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 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.

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.

If you have employees in your business, you generally withhold and pay the following kinds of employment taxes.

For more information, see Publication 15.

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.

You must make estimated tax payments for 2004 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.

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

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 Form 2210 to determine if you must complete the form.

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

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 usually 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.

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.

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.

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

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

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 includes a failure to make a reasonable attempt to comply with provisions of the Internal Revenue Code.

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

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

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.

Maximum limits apply to all these penalties.

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.

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.

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.

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.

Under an accrual method, you generally report income for 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 all events have occurred that fix the fact of liability, the liability can be determined with reasonable accuracy, and economic performance has occurred. See Publication 538 for an explanation of economic performance.

Expenses paid in advance generally can only be deducted in the year to which they apply under either the cash or an accrual method. (However, see Exception for recurring items under Accrual Method in Publication 538.) For example, suppose you have a subscription to a direct-selling journal that runs out at the end of 2003. 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 2003. You cannot deduct the $54 on your 2003 return. However, you can deduct half of the $54 in 2004 and the other half in 2005.

When figuring cost of goods sold, include the full cost of all merchandise you buy to sell to customers. This cost includes all postage and freight charges incurred.

Figure your purchases at the actual price you pay. Deduct a cash discount or a trade discount in figuring the cost of your purchases. A cash discount or a trade discount is the difference between the invoice price and the actual price you have to pay.

Subtract purchase returns and allowances from your total purchases for the year when figuring cost of goods sold. This includes any rebates or refunds you received off the purchase price. It also includes any credit you received for returned merchandise.

Subtract from your purchases for the year the cost of goods in your product line that you bought for personal use and the cost of goods you withdrew from inventory. Merchandise is considered withdrawn from inventory when it is no longer available for sale to customers. For example, if you sell a particular kind of soap and give some as a gift or use some yourself, you must withdraw the soap from inventory because it is no longer available for sale. Follow this procedure for all products withdrawn for personal use, even if you are using the product only to familiarize yourself with its characteristics or to demonstrate loyalty to the company whose products you sell.

The first step is to identify and count all merchandise in your inventory. Include all goods to which you have title at the end of the year. This generally will be any goods you have on hand and have not yet sold to customers.

Include merchandise you have purchased, if title has passed to you even if you have not yet physically received the goods. You may have title to goods that were shipped to you but are still in transit and not yet received. If the risk of loss during shipment is yours, you will probably have title to the goods during shipment. If you buy merchandise that is sent C.O.D., title passes when payment and delivery occur.

You may have title to goods purchased but not yet paid for. If you are billed for merchandise, you must usually pay the bill within a certain time. In this case, you have title to the goods and must include them in inventory, provided they are not sold by the end of the year.

Merchandise you receive on consignment is not purchased by you and is never included in your inventory. You have merchandise on consignment if you do not have to pay for what you have in stock until the time you sell it and collect the retail price from the customer.

The second step in figuring your inventory is to identify the cost of inventory items. Use the specific identification method when you can identify and match the actual cost to the items in inventory. Most direct sellers will be able to use this method.

If you cannot identify specific items with their invoices, you must make an assumption about which items were sold during the year and which remain. Make this assumption using either the first-in first-out (FIFO) method or the last-in first-out (LIFO) method.

The FIFO method assumes that the first items you purchased or produced are the first items you sold, consumed, or otherwise disposed of.

The LIFO method assumes that the last items that you purchased are sold, consumed, or otherwise disposed of first.

The third step in figuring your inventory is to value the items you have in inventory. The value of your inventory is a major factor in figuring your taxable income. The method you use is very important.

The two most common methods to value non-LIFO inventory are the cost method and the lower of cost or market method. LIFO inventory may only be valued at cost.

If you use the cost method to value your inventory items, the value of each item is usually its invoice price. Add transportation, shipping, and other necessary costs to acquire the items. Subtract appropriate discounts you received.

See Publication 538 for a discussion of the lower of cost or market method.

For a new business not using LIFO, you may choose either method to value your inventory. You must use the same method to value your entire inventory, and you cannot change the method without first obtaining IRS approval.

Many direct sellers receive a commission on their sales or purchases. Your commission might be called a bonus or percentage, and it might be based on both your own sales and the sales of other direct sellers working under you, or on purchases from the company with which you are affiliated.

Report the full amount of any commissions you receive as business income, even if you pay part of it to other direct sellers working under you. You can usually deduct the part you pay to others as a business expense. For more information, see Commissions under Other Expenses, later.

