. Youmust pay it whether you are a sole proprietoror a partner in a partnership. Use ScheduleSE (Form 1040) to figure your self-employ-ment tax. For more information about self-employment tax, see Publication 533.

Social Security Administration (SSA)time limit for posting self-employment in-come. Generally, the SSA will give you creditonly for self-employment income reported ona tax return filed within 3 years, 3 months, and15 days after the tax year you earned the in-come. If you file your tax return or report achange in your self-employment income afterthis time limit, SSA may change its records,but only to remove or reduce the amount.SSA will not change its records to increase

the amount of your self-employment income.

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.

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

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 likely withholds income taxfrom your pay. By revising your W4, youcan increase your withholding to cover

the income from your job and from directselling.

Estimated tax. If you do not pay taxthrough withholding, or do not haveenough withheld, you may have to payestimated tax.

Estimated tax is used to pay both income andself-employment taxes. For more informationon estimated tax, see Publication 505.

Exceptions. You do not have to pay esti-

mated tax if you meet either of the followingexceptions.

You had no 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 2001, minusany 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 forunderpayment of tax. You can use Form 2210to figure the penalty. Or, in most cases, youcan have the Internal Revenue Service figurethe penalty for you. See the Form 2210 in-structions to determine if you must completethe 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 placing

the 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 January 31,2001.

You must file Copy A of Form 1099MISCwith the Internal Revenue Service by Febru-ary 28, 2001. If you file electronically, youhave until April 2, 2001. Use Form 1096 tosummarize and transmit Form 1099MISC.See the instructions for Form 1096 for theaddress where you must file Form 1096 andthe accompanying Forms 1099MISC.

PenaltiesThe law imposes penalties for noncompliancewith tax laws. Some of these penalties arediscussed next. If you underpay your tax dueto fraud, you could be subject to a civil fraudpenalty. In certain cases, you could be sub-

ject 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 cannotexceed 25% of your tax, and it is reduced bythe failure-to-pay penalty (discussed next) forany month both penalties apply. However, if

you file your return more than 60 days afterthe due date or extended due date, the mini-mum penalty is the lesser of $100 or 100%of the unpaid tax. You will not have to paythe penalty if you can show reasonable causefor 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. This penalty does not apply during theautomatic 4month extension of time to file ifyou paid at least 90% of your actual tax li-ability before the original due date for yourreturn.

The monthly rate of the failure to paypenalty is half the usual rate (.25% insteadof .50%) if an installment agreement is in ef-fect for that month. You must have filed yourreturn by the due date (including extensions)to qualify for this reduced penalty.

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 for 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 you can show rea-sonable cause accompanied by good faith.

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

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

Substantial understatement of income

tax. For an individual, income tax is sub-stantially understated if the understatementexceeds the greater of the following amounts.

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.

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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) issubject to a penalty of $50 for each state-

ment. If the failure is due to intentional disre-gard of the requirement, the minimum penaltyis $100 per statement with no maximumpenalty.

Failure to supply identification number. Ifyou do not include your identification numberor the identification number of another personwhere required on a return, statement, orother document, you will be subject to apenalty of $50 for each failure. You will alsobe subject to the penalty if you do not giveyour identification number to another personwhen it is required on a return, statement, orother document.

You will not have to pay the penalty if youare able to show the failure was due to rea-sonable cause and not willful neglect.

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

Accounting PeriodsWhen preparing a statement of income andexpenses, you must use books and recordsfor a specific interval of time called an ac-counting period. The annual accounting pe-riod for your tax return is called a tax year.You can generally use one of the following taxyears.

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 generally cannotchange your tax year without IRS approval.

For more information, see Publication538.

Accounting MethodsAn accounting method is a set of rules usedto determine when and how income and ex-penses are reported. You must use the sameaccounting method from year to year. The twomost common accounting methods are thecash method and an accrual method. A thirdmethod, called a hybrid method, is generallya combination of cash and accrual.

The text and examples in this publicationgenerally assume you use the calendar yearas your tax year and either the cash or hybridmethod as your accounting method. If inven-tories are needed to account for your income,you must use an accrual method, discussedlater, for your sales and purchases. For more

information on accounting methods, seePublication 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 they were incurredin an earlier year.

