Business Expenses

The operating costs of running your business are called business expenses. These are costs you do not have to capitalize or include in the cost of goods sold.

Keep business expenses separate from personal expenses. If you have an expense that is part business and part personal, deduct only the business part.

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is appropriate and helpful for your business. An expense does not have to be indispensable to be considered necessary.

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

Salaries and Wages

You can generally deduct the pay you give your employees for the services they perform for 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 cannot deduct your own salary or any personal withdrawals you make from your business. You are not an employee of the business.

For detailed discussions of salaries, wages, and other payments to employees, see Publications 15, 15-B, and chapter 2 in Publication 535.

Taxes

You can deduct as a business expense various federal, state, local, and foreign taxes directly attributable to your direct-selling business. Some of these taxes were discussed earlier under Business Taxes and others are discussed next.

Income taxes. Most income taxes, including federal income taxes, cannot be deducted as a business expense. You can generally deduct personal state and local income taxes as an itemized deduction on Schedule A (Form 1040).

Personal property tax. You can deduct as a business expense any tax imposed by a state or local government on personal property used in your direct-selling business.

You can also deduct registration fees for the right to use property within a state or local area.

Example. May and Julius Winter drove their car 7,000 business miles out of a total of 10,000 miles during the tax year. They had to pay $25 for their annual state license tags and $20 for their city registration sticker. They also paid $235 in city personal property tax on the car, for a total of $280. They are claiming their actual car expenses for the year. Because they used the car 70% for business, they can deduct 70% of the $280, or $196, as a business expense.

Sales tax. Treat any sales tax you pay on a service or on the purchase or use of property as part of the cost of the service or property. If the service or the cost or use of the property is a deductible business expense, you can deduct the tax as part of that service or cost. If the property is merchandise bought for resale, the sales tax is part of the cost of the merchandise. If the property is depreciable, add the sales tax to the basis for depreciation. See Publication 551, Basis of Assets, for information about the basis of property.

Do not deduct state and local sales taxes imposed on the buyer that you must collect and pay over to the state or local government. Do not include these taxes in gross receipts or sales.

Fuel taxes. Taxes on gasoline, diesel fuel, and other motor fuels that you use in your business usually are included as part of the cost of the fuel. Do not deduct these taxes as a separate item.

Interest

Interest is the amount charged for the use of borrowed money. You can generally deduct all interest you pay or accrue during the tax year on a debt related to your business.

You can deduct interest on a debt only if you meet all the following requirements.

• You are legally liable for that debt.
• Both you and the lender intend that the debt be repaid.
• You and the lender have a true debtor-creditor relationship.

No deduction is allowed for interest paid or accrued on personal loans. If a loan is part business and part personal, allocate the interest 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 car 60% for business and 40% for personal purposes. You can deduct $360 (60% x $600) as a business expense on your Schedule C (Form 1040) or Schedule C-EZ (Form 1040). The remaining interest ($240) is a nondeductible personal expense.

Insurance

You can generally deduct premiums you pay for the following kinds of insurance related to your trade or business. This list is not all inclusive.

• Fire, theft, flood, or similar insurance.
• Car and truck insurance on vehicles used in your business if you do not use the standard mileage rate to figure your car expenses.
• Credit insurance to cover losses from unpaid debts.
• Liability insurance.
• Use and occupancy and business interruption insurance. This insurance pays for lost profits if your business is shut down due to a fire or other cause. Report the proceeds as ordinary income.

You generally cannot deduct the cost of life insurance paid on your own life. However, see chapter 7 in Publication 535 for information on when life insurance premiums are deductible.

Business and personal. If you pay premiums for insurance coverage that is both business and personal, deduct only the part that pays for business coverage. For example, if you use your car 25% in your direct-selling business and 75% for personal transportation, you can deduct 25% of your car insurance premiums if you claim actual expenses for the use of the car.

When to deduct. You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. If you make an advance payment on an insurance policy that provides coverage substantially beyond the end of the current tax year, deduct only the part that buys insurance for the current tax year. You must wait until the following tax year to deduct the part that buys insurance for that year, and so on.

Example. You are a direct seller. In June 2001, you pay $1,200 in premiums for theft insurance effective July 2001 through June 2003 ($50 per month). You can deduct $300 in 2001 ($50 × 6 months), $600 in 2002 ($50 × 12 months), and $300 in 2003.

Dividends. An insurance dividend is a return of part of the premiums you paid. If you receive dividends from business insurance premiums you deducted in an earlier year, report all or part of the dividend as business income. For more information on recovery of prior deductions, see Publication 525.

Telephone

You cannot deduct the cost of basic local telephone service (including any taxes) for the first telephone line you have in your home, even though you may have an office in your home. However, charges for business long distance phone calls on that line, as well as the cost of a second line into your home used exclusively for business, are deductible business expenses.

Example 1. Leo had a separate telephone line installed in his home for his direct-selling business. He had this phone number printed on his business cards and always uses it only for business calls.

Leo can deduct the full amount of his business phone bill because the phone is used exclusively for business.

Example 2. Mary and George run an active direct-selling business out of their home. For February, their phone bill was $65 ($20 for basic telephone service and $45 for long-distance calls).

The total charge for long-distance business calls on their bill is $31. Mary and George can deduct $31 as a business expense.

