Capital Expenses

You must capitalize some costs rather than deduct them. These costs are a part of your investment in your business and are called capital expenses. When you capitalize a cost, you add it to the basis of the property to which it relates.

Although you generally cannot take a current deduction for a capital expense, you may be able to take deductions for these costs over a period of years as explained later under Cost Recovery.

Kinds of Capital Expenses

You must capitalize the following costs.

• Going into business. The costs of getting started in business, before you are authorized to start selling your company's products, are capital expenses. These start up costs include the cost of exploring different direct-selling opportunities, the cost of any training you must have before becoming a direct seller for your product line, any fees you must pay to the company to become a direct seller, and similar costs. See chapter 9 of Publication 535 for information on how to treat these costs.
• Business assets. The cost of any asset (property) that will last substantially beyond the tax year it is placed in service is a capital expense. Examples of business assets include office furniture, business vehicles, and storage shelves. See Cost Recovery, later.
• Improvements. The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. However, normal repair expenses are deducted as current business expenses and are not capitalized. For example, if you have a car you use only for business, you can deduct as business expenses, maintenance and repair costs such as tune-ups, new headlights, or brake repairs. The cost of overhauling the engine, however, would be a capital expense.

Demonstrators

If you keep your company's products on hand to show to potential customers, their cost may be part of the cost of goods sold, a capital expense, a business expense, or a personal expense, depending on the circumstances. The cost of a product you use yourself is a personal expense, even if you occasionally show it to prospective customers.

Example.   Sheila is a direct seller who uses 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. By showing these items in her own home, she hopes to interest people in buying from her company or in becoming direct sellers themselves.

Sheila cannot take a deduction for the cost of any of these products. Because she uses them in her own home for personal reasons, their cost is not a cost of doing business.

Used one year or less.   If you have a product you use as a demonstrator for one year or less and the demonstrator itself is not available for purchase by your customers, its cost is a business expense.

If the demonstrator itself can be bought by your customers, include it in your inventory.

Example 1.   Constance is a direct seller of kitchenware. Customers must order items from a catalog, but she keeps at least one of each type on hand to show buyers. When her product line changes and an item is discontinued, she either starts using the demonstrator in her own kitchen or tries to sell it. When she had a garage sale, she sold a number of unused demonstrators.

Constance includes her demonstrators, including those for discontinued products, in her inventory of goods for sale. When she sells a demonstrator, including those she sold at the garage sale, she includes the income in her gross business receipts.

When Constance starts using a demonstrator in her own kitchen, it is a withdrawal of inventory for personal use. She subtracts the cost of the item from her purchases for the year. See Personal withdrawals under Cost of Goods Sold, earlier.

Example 2.   Lydia sells needlework kits at sales parties. She has catalogs and a number of kits to show customers. She uses these kits to demonstrate various needlework techniques.

The demonstrator kits last less than one year and are not sold to customers. Some are ruined and thrown away. Their cost is a business expense.

More than one year of use.   If you use a demonstrator for more than one year, its cost is a capital expense. However, if you expect to eventually sell the demonstrator, include it in your inventory of goods for sale.

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

His product line changes little from year to year, so Mike can use a book as a demonstrator for a long time. Although he periodically replaces his demonstrators with new ones and sells the old ones at a discount, he has kept some books as demonstrators for up to 3 years.

Because Mike eventually sells his demonstrators, they remain part of his inventory of goods for sale.

Example 2.   Janet sells the same line of educational books as Mike in Example 1. She tries to use her demonstrators as long as possible. She puts the books in plastic jackets to protect them, and ordinarily only stops using them as demonstrators when the company comes out with a new edition. Janet never sells the old demonstrators. She can recover the cost of the books she uses as demonstrators as discussed under Cost Recovery, next.

Cost Recovery

You can usually recover (subtract from income) your cost for capital expenses over a number of years. Each year a part of your basis is recovered through depreciation or amortization. Use depreciation to recover capital expenses for most tangible business assets. Use amortization to recover the cost of intangible assets, such as start-up costs. Amortization is discussed in chapter 9 of Publication 535.