Check received. If you receive a checkbefore the end of the tax year, you must in-clude it in income for the year you receive iteven though you do not cash or deposit it untilthe next 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 only be deducted 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 2000. 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 2000. You cannot deduct the$54 on your 2000 return, even if you use thecash method of accounting. However, youcan deduct half of the $54 in 2001 and theother half in 2002.

Business IncomeYou must report all income you receive as adirect seller. This includes any of the follow-ing.

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 receivefrom your selling business.

You must report this income regardless ofwhether it is reported to you on an informationreturn.

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 some of your customers buy their pro-ducts directly from the company, you, as thesales agent, do not have any sales incomefrom these transactions. You will generallyreceive a commission or bonus for makingthe sale, but you will have no direct incomefrom the sale itself. If all of your sales arehandled this way, the rules in this section donot apply to you. Report your commissionsas other business income. For more infor-mation, see Other Income, later.

Depending on the company with whichyou are affiliated and the nature of its mar-

keting and compensation plan, you may haveincome from sales, commissions, bonuses,or all three.

Example 1. Your customers pay you theretail price for goods they order. You forwardthe orders and payments to the company.The company sends the merchandise to fillthe orders. The company also sends you acommission.

You are acting as a sales agent for thecompany. You did not purchase the productsto sell to your customers. Your payment from

the company is a commission, not incomefrom sales. Include the commission in yourgross receipts. Do not include the amountyour customers pay for 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 yourcustomers. Your customers pay the companythe remainder of the retail price (usually cashon 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 for

the goods you sell them, either when you taketheir orders or when you make deliveries.After your customers place orders, you orderthe goods from the company (or from a directseller you work under). You either send themoney directly to the company with your or-ders, or you are billed later. In either case,you are able to charge your customers morethan you pay for the goods.

You are buying products wholesale andselling them retail. The full amount receivedfrom your customers is income from sales.

Example 4. You keep a supply of goodsthat your customers regularly buy from you.This allows you to fill their orders without de-lay. You order and pay for the goods before

your customers request them.You have purchased goods to resell tocustomers. The full amount received fromyour customers is income from sales.

Example 5. You have recruited severalother direct sellers who order their productsthrough you. Commissions or bonuses paidto you by the company are shared with thedirect sellers in your group based on sales,purchases, or some other formula establishedby the company whose products you sell. Youkeep the portion of the commissions you arenot required to distribute to the direct sellersin your group.

The bonuses you receive from the com-pany are included in gross receipts as com-missions, not as income from sales.

Gross ProfitGross receipts minus cost of goods soldequals gross profit.

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) Subtract the amount (if any) your cus-tomers paid that you had to return in theform of refunds, rebates, or other allow-

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ances. Show this on your tax return (line2 of Schedule C).

3) Finally, subtract the cost of the goodssold. To figure the cost of goods sold,you must know the value of the inventoryat the beginning and end of the year, andyour purchases during the year. SeeCost of Goods Sold, next, and Inventory,later.

Cost of Goods SoldTo figure your cost of goods sold, follow thesesteps.

1) Start with the value of your inventory atthe beginning of the tax year. This isusually 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.

3) Subtract from this total the inventory on

hand at the end of the year. The differ-ence is your cost of goods sold duringthe year.

Example 1. Janet sells cookware on thesales-party plan. On December 31, 1999, shedid not have any cookware on hand to sell tocustomers thus she does not have a begin-ning inventory for 2000.

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 herown use. She purchased $5,100 [$5,270 ($130 + $40)] worth of goods to sell to cus-tomers.

On December 31, 2000, Janet had several

sets of cookware in boxes awaiting deliveryto customers. The cost of these sets was$220. Her ending inventory for the year is$220, and her cost of goods sold for 2000 is$4,880 ($0 beginning inventory + $5,100purchases $220 ending inventory).

Example 2. Lisa is a direct seller of cos-metics. She has an established clientele andknows what items are steady sellers. Whenthe company has a special sale on theseitems, she buys extra quantities for futuresales. She had merchandise costing $200 onhand at the end of 1999 (which would be herbeginning inventory for 2000) and merchan-dise costing $175 at the end of 2000. Duringthe year she purchased $3,250 of merchan-dise. Purchase returns and allowances were$50. She withdrew $200 of cosmetics forpersonal use. Lisa figures her cost of goodssold for 2000 as follows:

Lisa figures her gross profit by subtractingthe cost of goods sold from her gross receipts($5,375) for 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 includesall postage and freight charges incurred.

