Basic Tax Information

The following discussion gives basic tax information that may help if you have never been in business for yourself. For more information about starting a business, see Publication 583.

Employer Identification Number (EIN)

EINs are used to identify the tax accounts of employers, certain sole proprietors, corporations, partnerships, estates, trusts, and other entities.

If you do not already have an EIN, you need to get one if any of the following apply to your business.

1. You have employees.
2. You have a qualified retirement plan.
3. You operate your business as a corporation or partnership.
4. You file returns for:
1. Employment taxes,
2. Excise taxes, or
3. Taxes on alcohol, tobacco, or firearms.

Use Form SS-4 to apply for an EIN.

Business Taxes

The following kinds of federal business taxes may apply to direct sellers.

• Income tax
• Self-employment tax
• Employment taxes

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

Income tax. All businesses except partnerships must file an annual income tax return. (Partnerships file an information return.) For example, if you operate your direct-selling business as a sole proprietor, you must file Schedule C or Schedule C-EZ as part of your individual income tax return (Form 1040). You are a sole proprietor if you are self-employed (work for yourself) and are the only owner of your unincorporated business.

Self-employment tax. Self-employment tax is the social security and Medicare tax for those who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of wage earners. If you are a direct seller, you generally must pay this tax on your income from direct selling. You must pay it whether you are a sole proprietor or a partner in a partnership. Use Schedule SE (Form 1040) to figure your self-employment tax. For more information about self-employment tax, see Publication 533.

Social Security Administration (SSA) time limit for posting self-employment income. Generally, the SSA will give you credit for self-employment income reported on a tax return filed within 3 years, 3 months, and 15 days after the tax year you earned the income. If you file your tax return or report a change in your self-employment income after this 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 employees in your business, you generally withhold and pay the following kinds of employment taxes.

• The federal income tax you withhold from employees' wages.
• Social security and Medicare taxes--both the amount you withhold from employees' wages and the amount you pay as the employer.
• Federal unemployment (FUTA) tax (none of which is withheld from the employees' wages).

For more information, see Publication 15.

Other taxes. For information about deducting personal property and other taxes, see Taxes under Business Expenses, later.

Estimated Tax

The federal income tax is a pay-as-you-go tax. You must pay it as you earn or receive income during the year. There are two ways to pay as you go.

• Withholding. If you are an employee, your employer likely withholds income tax from your pay. By revising your W-4, you can increase your withholding to cover the income from your job and from direct selling.
• Estimated tax. If you do not pay tax through withholding, or do not have enough withheld, you may have to pay estimated tax.

Estimated tax is used to pay both income and self-employment taxes. For more information on estimated tax, see Publication 505.

Exceptions. You do not have to pay estimated tax if you meet either of the following exceptions.

• You had no tax liability last year, you were a U.S. citizen or resident for the whole year, and your tax year covered all 12 months.
• Your total expected taxes for 2002, minus any expected tax credits and withholding, will be less than $1,000.

Form 1040-ES. Use Form 1040-ES to figure your estimated tax and make quarterly estimated tax payments.

Form 2210. If you did not pay enough estimated tax or have enough income tax withheld, you may be subject to a penalty for underpayment of tax. You can use Form 2210 to figure the penalty. In most cases, you can have the Internal Revenue Service figure the penalty for you. See the Form 2210 instructions to determine if you must complete the form.

Information Returns

If you have other direct sellers working under you and you sell $5,000 or more in goods during the year to any one of those sellers, you must report the sales on an information return. The information return, Form 1099-MISC, must show the name, address, and identification number of the seller placing the orders. Check box 9 of Form 1099-MISC to show these sales. Do not enter a dollar amount. You must give Copy B or a qualified statement (such as a letter showing this information along with commissions, prizes, awards, etc.) to the seller by January 31, 2002.

You must file Copy A of Form 1099-MISC with the Internal Revenue Service by February 28, 2002. If you file electronically, you have until April 1, 2002. Use Form 1096 to summarize and transmit Form 1099-MISC. See the instructions for Form 1099-MISC.

Penalties

The law imposes penalties for noncompliance with tax laws. Some of these penalties are discussed next. If you underpay your tax due to fraud, you could be subject to a civil fraud penalty. In certain cases, you could be subject to criminal prosecution.

Failure-to-file penalty. If you do not file your return 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 the due date for each month or part of a month that the return is late. This penalty cannot exceed 25% of your tax, and it is reduced by the failure-to-pay penalty (discussed next) for any month both penalties apply. However, if you file your return more than 60 days after the due date or extended due date, the minimum penalty is the lesser of $100 or 100% of the unpaid tax. You will not have to pay the penalty if you show that you failed to file on time because of reasonable cause and not because of willful neglect.

Failure-to-pay penalty. You may have to pay a penalty of 1/2 of 1% of your unpaid taxes for each month or part of a month after the due date that the tax is not paid. This penalty cannot be more than 25% of your unpaid tax. You will not have to pay the penalty if you can show good reason for not paying the tax on time. This penalty does not apply during the automatic 4-month extension of time to file if you paid at least 90% of your actual tax liability on or before the due date of your return and you pay the balance when you file the return.