Away from home. If you travel away from home and make a business phone call, you can deduct the cost of the call, whether or not the rest of your travel expenses are deductible.

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

Example. Lydia is interested in sponsoring others as direct sellers for her product line. She often talks by phone with her sister who lives 50 miles away. They talk about personal matters. When Lydia mentions her direct-selling work, she usually says something to encourage her sister to become a direct seller too.

Lydia's phone calls to her sister are personal and nondeductible. Their primary purpose is not to recruit her sister as a direct seller, but to continue their personal relationship.

Other Expenses

Discussed next are other expenses you may have as a direct seller.

Business licenses. License and regulatory fees paid each year to state or local governments are generally deductible business expenses. Some licenses and fees related to starting your business may have to be amortized. See chapter 9 of Publication 535 for more information.

Catalogs. The cost of catalogs you use in your selling business for more than one year must be capitalized. The cost can then be recovered as explained under Cost Recovery, earlier. If the catalogs are used in your selling business for one year or less, you can deduct their full cost in the tax year you pay for them.

Commissions. If you must pay a bonus, percentage, or other type of commission to direct sellers working under you, you can deduct it. Report the full amount of any commissions you receive as business income, and deduct the commissions you pay as ordinary and necessary business expenses.

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

Freda received a commission or "performance bonus" for March equal to 10% of the $1,300, or $130, in sales. She reports the entire $130 as business income on her tax return.

Freda must pay the direct sellers working under her a commission of 7% on their monthly sales of $400. She paid each of them $28 (7% of $400) for their March sales. She deducts the total, $56, as a business expense on her tax return.

Computer. If you use a computer in your direct sales business, you can depreciate it. However, if you use it 50% or less in your business, you must use the Alternative Depreciation System (ADS) under MACRS to figure your depreciation deduction. For more information, see chapter 4 in Publication 946.

Home meetings. If you have business meetings in your home, you can deduct expenses for the meetings only when they meet certain tests.

• The expenses of entertaining business associates in your home are deductible if they meet the rules discussed under Meals and Entertainment, later, and you can prove your expenses as discussed later under Recordkeeping.
• The expenses of maintaining your home as a place of business are deductible if you meet the tests discussed under Business Use of Your Home, later.

Example. Barbara and Bill hold biweekly meetings in their home for the direct sellers who work under them. They discuss selling techniques, solve business problems, and listen to presentations by company representatives.

Because the meetings are for business, Barbara and Bill can deduct 50% of the cost of the food and beverages they provide. The 50% limit is explained later under Meals and Entertainment. They keep a copy of their grocery receipts for these refreshments and record the date, time, and business nature of each meeting. Because the meetings are held in their living room rather than in a special area set aside only for business, they cannot deduct any of their home expenses for the meetings.

Journal subscriptions. If you subscribe to a journal for direct sellers, you can deduct the annual subscription fee as a business expense.

Club dues and membership fees. Generally, you cannot deduct amounts you pay or incur for membership in any club organized for business, pleasure, recreation, or any other social purpose. This includes country clubs, golf and athletic clubs, hotel clubs, sporting clubs, airline clubs, and clubs operated to provide meals under circumstances generally considered to be conducive to business discussions. The purpose and activities of a club, not its name, will determine whether or not you can deduct the dues.

Exception. None of the following organizations will be treated as a club organized for business, pleasure, recreation, or other social purpose, unless one of its main purposes is to conduct entertainment activities for members or their guests or to provide members or their guests with access to entertainment facilities.

• Boards of trade.
• Business leagues.
• Chambers of commerce.
• Civic or public service organizations.
• Professional associations.
• Trade associations.

Legal and professional fees. Legal and professional fees, such as fees charged by accountants, that are ordinary and necessary expenses directly related to operating your business are deductible as business expenses. However, you usually cannot deduct legal fees paid to acquire business assets. Those are added to the basis of the property.

If the fees include payments for work of a personal nature (such as making a will), you can take a business deduction only for the part of the fee related to your business. The personal portion of legal fees for producing or collecting taxable income, doing or keeping your job, or for tax advice may be deductible on Schedule A (Form 1040) if you itemize deductions. See Publication 529, Miscellaneous Deductions.

Tax preparation fees. You can deduct as a trade or business expense the cost of preparing that part of your tax return relating to your business as a sole proprietor. The remaining cost may be deductible on Schedule A (Form 1040) if you itemize deductions.

You can also take a business deduction for the amount you pay or incur in resolving asserted tax deficiencies against your business as a sole proprietor.

Samples and promotional items. You can deduct the cost of samples you give to your customers and the cost of promotional items such as posters. You cannot deduct the cost of any samples you use personally.

Service charges. You can deduct service charges you pay on orders for goods. The service charge can be a flat charge or it can be based on other criteria.

Supplies. Unless you have deducted the cost in any earlier year, you generally can deduct the cost of materials and supplies actually consumed and used during the tax year.

If you keep incidental materials and supplies on hand, you can deduct the cost of the incidental materials and supplies you bought during the tax year if all three of the following requirements are met.

• You do not keep a record of when they are used.
• You do not take an inventory of the amount on hand at the beginning and end of the tax year.
• Your taxable income is clearly reflected by this method.

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