Figure your purchases at the actual priceyou pay. Deduct a cash discountor a tradediscount in figuring the cost of your pur-chases. A cash discount or a trade discountis the difference between the invoice priceand the actual price you have to pay.

Purchase returns and allowances. Sub-tract purchase returns and allowances fromyour total purchases for the year when figur-ing cost of goods sold. This includes any re-bates or refunds you received off the pur-chase price. It also includes any credit youreceived for returned merchandise.

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 longeravailable for sale to customers. For example,

if you sell a particular kind of soap and givesome as a gift or use some yourself, you mustwithdraw the soap from inventory because itis no longer available for sale. Follow thisprocedure for all products withdrawn for per-sonal use, even if you are using the productonly to familiarize yourself with its character-istics or to demonstrate loyalty to the com-pany whose products you sell.

InventoryMany direct sellers have little or no inventory.Others keep a considerable inventory onhand. In either case, if you have income fromsales, you need to know how to figure yourinventory at the end of each tax year. Yourinventory practices must be consistent fromyear to 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 the prior year'sending inventory. 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 theend 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 receivedthe goods. You may also have title to goodsthat were shipped to you but not yet received.If the risk of loss during shipment is yours,you will probably have title to the goods dur-ing shipment. If you buy merchandise that issent C.O.D., title passes when payment anddelivery occur.

Goods not yet paid for. You may havetitle to goods not yet paid for. If you are billedfor merchandise you must usually pay the bill

Gross receipts ............................................ $5,375 within a certain time, whether or not you havesold the goods. In this case, you have titleto the goods and must include them in in-ventory provided they are not sold by the endof 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 with theitems in inventory. Most direct sellers will beable to 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 may 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, and other necessarycosts to acquire the items. Subtract any dis-counts you received.

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 withoutfirst obtaining IRS approval.

Other IncomeYou must report on your tax return all incomeyou receive from your business unless it isexcluded by law. In most cases, your busi-ness income will be in the form of cash,checks, and credit card charges. But businessincome can be in other forms, such as prop-erty or services. These and other types of in-come are explained next.

Commissions, bonuses, and percentages.Many direct sellers receive a commission ontheir sales or purchases. Your commissionmight be called a bonus or percentage,and it might be based on both your own salesand the sales of other direct sellers workingunder you, or on purchases from the com-pany with which 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 can usually deduct the partyou pay to others as a business expense. For

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

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

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

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

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

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more information, see Commissions underOther Expenses, later.

Prizes, awards, and gifts. If you receiveprizes, awards, or gifts in your role as a di-rect seller, report their full value as businessincome. The following are examples of itemsthat 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.

Membership in organizations or clubs.

Tickets to sporting events, shows, orconcerts.

Value of goods or services received. Re-port income received in the form of goods orservices at their fair market value. Fairmarket value is the price agreed on betweena willing buyer and a willing seller when bothhave reasonable knowledge of the facts andneither 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, see Publica-tion 525.

Capital ExpensesYou must capitalize some costs rather thandeduct them. These costs are a part of yourinvestment in your business and are called

capital expenses.Although you generally cannot take acurrent 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 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. See chapter 9 of Publication535 for information on how to treat thesecosts.

Business assets. The cost of any asset(property) that will last substantially be-yond the tax year it is placed in serviceis a capital expense. Examples of busi-ness assets include: office furniture,business vehicles, and storage shelves.See Cost Recovery, later.

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, would be a capital ex-pense.

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 the products in her own home.When potential customers come to her house,she can show them drapes she bought from

the company, as well as her 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 a deduction 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 you use as a demonstrator for oneyear or less and the demonstrator itself is notavailable for purchase by your customers, itscost is a business expense.

If the demonstrator itself can be bought

by your customers, include it in your inven-tory.

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 number ofunused 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 personal use. She subtractsthe cost of the item from her purchases for theyear, as discussed under Cost of Goods 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 oneyear and are not sold to customers. Some areruined and thrown away. Their cost is abusiness expense.