If you receive prizes, awards, or gifts in your role as a direct seller, report their full value as business income. The following are examples of items that must be included in income.

Report income received in the form of goods or services at their fair market value. Fair market value is the price agreed on between a willing buyer and a willing seller when both have reasonable knowledge of the facts and neither is forced to buy or sell.

If you receive the free use of property through your direct-sales performance, you must include the fair market value of the use of the property in your business income. There are special rules for the free use of an automobile and certain other property. For more information, see Valuation of Fringe Benefits in Publication 525.

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.

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.

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.

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

The maximum section 179 cost you can choose to deduct for 2003 is generally $100,000.

Certain benefits, including an increased section 179 deduction, are available for certain property you place in service in the New York Liberty Zone or in an empowerment zone.

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.

For more information, see chapter 2 in Publication 946.

You can take a special depreciation allowance to recover part of the cost of qualified property placed in service during the tax year. An allowance applies for the first year you place the property in service. For qualified property acquired before May 6, 2003, it is an additional 30% deduction. For qualified property acquired after May 5, 2003, it is an additional 50% deduction, or you can elect to take an additional deduction determined at the 30% rate. You can take the additional 30% or 50% deduction after any section 179 deduction and before you figure regular depreciation under MACRS for the year you place the property in service. For more information, see chapter 3 in Publication 946.

For most passenger automobiles, the section 179 deduction and depreciation deduction (including the special depreciation allowance) you can claim is limited. See Publication 946 for limits that apply for trucks, vans and electric passenger automobiles placed in service in 2003.

For a passenger automobile that is qualified property for a special depreciation allowance (see definitions below) placed in service during 2003, the total of your section 179 deduction and depreciation deduction (including the special depreciation allowance) cannot be more than $10,710 for a car acquired after May 5, 2003 ($7,660 for a car acquired before May 6, 2003). If you elected not to claim the special depreciation allowance for the automobile or if the automobile is not qualified property, the limit is generally $3,060. For 2004 and 2005, the maximum deduction amounts for a passenger automobile placed in service in 2003 are $4,900 and $2,950 respectively. The maximum deduction for each year after 2005 is $1,775.

Qualified property for the 30% special depreciation allowance includes a car that meets all the following requirements.

Qualified property for the 50% special depreciation allowance includes a car that meets all the following requirements.

You can elect to claim the 30% special depreciation allowance instead of the 50% special depreciation allowance for property that qualifies for the 50% allowance. This election applies to all property in the same property class placed in service during the year.

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

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).

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.

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.

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.

If you pay premiums for insurance coverage that is both business and personal, deduct only the part that is 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.

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 for the current tax year. You must wait until the following tax year to deduct the part for that year, and so on.

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.

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.

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

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

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.

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.

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 5 in Publication 946.

If you have business meetings in your home, you can deduct expenses for the meetings as entertainment expenses and as expenses related to the business use of your home only when they meet certain tests.

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

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.

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.

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.

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.

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.

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.

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.

Exclusive use means you use a specific part of your home solely for carrying on your direct-selling business. You do not meet the exclusive use test if you use the area in question for your direct-selling business and that same part for personal purposes.

If you use part of your home for the storage of inventory or product samples, you can claim expenses for the business use of your home without meeting the exclusive use test. However, you must meet all the following tests.

Regular use means you use a specific part of your home for business on a continuing basis. Occasional or incidental business use of part of your home does not meet the regular use test even if you do not use that part for any other purpose.

Your home office will qualify as a principal place of business if you meet both the following requirements.

Alternatively, if you do business at more than one location and your home office does not qualify as your principal place of business based on these rules, you determine your principal place of business based on the following factors.

If you meet with clients or customers in your home in the normal course of your direct selling business, even though you also carry on business at another location, you can deduct your expenses for the part of your home used exclusively and regularly for business if both the following apply.

You do not qualify to deduct expenses for the business use of your home if you have only occasional meetings or telephone calls.

You can deduct the expenses for a separate free-standing structure, such as a studio, garage, or barn, if you use it exclusively and regularly for your business. This structure does not have to be your principal place of business or a place where you meet clients or customers.

If the gross income from the business use of your home equals or exceeds your total business expenses (including depreciation), you can deduct all your business expenses related to the use of your home. If your gross income from the business use of your home is less than your total business expenses, your deduction for certain expenses for the business use of your home is limited.

