Important Changes
for 2002

Standard mileage rate.   The standard mileage rate for the cost of operating your car in 2002 is 36½ cents a mile for all business miles.

Special depreciation allowance.   You can take a special depreciation allowance (or Liberty Zone depreciation allowance) for qualified property (or Liberty Zone property) you place in service during 2002. The allowance is an additional deduction of 30% of the property's depreciable basis. For more information, see chapter 3 in Publication 946.

Increased section 179 deduction for enterprise zone businesses.   If you placed section 179 property in service in an empowerment zone during 2002, you may be able to increase your section 179 deduction by as much as $35,000 (up from $20,000). For more information, see Increased dollar limit under Enterprise Zone Businesses in chapter 2 of Publication 946.

For information on empowerment zones and enterprise communities, see Publication 954, Tax Incentives for Empowerment Zones and Other Distressed Communities.

Increased section 179 deduction for businesses in the New York Liberty Zone.   If you placed section 179 property in service in the New York Liberty Zone (Liberty Zone) during 2002, you may be able to increase your section 179 deduction by as much as $35,000. For more information, see Increased dollar limit under Liberty Zone Property in chapter 2 of Publication 946.

Reduced section 179 dollar limit for Liberty Zone property exceeding $200,000.   Generally, you must reduce the dollar limit on the section 179 deduction for a year by the cost of qualifying section 179 property placed in service in the year that is more than $200,000. You take into account only 50% (instead of 100%) of the cost of section 179 property which is qualified Liberty Zone property placed in service in a year. See Reduced dollar limit under Liberty Zone Property in chapter 2 of Publication 946.

Depreciation limits on business cars.   The total section 179 deduction and depreciation (including the special depreciation allowance) you can take on a car you use in your business and first place in service in 2002 is generally $7,660. For more information, including the maximum depreciation you can deduct in later years, see Passenger automobiles under Listed Property, later.

Important Reminders

Accounting methods.   Certain small business taxpayers that are qualifying taxpayers or qualifying small business taxpayers may be eligible to adopt or change to the cash method of accounting and may not be required to account for inventories. For more information, including the definitions of a qualifying taxpayer and a qualifying small business taxpayer, see Publication 538, Accounting Periods and Methods.

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843- 5678) if you recognize a child.

Introduction

This publication explains general tax information of interest to direct sellers. It covers how to treat income, expenses, and other items related to having a direct-sales business. It also illustrates two filled-in tax forms that most direct sellers must file along with Form 1040. They are Schedule C (Form 1040), Profit or Loss From Business, and Schedule SE (Form 1040), Self-Employment Tax.

Who is a direct seller?   Some of the characteristics that identify direct sellers are listed below. A more complete discussion is contained under the heading Who Is a Direct Seller, later.

• How you sell. You sell consumer products to others on a person-to-person basis, usually working out of your home. Or, you deliver or distribute newspapers or shopping news.
• Where you sell. You may sell door-to-door, through the sales party plan, or by appointment in someone else's home.
• When you sell. You may sell on a regular basis or only occasionally. You may sell full-time or part-time, such as a sideline to a regular job.

Who is not a direct seller?   You are not a direct seller if you are employed in a store, sell through a retail sales outlet, or sell your employer's product away from the employer's place of business.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

You can e-mail us while visiting our web site at www.irs.gov.

You can write to us at the following address:

Internal Revenue Service
Tax Forms and Publications
W:CAR:MP:FP
1111 Constitution Ave. NW
Washington, DC 20224

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

Useful Items

You may want to see:

Publication

• 1   Your Rights as a Taxpayer
• 15   Circular E, Employer's Tax Guide
• 15-A   Employer's Supplemental Tax Guide
• 15-B   Employer's Tax Guide to Fringe Benefits
• 334   Tax Guide for Small Business
• 463   Travel, Entertainment, Gift, and Car Expenses
• 505   Tax Withholding and Estimated Tax
• 525   Taxable and Nontaxable Income
• 533   Self-Employment Tax
• 535   Business Expenses
• 538   Accounting Periods and Methods
• 583   Starting a Business and Keeping Records
• 587   Business Use of Your Home
• 946   How To Depreciate Property

Form (and Instructions)

• SS-4   Application for Employer Identification Number
• Sch A (Form 1040)   Itemized Deductions
• Sch C (Form 1040)   Profit or Loss From Business
• Sch C-EZ (Form 1040)   Net Profit From Business
• Sch SE (Form 1040)   Self-Employment Tax
• 1040   U.S. Individual Income Tax Return
• 1040-ES   Estimated Tax for Individuals
• 1099-MISC   Miscellaneous Income
• 2210   Underpayment of Estimated Tax by Individuals, Estates, and Trusts
• 4562   Depreciation and Amortization
• 8829   Expenses for Business Use of Your Home

See How To Get Tax Help near the end of this publication for information about getting publications and forms.