More than one 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 he

periodically 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. Shetries to use her demonstrators as long aspossible. She puts the books in plastic jacketsto protect them, and ordinarily only stops us-ing them as demonstrators when the com-pany comes out with a new edition. Janetnever sells the old demonstrators. She canrecover the cost of the books she uses as

demonstrators as discussed under Cost Re-covery, next.

Cost RecoveryYou can usually recover your cost for capitalexpensessubtract them from incomeovera number of years. Each year a part of yourbasis is recovered through depreciation oramortization. Use depreciation to recovercapital expenses for most tangible businessassets. Use amortization to recover the costof intangible assets, such as start-up costs.Amortization is discussed further in chapter9 of Publication 535.

Under certain circumstances, you may beable to treat a limited amount of the cost ofqualifying property as a current expenserather than a capital expense. This is calledthe section 179 deduction, discussed next.

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

Section 179 DeductionYou can elect to deduct all or part of the costof certain qualifying property in the year youplace it in service. Property is placed in ser-vice when it is ready and available for a spe-

cific use.

Qualifying property. Qualifying property in-cludes tangible personal property for whichdepreciation is allowable. See chapter 2 inPublication 946 for more information.

Maximum dollar limit. The total section 179cost you can choose to deduct for 2000 is$20,000.

If the total cost of qualifying property isless than $20,000, your section 179 deductioncannot be more than the cost of the property.

TIP

The maximum section 179 deductionincreases to $24,000 in 2001 and$25,000 in 2003.

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Taxable income limit. The total cost you candeduct each year is further limited to the tax-able income from the active conduct of anytrade or business during the year.

Any cost not deductible in one year be-cause of this limit can be carried to the nexttax year.

More information. For more information,see chapter 2 in Publication 946.

DepreciationIf you do not choose a section 179 deductionor you choose a section 179 deduction anddo not recover all your cost, you can take adepreciation deduction for part or all of thecost you did not claim as a section 179 de-duction.

Property whose cost can be recoveredthrough depreciation is depreciable property.Depreciable property may be tangible or in-tangible. Intangible property is commonlyamortized.

1) Tangible property is property you cansee or touch and includes both real andpersonal property.

a) Real property is land and generally

anything built on land, growing onland, or attached to land. However,land itself is never depreciable.

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

2) Intangible property generally has valuebut you cannot see or touch it. Intangibleproperty includes items such as copy-rights, franchises, trademarks, and tradenames.

You can depreciate property if it meets thefollowing requirements.

It is used in business or held for the pro-

duction of income. It is something that wears out, decays,

gets used up, becomes obsolete, or losesvalue from natural causes.

It is expected to last more than one year.In other words, it has a useful life thatextends substantially beyond the year itis placed in service.

You must use the modified acceleratedcost recovery system (MACRS) for most tan-gible depreciable property placed in serviceafter 1986.

For more information about the depreci-ation of property placed in service after 1986,see Publication 946. It contains a detaileddiscussion of MACRS.

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

Listed PropertyListed property includes property which lendsitself to personal use such as transportationor entertainment equipment, certain comput-ers and cellular phones. There are additionalrecordkeeping requirements and rules youmust follow when depreciating listed property.If listed property is not used more than 50%for a qualified business use during any taxyear, special rules apply to the section 179

deduction and the depreciation deduction.See chapter 4 in Publication 946.

Passenger automobiles. For passengerautomobiles, the total depreciation deduction(including the section 179 deduction) you canclaim is limited.

For automobiles placed in service during2000, your depreciation, including the section179 deduction, cannot be more than $3,060.For 2001 and 2002, the maximum depreci-ation deduction is $4,900 and $2,950, re-spectively. The maximum depreciation de-duction for each year after 2002 is $1,775.

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

Example. Peter purchases a car this yearfor $4,500 and he uses it 60% for business.He chooses to take a section 179 deductionfor the car. The cost of Peter's car that quali-fies for the section 179 deduction is $2,700($4,500 60%). However, Peter's section 179deduction is limited to $1,836 ($3,060 60%).

Business ExpensesThe operating costs of running your businessare called business expenses. These arecosts you do not have to capitalize or includein the cost of goods sold.

Keep business expenses separate frompersonal expenses. If you have an expensethat is partly for business and partly personal,deduct only the business part.