The monthly rate of the failure-to-pay penalty is half the usual rate (.25% instead of .50%) if an installment agreement is in effect for that month. You must have filed your return by the due date (including extensions) to qualify for this reduced penalty.

Penalty for frivolous return. You may have to pay a penalty of $500 if you file a return that does not include enough information to figure the correct tax or that contains information clearly showing the tax you reported is substantially incorrect.

You will have to pay the penalty if you filed this kind of return for either of the following reasons.

• A frivolous position on your part.
• A desire to delay or interfere with the administration of federal income tax laws.

This penalty is in addition to any other penalty provided for by law.

Accuracy-related penalty. An accuracy-related penalty of 20% applies to any underpayment due to the following reasons.

• Negligence or disregard of rules or regulations.
• Substantial understatement of income tax.

This penalty also applies to conditions not discussed here.

Even though an underpayment was due to both negligence and substantial underpayment, the total accuracy-related penalty cannot exceed 20% of the underpayment. The penalty is not imposed if you can show reasonable cause and that you acted in good faith.

Negligence. Negligence includes the lack of any reasonable attempt to comply with provisions of the Internal Revenue Code.

Disregard. Disregard means the careless, reckless, or intentional disregard of rules or regulations.

Substantial understatement of income tax. For an individual, income tax is substantially understated if the understatement exceeds the greater of the following amounts.

• 10% of the correct tax.
• $5,000.

Information reporting penalties. A penalty applies if you do not file information returns by the due date, do not include all required information, or do not report correct information. The amount of the penalty is based on when you file the correct information return, as follows.

• Correct information returns filed within 30 days after the due date, $15 each.
• Correct information returns filed after the 30-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 statements. If you do not provide a complete, correct, and timely copy of an information return (payee statement), you may be subject to a penalty of $50 for each statement. If the failure is due to intentional disregard of the requirements, the minimum penalty is $100 per statement with no maximum penalty.

Failure to supply identification number. If you do not include your identification number (SSN or EIN) or the identification number of another person where required on a return, statement, or other document, you may be subject to a penalty of $50 for each failure. You may also be subject to the penalty if you do not give your identification number to another person when it is required on a return, statement, or other document.

You will not have to pay the penalty if you can show the failure was due to reasonable cause and not willful neglect.

Accounting Periods and Methods

All income tax returns are prepared using an accounting period (tax year) and an accounting method.

Accounting Periods

When preparing a statement of income and expenses, you must use books and records for a specific interval of time called an accounting period. The annual accounting period for your tax return is called a tax year. You can generally use one of the following tax years.

• A calendar year, which begins on January 1 and ends on December 31.
• A fiscal year (including a period of 52 or 53 weeks). A regular fiscal year is 12 consecutive months ending on the last day of any month except December.

You establish a tax year when you file your first income tax return. If you filed your first return as a wage earner using the calendar year, you must use the calendar year as your business tax year. You generally cannot change your tax year without IRS approval.

For more information, see Publication 538.

Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenses are reported. You must use the same accounting method from year to year. The two most common accounting methods are the cash method and an accrual method. A third method, called a hybrid method, is generally a combination of cash and accrual.

The text and examples in this publication generally assume you use the calendar year as your tax year and either the cash or hybrid method as your accounting method. Generally, if inventories are needed to account for your income, you must use an accrual method, discussed later, for your sales and purchases. However, if you are a qualifying taxpayer, you can choose to do the following, even if you produce, purchase, or sell merchandise in your business.

• Use the cash method of accounting.
• Not keep an inventory, even if you do not change to the cash method.

For more information, including the definition of a qualifying taxpayer, see Inventories in Publication 334.

Cash method. Under the cash method, you report income in the year it is received, credited to your account, or made available to you on demand. You need not have physical possession of it. You deduct expenses in the year you pay them, even if they were incurred in an earlier year.

Check received. If you receive a check before the end of the tax year, you must include it in income for the year you receive it even though you do not cash or deposit it until the next year.

Accrual method. Under an accrual method, you generally report income in the tax year when all events have occurred that fix your right to receive the income and you can determine the amount with reasonable accuracy. Generally, you deduct or capitalize business expenses when you become liable for them, whether or not you pay them in the same year.

Prepaid expenses. Expenses paid in advance can only be deducted in the year to which they apply under either the cash or an accrual method. For example, suppose you have a subscription to a direct-selling journal that runs out at the end of 2001. It will cost you $30 to renew the subscription for one year or $54 for 2 years. You decide to renew for 2 years and mail your check at the end of November 2001. You cannot deduct the $54 on your 2001 return, even if you use the cash method of accounting. However, you can deduct half of the $54 in 2002 and the other half in 2003.

Previous| First | Next

Publication Index | IRS-Forms Main | Home