Who Is a Direct Seller?

You are a direct seller if you meet all the following conditions.

1. You are engaged in one of the following trades or businesses.
   1. Selling or soliciting the sale of consumer products, either -
      1. In a home or other place that is not a permanent retail establishment, or
      2. To any buyer on a buy-sell basis or a deposit-commission basis for resale in a home or other place that is not a permanent retail establishment.
   2. Delivering or distributing newspapers or shopping news (including any services directly related to that trade or business).
2. Substantially all your pay (whether paid in cash or not) for services described in (1) is directly related to sales or other output (including the performance of services) rather than to the number of hours worked.
3. Your services are performed under a written contract between you and the person for whom you perform the services, and the contract provides that you will not be treated as an employee for federal tax purposes.

As a direct seller, you usually sign up with a particular company to sell its product line. The company may refer to you by one of the following titles.

• Consultant
• Coordinator
• Dealer
• Demonstrator
• Designer
• Director
• Distributor or direct distributor
• Instructor
• Manager or supervisor
• Representative or sales representative

Self-employed.   Direct sellers are self-employed. This generally means you have to pay self-employment tax (discussed later under Business Taxes).

Employee.   You are a direct seller only if you are in business for yourself. Selling consumer products as a company employee does not make you a direct seller.

The fact that you work under another direct seller does not make you that person's employee.

Recruiting.   You are engaged in the trade or business of selling or soliciting the sale of consumer products if you attempt to increase the sales of direct sellers who work under you (your downline group) and your earnings depend in part on how much they sell. Recruiting, motivating, and training are examples of attempts to increase sales.

Host or hostess.   You are not a direct seller if you simply host a party at which sales are made. 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 make sales. You must report it as income at its fair market value. See Other Income, later.

Your out-of-pocket party expenses are subject to the 50% limit for meal and entertainment expenses, discussed under Meals and Entertainment, later. These expenses are deductible as miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income limit on Schedule A (Form 1040), but only up to the amount of income you receive for giving the party. See Not-for-Profit Limit, later.

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 a social security and Medicare tax primarily for those who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most 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.

The 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, the SSA may change its records, but only to remove or reduce the amount. The 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.   You can deduct personal property and other taxes as a business expense if you incur them in the ordinary course of your business. For information about deducting these 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 tax you owe on 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. General rule for making estimated tax payments.   You must make estimated tax payments for 2003 if you expect to owe at least $1,000 in tax, after subtracting your withholding and credits, and you expect your withholding and credits to be less than the smaller of the following.

• 90% of the tax to be shown on your 2003 tax return.
• 100% of the tax shown on your 2002 tax return. Your 2002 tax return must cover all 12 months for this rule to apply.

Paying estimated tax.   You can use Form 1040-ES to figure your estimated tax and make quarterly estimated tax payments. Or, you can make estimated payments by electronic funds withdrawal or by credit card. See the Form 1040-ES instructions or How To Pay Estimated Tax in Publication 505.

Underpayment penalty.   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.

Exceptions.   Generally, you do not have to pay an underpayment penalty if you meet either of the following exceptions.

• Your total tax is less than $1,000.
• You had no tax liability last year.

For more information on estimated tax, see Publication 505.

Information Returns

You must file an information return to report that you made direct sales of at least $5,000 of consumer products to a buyer for resale anywhere other than a permanent retail establishment. The information return, Form 1099-MISC, must show the name, address, and identification number of the buyer (recipient). Check box 9 of Form 1099-MISC to show these sales. Do not enter a dollar amount.

You must also provide a statement to the buyer by January 31 of the year following the calendar year for which the information return is filed, showing your name, address, phone number for contacting you, and identifying number. The statement you give to the buyer for these direct sales may be in the form of a letter showing this information along with commissions, prizes, awards, etc. See the instructions for Form 1099-MISC for more information.

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 ½ 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 a failure to make a 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 filed after August 1 or not filed, $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.

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