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. A neces-saryexpense is one that is appropriate andhelpful for your business. An expense doesnot have to be indispensable to be considerednecessary.

This section discusses business expenses

you might have as a direct seller. For moreinformation on business expenses, see Pub-lication 535.

Salaries and WagesYou can generally deduct the pay you giveyour employees for the services they performfor your business. The pay may be in cash,property, or services. It may include wages,salaries, vacation allowances, bonuses,commissions, and fringe benefits.

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,see Publications 15, 15B, and chapter 2 inPublication 535.

TaxesYou can deduct as a business expense vari-ous federal, state, local, and foreign taxesdirectly attributable to your direct-sellingbusiness. Some of these taxes were dis-cussed earlier under Business Taxes andothers are discussed next.

Income taxes. Most income taxes, includingfederal income taxes, cannot be deducted asa business expense. You can generally de-duct personal state and local income taxes

as an itemized deduction on Schedule A(Form 1040).

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 can also deduct registration fees forthe right to use property within a state or localarea.

Example. May and Julius Winter drovetheir car 7,000 business miles out of a total

of 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 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.See Publication 551, Basis of Assets, for in-formation about the basis of property.

CAUTION

!Do not deduct state and local salestaxesimposed on the buyerthat 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. Do not deduct these taxesas a separate item.

InterestInterest is the amount charged for the use ofborrowed money. You can generally deductall interest you pay or accrue in the tax yearon a debt related to your business. To takethe deduction, you must have a true obli-gation to pay a fixed or determinable sum ofmoney.

No deduction is allowed for interest paidor accrued on personal loans. If a loan is partbusiness and part personal, allocate the in-terest between the two. For more information,see chapter 5 in Publication 535.

Example. During the tax year, you paid$600 interest on a car loan. You used the car60% for business and 40% for personal pur-

poses. You can deduct $360 (60% x $600)as a business expense on your Schedule C(Form 1040) or Schedule CEZ (Form 1040).The remaining interest ($240) is a non-deductible personal expense.

InsuranceYou can generally deduct premiums you payfor the following kinds of insurance related toyour trade or business. This list is not all in-clusive.

Fire, theft, flood, or similar insurance.

Car and truck insurance on vehicles usedin your business if you do not use the

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standard mileage rate to figure your carexpenses.

Credit insurance to cover losses fromunpaid debts.

Liability insurance.

Use and occupancy and business inter-ruption insurance. This insurance paysfor 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 7 in Publication 535 for informa-tion on when life insurance premiums aredeductible.

Business and personal. If you pay premi-ums for insurance coverage that is bothbusiness and personal, deduct only the partthat pays for business coverage. For exam-ple, if you use your car 25% in your direct-selling business and 75% for personal trans-portation, you can deduct 25% of your carinsurance premiums if you claim actual ex-penses for the use of the car.

When to deduct. Under the cash methodof accounting, premiums are not deductible

until paid. If you make an advance paymenton an insurance policy that covers more thanone tax year, deduct only the part that buysinsurance for the current tax year. You mustwait until the following tax year to deduct thepart that buys insurance for that year, and soon.

Example. You are a direct seller. In June2000, you pay $1,200 in premiums for theftinsurance effective July 2000 through June2002 ($50 per month). You can deduct $300in 2000 ($50 6 months), $600 in 2001 ($50 12 months), and $300 in 2002.

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,report all or part of the dividend as businessincome. For more information on recovery ofprior deductions, see chapter 1 of Publication535.

TelephoneYou cannot deduct the cost of basic localtelephone service (including any taxes) for thefirst telephone line you have in your home,even though you may have an office in yourhome. However, charges for business longdistance phone calls on that line, as well asthe cost of a second line into your home usedexclusively for business, are deductible busi-ness expenses.

Example 1. Leo had a separate tele-phone line installed in his home for hisdirect-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 and $45 forlong-distance calls).

The total charge for long-distance busi-ness calls on their bill is $31. Mary and

George 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 business

calls 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 and regulatoryfees paid each year to state or local govern-ments are generally deductible business ex-penses. Some licenses and fees may haveto be amortized. See chapter 9 of Publication535 for more information.