If you qualify to deduct expenses for the business use of your home, you must figure your deduction on Form 8829 and attach it to Form 1040. You deduct the expenses on Schedule C (Form 1040).

For more information, including how to figure the deduction, see Publication 587.

You cannot deduct the cost of transportation between your home and your main or regular place of work. The cost of commuting is a nondeductible personal expense, regardless of the distance or whether work is performed during the trip.

If you work at two places in one day, you can deduct the expense of getting from one workplace to the other. However, if you do not go directly from one location to the other, deduct only the amount it would have cost you to go directly from the first location to the second.

If you use your vehicle in your business, see Publication 463 for information on how to figure your expenses for business transportation.

Include as meals the amounts spent on food and beverages and the taxes and tips on those amounts. Generally, no deduction is allowed for an entertainment-related meal unless you or your employee is present when the food or beverages are provided.

Include as entertainment any activity generally considered to provide entertainment, amusement, or recreation. This includes entertaining guests at nightclubs; at social, athletic, and sporting clubs; at theaters; at sporting events; on yachts; and on hunting, fishing, and vacation trips or on similar outings. It can also include meeting your customers' personal, living, or family needs, such as providing meals, a hotel suite, or a car. However, see Not directly related, later.

For entertainment expenses to meet the directly-related test, all the following must apply.

You do not have to show that business income or another business benefit actually resulted from each entertainment expense.

It is not necessary to devote more time to business than to the entertainment. However, if the business discussion is only incidental to the entertainment, it does not qualify as directly related.

Generally, expenses are not directly related if you are not there, or there are substantial distractions that prevent you from actively conducting business. The following are situations where there are substantial distractions.

You may prove the entertainment is directly related by clearly establishing you had a substantial business discussion during the entertainment.

When entertainment takes place on a hunting or fishing trip, or on a yacht or pleasure boat, the conduct of business is not considered the main reason for the combined business and entertainment unless you clearly show otherwise.

You can deduct entertainment expenses (including expenses for entertainment-related meals) that do not meet the directly-related test if both the following apply.

An ordinary and necessary entertainment expense is generally associated with your direct-selling business if you can show you had a clear business purpose for the expense. The purpose may be to get new business or to encourage the continuation of an existing business relationship.

Whether a business discussion is substantial depends upon the facts and circumstances in each case. You must show that you actively engaged in a discussion, meeting, negotiation, or other business transaction to get income for your business or another specific business benefit.

The meeting does not have to be for a specified length of time. However, you must show that the business discussion was substantial in relation to the entertainment. It is not necessary to devote more time to business than to the entertainment and you do not have to discuss business during the meal or entertainment.

You must divide your entertainment expenses between business and nonbusiness expenses. You can deduct only the business part. If you cannot establish the part of the expense for each person participating, you can allocate the expense to each participant on a pro rata basis. For example, if you entertain a group of 11 (including yourself)—three business prospects and seven social guests—deduct only four-elevenths of the expense.

You generally cannot deduct the cost of entertainment for your spouse or for the spouse of a business customer. However, you can deduct these costs if you can show that you had a clear business purpose, rather than a personal or social purpose, for providing the entertainment.

You cannot deduct expenses for meals and entertainment to the extent they are lavish or extravagant. An expense is not considered lavish or extravagant if it is reasonable considering the facts and circumstances. Expenses will not be disallowed merely because they are more than a fixed dollar amount or take place at a deluxe restaurant, hotel, nightclub, or resort.

Generally, you can deduct your business meal expenses while traveling away from home for business (other than lavish or extravagant amounts). However, if you entertain a business customer locally and the conditions discussed earlier are met, the cost of your own meal is deductible only to the extent the cost exceeds the amount you would normally have spent for personal purposes.

You do your direct selling on the sales party plan. As an incentive for people to host your parties, you offer them a variety of gifts. The choice of gift depends on the success of the party—the higher the volume of sales, the more valuable the gift.

In this situation, your gift to the host or hostess is actually payment for hosting the party, and the host or hostess must report the fair market value of the gift as income.

You can deduct the cost of the gift. If you give hosts and hostesses items from your inventory or items you purchase from the company at the same time you purchase goods you sell, their cost will be included in the cost of goods sold. You cannot deduct their cost again as a business expense. However, if you purchase the gifts separately from the goods you sell, deduct their cost as an ordinary and necessary business expense.

