Money, Debt and Taxes

Some people’s income is based on their sales and not on the number of hours they work. They are known as direct sellers. Sometimes there is confusion regarding the special set of tax rules that applies to direct sellers.

This fact sheet, the seventeenth in the Tax Gap series, is designed to help direct sellers better understand the rules so they can get the most out of their deductions and pay their fair share of taxes.

The largest portion of the tax gap, or the amount of tax that goes unpaid each year, results from taxpayers underreporting their taxable income. Most people want to pay their fair share of taxes, but many simply need a better understanding of their
obligations.

Direct sellers include any of the following:

• A person who sells consumer products in the home or a place of business other than a permanent retail establishment,
• A person who sells consumer products on a deposit or commission basis, or to other persons who will sell the products in the home or place of business,
• A person who delivers and/or distributes newspapers or shopping guides.

Direct sellers have certain things in common. Their compensation is related to sales rather than to the number of hours worked. Services are performed under a written contract between the seller and the person for whom the seller performs the services.

And the contracts involved provide that sellers are not treated as employees for federal tax purposes.

Income Sources

Direct sellers report income on Form 1040 Schedule C or C-EZ. The various forms of income a direct seller may need to report might include:

• Sales,
• Commissions, bonuses, or percentages of income received for sales and the sales of others who work for the seller,
• Prizes, awards, and gifts received from the selling business,
• Products received for meeting certain sales quotas.

A direct seller must include all income received on the tax return regardless of whether or not he or she received an information return, usually a Form 1099-MISC reporting that income. A seller who sells at least $5,000 in the aggregate of consumer products to a buyer for resale anywhere other than a permanent retail establishment is required to report the sale by checking item 9 on Form 1099-MISC.

Expense Issues

Direct sellers can generally deduct ordinary and necessary business expenses. However, start-up expenses are capital expenses and are not deductible unless the seller elects to deduct the expenses. The seller makes an election by attaching a statement to his or her income tax return prepared for the year the business begins and filed by the due date.

Start-up expenses may include the following costs: exploring different direct-selling opportunities; training to be a seller for a product line; fees paid to the company to become a direct seller; and purchasing a starter kit from the company.

Start-up expenses paid or incurred after Oct. 22, 2004, may be deductible the year the business begins by an amount equal to the lesser of:

• The amount of start-up expenses, or
• $5,000, reduced by the amount the start-up expenses exceed $50,000,
• The remainder of the expenses may be deducted ratably over the 180-month period beginning with the month the business begins.

(Start-up expense rules were amended in 2004. Expenses paid or incurred on or before Oct. 22, 2004, are treated differently.)

Since direct sellers purchase and sell merchandise, inventories of products at the beginning and end of each taxable year are necessary to correctly reflect taxable income.

Products held in inventory include: merchandise with title vested in the seller; goods under contract for sale but not yet segregated and applied to the contract; and goods out on consignment.

Related Items:

• The Tax Gap
• Fact Sheet 2006-23, Cost of Goods Sold and the Tax Gap
• Publication 334, Tax Guide for Small Businesses

The Internal Revenue Service reminds taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby, an activity not engaged in for profit.

In order to educate taxpayers regarding their filing obligations, this fact sheet, the eleventh in a series, explains the rules for determining if an activity qualifies as a business and what limitations apply if the activity is not a business. Incorrect deduction of hobby expenses account for a portion of the overstated adjustments, deductions, exemptions and credits that add up to $30 billion per year in unpaid taxes, according to IRS estimates.

In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.

In order to make this determination, taxpayers should consider the following factors:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Does the taxpayer depend on income from the activity?
• If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
• Has the taxpayer changed methods of operation to improve profitability?
• Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
• Has the taxpayer made a profit in similar activities in the past?
• Does the activity make a profit in some years?
• Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.

If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.

Deductions for hobby activities are claimed as itemized deductions on Schedule A (Form 1040). These deductions must be taken in the following order and only to the extent stated in each of three categories:

• Deductions that a taxpayer may take for personal as well as business activities, such as home mortgage interest and taxes, may be taken in full.
• Deductions that don’t result in an adjustment to basis, such as advertising, insurance premiums and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
• Business deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.

Link:

• Further information is available in IRS Publication 535, Business Expenses