Catalogs. The cost of catalogs you use inyour selling business for more than one yearmust be capitalized. The cost can then berecovered as explained under Cost Recovery,earlier. If the catalogs are used in your selling

business for one year or less, you can deducttheir full cost in the tax year you pay for them.

Commissions. If you must pay a bonus,percentage, or other type of commission todirect sellers working under you, you can de-duct it. Report the full amount of any com-missions you receive as business income,and deduct the commissions you pay as or-dinary and necessary business 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 depreciate it ifyou use it more than 50% in your business.For more information, see chapter 4 in Publi-cation 946.

Home meetings. If you have businessmeetings in your home, you can deduct ex-penses for the meetings only when they meetcertain tests.

The expenses of entertaining businessassociates in your home are deductibleif they meet the rules discussed underMeals and Entertainment, later, and youcan prove your expenses as discussedlater under Recordkeeping.

The expenses of maintaining your homeas a place of business are deductible ifyou 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.

Club dues and membership fees. Gener-ally, you cannot deduct amounts you pay orincur for membership in any club organizedfor business, pleasure, recreation, or anyother social purpose. This includes countryclubs, golf and athletic clubs, hotel clubs,sporting clubs, airline clubs, and clubs oper-ated to provide meals under circumstancesgenerally considered to be conducive tobusiness discussions.

Exception. None of the following organ-izations will be treated as a club organized forbusiness, pleasure, recreation, or other socialpurpose, unless one of its main purposes isto conduct entertainment activities for mem-bers or their guests or to provide membersor their guests with access to entertainmentfacilities.

Boards of trade.

Business leagues.

Chambers of commerce.

Civic or public service organizations.

Professional associations.

Trade associations.

Legal and professional fees. Legal andprofessional fees, such as fees charged byaccountants, that are ordinary and necessaryexpenses directly related to operating yourbusiness are deductible as business ex-penses. However, you usually cannot deduct

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legal fees paid to acquire business assets.Those are added to the basis of the property.

If the fees include payments for work of apersonal nature (such as making a will), youcan take a business deduction only for thepart of the fee related to your business. Thepersonal portion of legal fees for producingor collecting taxable income, doing or keepingyour job, or for tax advice may be deductibleon Schedule A (Form 1040) if you itemizedeductions. See Publication 529, Miscella-neous Deductions.

Tax preparation fees. You can deduct as atrade or business expense the cost of pre-paring that part of your tax return relating toyour business as a sole proprietor. The re-maining cost may be deductible on ScheduleA (Form 1040) if you itemize deductions.

You can also take a business deductionfor the amount you pay or incur in resolvingasserted tax deficiencies against your busi-ness as a sole proprietor.

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 it canbe based on other criteria.

Supplies. Unless you have deducted thecost in any earlier year, you generally candeduct the cost of materials and supplies ac-tually consumed and used during the taxyear.

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.

Your taxable income is clearly reflectedby this method.

Business Useof Your HomeMany direct sellers work out of their own

homes and have business expenses for usingtheir homes. You can deduct certain ex-penses for using your home if you meet thefollowing tests.

Qualifying for a DeductionTo deduct expenses related to the businessuse of your home, you must meet the follow-ing tests. Even then your deduction may belimited. See Deduction limit, later.

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

a) Exclusive (however, see Exceptionunder Exclusive use, later),

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) used in connectionwith your trade or business.

Exclusive use. Exclusive use means youuse a specific part of your home solely forcarrying on your direct-selling business. Youdo notmeet the exclusive use test if you usethe area in question for your direct-sellingbusiness and that same part for personalpurposes.

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. If you use part of your homefor the storage of inventory or product sam-ples, you can claim expenses for the businessuse of your home without meeting the exclu-sive use test. However, you must meet all thefollowing tests.

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.

Example. Your home is the sole fixedlocation of your business. You regularly usehalf your basement for storing inventory aswell as for personal purposes. You can de-duct the expenses for the storage space eventhough this part of your basement is not usedexclusively for business.

Regular use. Regular use means you usea specific part of your home for business ona continuing basis. Occasional or incidentalbusiness use of part of your home does notmeet the regular use test even if you do notuse that part for any other purpose.

Principal place of business. Your home of-fice will qualify as a principal place of busi-ness if you meet both the following require-ments.

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

2) You have no other fixed location whereyou conduct substantial administrativeor management activities of your tradeor business.