You have several direct sellers working under you. Because your income depends in part on their sales, you regularly meet with them, encourage them, and provide them with incentives and support. As an incentive to make sales, you sometimes offer a prize, such as an evening on the town or tickets to a sporting event, to the person who sells the most during the month.

In this situation, the prizes you give are actually payments for the winners' selling efforts. You can deduct the cost of the prizes as ordinary and necessary business expenses. The direct sellers who receive your incentive prizes must report them as income at their fair market value. For more information, see Other Income, earlier.

You sell cosmetics door-to-door. To spur sales, you often give away small samples.

In this situation, you can deduct the cost of the samples. If you purchase samples separately from the products you sell, you can deduct their cost as an ordinary and necessary business expense.

Do not deduct the cost of the same item twice. If the item was included in inventory, you cannot later deduct it as a business expense. The item will already be part of the cost of goods sold.

You cannot deduct more than $25 for business gifts you give directly or indirectly to any one person during the year (see the exceptions discussed later). Personal gifts are not deductible.

A gift to the spouse (or family member) of a customer is generally considered an indirect gift to the customer. However, if you have bona fide independent business connections with the spouse (or family member) and the gift is not intended for the customer's eventual use, this rule does not apply.

If you and your spouse both give gifts, you are treated as one taxpayer for the $25 limit. It does not matter whether you have separate businesses or independent connections with the recipient.

Costs that do not add substantial value to a gift, such as engraving on jewelry, packaging, insuring, and mailing, are generally not included in determining the cost of a gift for purposes of the $25 limit. For example, the cost of gift wrapping is considered an incidental cost. However, the purchase of an ornamental basket for packaging fruit is not considered an incidental cost if the basket's value is substantial in relation to the value of the fruit.

The following items are not included in the $25 limit for business gifts.

Any item that might be considered either a gift or entertainment will generally be considered entertainment and not subject to the $25 limit. However, if you give a customer packaged food or beverages to be used later, they are gifts.

If you provide business associates with tickets to a theater performance or a sporting event and you do not accompany them, you may treat the tickets as either a gift or entertainment, whichever is to your advantage. However, if you go to the event with them, you must treat the cost of the tickets as an entertainment expense.

In deciding whether your direct selling is carried on for profit, take into account all facts about the activity. No one factor alone is decisive. The following are factors to consider.

If the IRS inquires about your tax return, you may be asked to provide proof that your direct-selling activity is carried on for profit. However, your direct selling is presumed to be carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year, unless the IRS establishes otherwise.

If you are starting a business and do not have 3 years showing a profit, you may want to elect to have the presumption made after you have the 5 years of experience allowed by the test. For more information on postponing any determination that your direct selling is not carried on for profit, see Using the presumption later under Not-for-Profit Activities in chapter 1 of Publication 535.

If the entertainment took place before or after a substantial and bona fide business discussion, in addition to the information in (1), (2), (3), (4), and (6) above, you must be able to prove the following.

If you entertain a readily identifiable group of people, you do not have to record the name of each person. It is enough to designate the group. For example, if you entertain all the members of a garden club, an entry such as “members of the Hillcrest Garden Club” is enough.

Usually, each separate payment you make must be recorded as a separate expense. For example, if you entertain someone at dinner and then go to the theater, the dinner expense and the cost of the theater tickets are separate expenses. You must record them separately in your records.

Expenses of a similar nature occurring during the course of a single event will be considered a single expense. For example, if during entertainment at a cocktail lounge you pay separately for each serving of refreshments, treat the total expense for the refreshments as a single expense.

Some items can be totaled in categories. You can make one daily entry for such categories as taxi fares, telephone calls away from home, gas and oil, and other incidental travel costs. Meals should be a separate category. Include tips for meal-related services with the costs of the meals.

A receipt or bill is often the best evidence to prove the amount of an expense. Documentary evidence is needed for all your lodging expenses unless, under an accountable plan, your employer pays you a per diem reimbursement of no more than the government rate in effect at that time and in that area. It is also generally needed for any other expense of $75 or more.

Documentary evidence will ordinarily be considered adequate if it shows the amount, date, place, and essential character of the expense. For example, a hotel receipt is enough to support expenses for business travel if it has the name and location of the hotel, the dates you stayed there, and separate amounts for charges such as lodging, meals, and telephone calls. A restaurant receipt is enough to prove an expense for a business meal if it has the name and location of the restaurant, the number of people served, and the date and amount of the expense. If a charge is made for items other than meals and beverages, the receipt must show that this is the case.