Under certain circumstances, you may be able to recover a limited amount of the cost of qualifying property as a current expense by electing the section 179 deduction rather than recover the cost as a capital expense. The section 179 deduction is discussed later.

Form 4562.   Generally, use Form 4562 to report depreciation, amortization, and the section 179 deduction. A filled-in Form 4562 is illustrated in an example in Publication 946.

Section 179 Deduction

You can elect to deduct all or part of the cost of certain qualifying property in the year you place it in service. Property is placed in service when it is first made ready and available for a specific use.

Qualifying property.   Qualifying property includes tangible personal property for which depreciation is allowable. See chapter 2 in Publication 946 for more information.

Dollar limit.   The total section 179 cost you can choose to deduct for 2002 is generally $24,000.

Beginning in 2003, the total amount you can choose to deduct under section 179 will increase generally to $25,000.

Business income limit.   The total cost you can deduct each year after you apply the dollar limit is further limited to the taxable income from the active conduct of any trade or business during the year.

Any cost not deductible in one year because of this limit can be carried to the next tax year.

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

Depreciation

If you do not choose a section 179 deduction or you choose a section 179 deduction and do not recover all your cost, you can take a depreciation deduction (and possibly a special depreciation allowance) for part or all of the cost you did not claim as a section 179 deduction.

Property whose cost can be recovered through depreciation is depreciable property. Depreciable property includes most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. Depreciable property also includes certain intangible property.

You can depreciate property if it meets the following requirements.

• It must be property you own.
• It must be used in your business or income-producing activity.
• It must have a determinable useful life. This means it is something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.
• It must be expected to last more than one year.
• It must not be excepted property, such as certain intangible property and property placed in service and disposed of in the same year.

You must use the modified accelerated cost recovery system (MACRS) to depreciate most property placed in service after 1986.

For information about the depreciation of property placed in service after 1986, see Publication 946. Chapter 4 contains a detailed discussion on figuring depreciation under MACRS.

For information about the depreciation of property placed in service before 1987, see Publication 534, Depreciating Property Placed in Service Before 1987.

Special depreciation allowance.   The special depreciation allowance is an additional 30% deduction you can claim for the year you place qualified property in service after any section 179 deduction and before you figure regular depreciation under MACRS. For more information about the special depreciation allowance, see chapter 3 in Publication 946.

Listed Property

Listed property includes property which lends itself to personal use such as property used for transportation, entertainment equipment, certain computers, and cellular phones. In addition, there are recordkeeping requirements and rules you must follow when depreciating listed property. If listed property is not used more than 50% for a qualified business use during any tax year, you cannot claim the section 179 deduction and special rules apply to the depreciation deduction. See chapter 5 in Publication 946.

Passenger automobiles.   For most passenger automobiles, the section 179 deduction, special depreciation allowance, and depreciation deduction you can claim is limited.

For an automobile that is qualified property placed in service during 2002, the total of your section 179 deduction, special depreciation allowance, and depreciation deduction cannot be more than $7,660. If you elected not to claim the special depreciation allowance for the automobile or the automobile is not qualified property, the limit is generally $3,060. For 2003 and 2004, the maximum deduction amounts for an automobile placed in service in 2002 are $4,900 and $2,950, respectively. The maximum deduction for each year after 2004 is $1,775.

Qualified property includes a car that meets all the following requirements.

• You bought the car new after September 10, 2001.
• You placed the car in service for business in 2002.
• You used the car more than 50% in a qualified business use.

If your business/investment use of the automobile is less than 100%, you must reduce the maximum deduction amount proportionately.

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

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 partly for business and partly personal, deduct only the business part on your business return.

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 required 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 and 15-A, 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 2002, you pay $1,200 in premiums for theft insurance effective July 2002 through June 2004 ($50 per month). You can deduct $300 in 2002 ($50 × 6 months), $600 in 2003 ($50 × 12 months), and $300 in 2004.

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 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.

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