Alternatively, if you do business at morethan one location and your home does not

qualify as your place of business based onthese rules, you determine your principalplace of business based on the followingfactors.

1) The relative importance of the activitiesperformed at each location.

2) The time spent at each location if therelative importance factor does not de-termine your principal place of business.

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 boththe 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.

You do not qualify to deduct expenses forthe business use of your home if you haveonly occasional meetings or telephone calls.

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 your busi-ness. This structure does not have to be yourprincipal place of business or a place whereyou meet clients or customers.

Deduction limit. If the gross income from thebusiness use of your home equals or exceedsyour total business expenses (including de-preciation), you can deduct all your businessexpenses. If your gross income is less thanyour total business expenses, the deductionfor certain expenses for the business use ofyour home is limited.

Where to deduct. If you qualify to deductexpenses for the business use of your home,you must figure your deduction on Form 8829and attach it to Form 1040. You deduct theexpenses on Schedule C (Form 1040).

More information. For more information,including how to figure the deduction, seePublication 587.

Travel and LocalTransportationTravel expenses generally are those businessrelated expenses for trips that require you tospend the night away from home for ex-ample, the cost of travel to a distant city toattend a business-related function or con-vention. Local transportation expenses gen-erally are those business related expenses fortrips you make in the area of your tax home

for example, the cost of transportation tocall on customers or make deliveries in thecity where you work and its 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 moreinformation, see Recordkeeping, later.

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TravelGenerally, your tax home is your regularplace of business or post of duty, regardlessof where you maintain your family home.

If you temporarily travel away from yourtax home on business, you can deduct yourordinary and necessary travel expenses. Youcannot deduct lavish or extravagant expensesor those for personal or vacation purposes.

You can deduct all your travel expenses,subject to certain limits, if your trip was en-tirely business related. This includes ex-

penses for attending a seminar, meeting,convention, or other function if you can showthat your attendance benefits your business.If your trip was primarily for business and,while at your business destination, you ex-tended your stay for a vacation, made anonbusiness side trip, or had other nonbusi-ness activities, deduct only your business-related travel expenses. These expenses in-clude the travel costs of getting to and fromyour business destination and any business-related expenses at your business destina-tion.

Example. You live in and conduct yourdirect selling business from Atlanta and takea business trip to New Orleans. On your way

home, you stop in Mobile to visit your parents.You spend $830 for the 9 days you are awayfrom home for transportation, meals, lodging,and other travel expenses. If you had notstopped in Mobile, you would have been goneonly 6 days, and your total cost would havebeen $730. You can deduct $730 for your trip,including the cost of round-trip transportationto and from New Orleans. The cost of yourmeals is subject to the 50% limit on mealsexplained 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 directly

related to your business.For more information, see Publication 463.

Local TransportationYou can deduct local transportation expensesfor your business. Generally, local transpor-tation expense is the cost of getting from oneworkplace to another in the course of yourbusiness when traveling within the city orgeneral area that is your tax home, or of get-ting from your home to a temporary work lo-cation. It includes the following kinds of tripsyou make in the area where you live andwork.

Visiting clients or customers.

Attending business meetings away fromyour workplace.

Transportation expenses include train, bus,and cab fares, car rental fees, and the costof driving and maintaining your car for busi-ness transportation. Meals and lodging arenot 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 works full time as a bankteller. She also sells cosmetics part time toher co-workers at the bank. After her cus-tomers select items from a catalog, she sendsthe orders to the cosmetics company. Shedelivers the items to the bank when she re-ceives 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 workplace to theother. However, if you do not go directly fromone location to the other, deduct only theamount it would have cost you to go directlyfrom the first location to the second.

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

Meals andEntertainmentBecause you are in the selling business, youmay take business associates to lunch orotherwise entertain them. The cost can be adeductible business expense. However, cer-tain conditions must be met before you cantake a deduction for business meals andentertainment, and you generally can onlydeduct 50% of the cost. This section dis-cusses those rules.

Meals. Include as meals the amounts spenton food and beverages and the taxes and tipson those amounts. Generally, no deduction isallowed unless you or your employee is

present when the food or beverages are pro-vided.

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 yourcustomers personal, living, or family needs,such as furnishing a hotel suite or a car.However, see Not directly related, later.