A canceled check, together with a bill from the payee, usually establishes the cost. However, a canceled check by itself does not prove a business expense without other evidence to show a business purpose.

If you do not have adequate records to prove an element of an expense, you must prove the element by providing both of the following.

You may be required to provide additional information to the IRS to clarify or establish the accuracy or reliability of the information in your records, statements, testimony, or documentary evidence.

Kathleen reports $14,600 as her gross sales on line 1. On line 2, she would enter any refunds she had to give on merchandise, as well as adjustments made to customers' purchases. Since she has no entry on line 2, she enters $14,600 on line 3.

Kathleen uses Part III to figure her cost of goods sold for the year. She has no inventory at the beginning or end of the year. Therefore, she has no entry on line 35 or line 41 of Part III. She purchased $10,000 worth of household products during 2003 for $9,490. (She received trade discounts of $510.) She enters her net cost of $9,490 ($10,000 - $510) on line 36. She also enters this amount on lines 40 and 42 of Part III and on line 4 of Part I.

Gross profit, $5,110, is the difference between Kathleen's net receipts of $14,600 on line 3 and the cost of goods sold of $9,490 on line 4.

Kathleen reports the $200 received as a bonus on line 6. She does not include on Schedule C any income not related to her direct-selling business, such as income from investments or her salary. She reports such income on other lines of Form 1040.

Kathleen's gross income from direct selling is $5,310, the sum of her gross profit of $5,110 on line 5 and the bonus of $200 on line 6.

Kathleen gave her customers samples that cost $48. This amount was not included in the cost of goods sold on line 4.

Kathleen's business mileage was 2,100 miles, and her total 2003 mileage was 6,000 miles. She used her car 35% for business. She uses the standard mileage rate to figure the deduction of $756 (2,100 × .36).

Kathleen must also complete Part IV of Schedule C.

$280 is 35% of the total interest of $800 paid during the year on Kathleen's car loan.

Kathleen spent $260 for various office supplies and postage for her direct-selling business.

Kathleen paid $392 in 2003 for order blanks, bags, and miscellaneous selling supplies.

$168 is 35% of the personal property tax of $480 Kathleen paid on her car in 2003.

Kathleen attended two direct-selling seminars during 2003. Her travel expenses, including lodging, were $515, which she entered on line 24a. Her meals and entertainment, subject to the 50% limit, were $200 and were entered on line 24b. The nondeductible amount of $100 is shown on line 24c and the net deduction of $100 is shown on line 24d.

Kathleen uses her second telephone 100% for business purposes. She paid $264 for local service on her second phone and $62 for long-distance calls. She enters the total of $326 on this line. She has no deduction for other utilities because she does not use any part of her home exclusively for business.

This line is for other direct-selling expenses not listed separately on the schedule. These expenses are listed in Part V on page 2. Kathleen paid $35 to her bank for check printing and account charges for her separate business bank account. She paid membership dues of $30 to a local business association and $38 for a 1-year subscription to a retail sales magazine. She enters these expenses, along with the $199 she paid for catalogs, in Part V. She totals the expenses, $302, on line 48 and enters the total on line 27.

Kathleen adds all her business deductions listed on lines 8 through 27 and enters the total of $3,147 on this line.

Kathleen subtracts her total deductions on line 28 from her Schedule C gross income on line 7. Because her gross business income is greater than her total deductions, she has a tentative profit of $2,163.

Kathleen did not use any part of her home for business, so she does not make an entry here.

Kathleen has a net profit of $2,163 (line 29 - line 30). She enters her net profit here, on line 12 of Form 1040, and on line 2, Section A of Schedule SE (Form 1040).

Kathleen does not have a loss, so she skips this line. If she had a loss and was not at risk for all her investment in the business, she would have to attach Form 6198. See the Schedule C instructions for the meaning of at risk.

Kathleen enters $2,163, the amount from line 31 of Schedule C (Form 1040).

Kathleen enters the amount from line 2, $2,163.

Kathleen multiplies her net profit by .9235 and enters the result, $1,998.

Kathleen multiplies $1,998 (line 4) by .153 and enters $306 as her self-employment tax. She also enters this amount on line 55 of Form 1040.

Kathleen enters one-half of the amount from line 5. She also enters this amount on line 28 of Form 1040 as an adjustment to income.

If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.

The Taxpayer Advocate independently represents your interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.

To contact your Taxpayer Advocate:

For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.

To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications and an index of tax topics. It also describes other free tax information services.