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, allthe 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 from each

entertainment expense.

It is not necessary to devote more time tobusiness 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 you are not there,or there are substantial distractions that pre-vent you from actively conducting business.The following are situations where there aresubstantial distractions.

1) A meeting or discussion at a nightclub,theater, or sporting event.

2) A meeting or discussion during what isessentially a social gathering, such as acocktail party.

3) A meeting with a group that includespersons who are not business associ-ates at places such as cocktail lounges,country clubs, golf clubs, athletic clubs,

or vacation resorts.

You may prove the meal or entertainmentis directly related by clearly establishing youhad 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 youclearly show otherwise.

Associated. You can deduct meal andentertainment expenses that do not meet thedirectly-related test if both the following apply.

The expenses are associated with yourdirect-selling business.

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

An ordinary and necessary meal or enter-tainment expense is generally associated withyour direct-selling business if you can showyou had a clear business purpose for the ex-pense. The purpose may be to get new busi-ness or to encourage the continuation of anexisting business relationship.

Substantial business discussion. Whethera business discussion is substantial dependsupon the facts and circumstances in each

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case. You must show that you actively en-gaged in a discussion, meeting, negotiation,or other business transaction to get incomefor your business or another specific businessbenefit.

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.Deduct only the business part. If you cannotestablish the part of the expense for eachperson participating, you can allocate the ex-pense to each participant on a pro-rata basis.For example, if you entertain a group of 11(including yourself)three business prospectsand seven social guestsdeduct only 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 costs

if you can show that you had a clear businesspurpose, rather than a personal or socialpurpose, 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. 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. Generally, you can deduct yourbusiness meal expenses while traveling awayfrom home for business (other than lavish orextravagant amounts). However, if you en-tertain a business customer locally and theconditions discussed earlier are met, the costof your own meal is deductible only to theextent the cost exceeds the amount youwould normally have spent for personal pur-poses.

LimitYou can usually 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.

Taxes and tips related to a business mealor entertainment activity are included in theamount subject to the 50% limit. Expensessuch as cover charges to a nightclub, rent fora room where you hold a dinner or cocktailparty, or the amount paid for parking at asports arena are subject to the 50% limit.However, the cost of transportation to andfrom a business meal or entertainment activitythat is otherwise allowable is not subject tothe 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 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 amount

is 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).

Exceptions to the 50% limit are discussedin Publication 463.

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 next, you can deduct thecost 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 must report thefair 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 at the same time you purchase goodsyou sell, their cost will be included in the costof goods sold. You cannot deduct their costagain as a business expense. However, if

you purchase the gifts separately from thegoods you sell, deduct their cost as an ordi-nary 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 sporting 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 prizes

as 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 can

deduct their costs as an ordinary and neces-sary business expense.Do not deduct the cost of the same item

twice. If the item was included in inventory,you cannot later deduct it as a business ex-pense. The item will already be part of thecost of goods sold.

Gift limit. Do not deduct more than $25 forbusiness gifts you give directly or indirectly toany one person during the year (see the ex-ceptions discussed later). You can deductonly business gifts. Personal gifts are notdeductible.

Figuring the limit. A gift to the spouse (orfamily member) of a customer is generally

considered an indirect gift to the customer.However, if you have bona fide independentbusiness connections with the spouse (orfamily member) and the gift is not intended forthe customer's eventual use, this rule doesnot apply.

If you and your spouse both give gifts, youare treated as one taxpayer. It does not mat-ter whether you have separate businessesor independent connections with the 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 considered

an 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 business

premises 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.

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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.

This limit applies, for example, if you gointo direct selling primarily for the businessdeductions you can take. It also applies if youbecome a direct seller only so you and your

friends can buy products at reduced rates.If the not-for-profit limit applies, you must

take 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 the facts about the activity. Noone factor alone is decisive. The following arefactors 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 indicates 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 of

operation 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 to becarried on for profit if it produced a profit inat least 3 of the last 5 tax years, including thecurrent year, unless the IRS establishes oth-erwise.

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 Usingthe 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 set

of 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 by

check, 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. For instance,organize them by year and type of ex-pense.

If you cannot provide a canceledcheck to prove payment of an expense

item, 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 reco

Documents

US Internal Revenue Service: p911--2000