Retail Industry ATG - Chapter 3: Examination Techniques for Specific
Industries (Direct Sellers)
The costs of getting started in a business, before the direct seller is authorized to start selling products, are capital
expenses. These start-up expenses include the cost of exploring different direct-selling opportunities; the cost of
any training the direct seller must have before becoming a direct seller for their product line, any fees that must be
paid to the company to become a direct seller, and similar costs.
Start-up expenses in direct selling companies include the cost of a starter kit purchased directly from the
company. The starter kit may include optional products that are part of the sales display; conceivably, the
products could be sold to a customer.
Some tax issues raised include:
* Starter Kit - How does the direct seller account for the cost of the kit and related items?
* Discontinued Display Items - When products become obsolete (discontinued) where do they go? Are they sold at
a discount, converted to personal use, or given away as a gift?
* Other Income - For items taken out of the kit and/or inventory and disposed of by sale, where income is reported,
and was fair market value or adjusted basis used to calculate income? If converted to personal use or given away
as a gift, how is this reported on the books?
We need to consider whether expenses are start-up expenditures under IRC Section 195 or inventory and/or cost
of goods sold under IRC Section 471. Let’s first consider start-up expenditures.
IRC Section 195
IRC Section 195(c) (1) defines the term “start-up expenditure” to mean any amount –
* paid or incurred in connection with –
- investigating the creation or acquisition of an active trade or business, or
- creating an active trade or business, or
- any activity engaged in for profit for the production of income before the day on which the active trade or
business begins, in anticipation of such activity becoming an active trade or business, and
* Which, if paid or incurred in connection with the operation of an existing active trade or business, would be
allowable as a deduction for the taxable year in which paid or incurred.
IRC Section 195(a) provides that start-up expenditures generally may not be deducted. However, a taxpayer may
elect to deduct certain start-up expenditures. For amounts paid or incurred after October 22, 2004 (the date of
enactment of the American Jobs Creation Act of 2004), IRC Section 195(b) (1) provides that if a taxpayer makes an
* the taxpayer is allowed to deduct, for the taxable year in which the active trade or business begins, an amount
equal to the lesser of –
- the amount of start-up expenditures, or
- $5,000, reduced by the amount by which the start-up expenditures exceed $50,000, and
* The remainder of the start-up expenditures may be deducted ratably over the 180-month period beginning with
the month in which the active trade or business begins.
For amounts paid or incurred on or before October 22, 2004, IRC Section 195(b) (1) provided that, if a taxpayer
makes an election, start-up expenditures may be treated as deferred expenses and deducted ratably over a period
of not less than 60 months, as may be selected by the taxpayer, beginning with the month in which the active trade
or business begins.
An election under IRC Section 195(b) (1) must be made no later than the due date (including extensions) for filing
the return for the taxable year in which the trade or business begins. The election is made by attaching a
statement to the taxpayer’s return.
If the taxpayer completely disposes of a trade or business before the end of the period over which the start-up
expenditures are being deducted ratably, any expenditures that have not yet been deducted may be deducted to
the extent allowed under IRC Section 165.
Inventory and Cost of Goods Sold
Per Treasury Regulation Section 1.471-1, in order to reflect taxable income correctly, inventories at the beginning
and end of each taxable year are necessary in every case in which the production, purchase, or sale of
merchandise is an income-producing factor. Merchandise should be included in the inventory only if title thereto is
vested in the taxpayer. Accordingly, the seller should include in inventory goods under contract for sale but not yet
segregated and applied to the contract and goods out upon consignment, but should exclude from inventory goods
sold (including containers), title to which has passed to the purchaser.
What if the direct seller keeps the company’s products on hand to show to potential customers? Is the cost of
purchase part of the cost of goods sold, a capital expense, a business expense or a personal expense? It all
depends on the circumstances at the time of purchase. However, the cost of a product that is used by the direct
seller is a personal expense, even if that product is occasionally shown to prospective customers. Some direct
sellers erroneously think they can decorate their home with products and deduct the cost as a business expense.
To be deductible under IRC Section 162, the expense must be an ordinary and necessary expense paid or
incurred in carrying on a trade or business (also see Regulation 1.162-3). Under IRC Section 262, no deduction
generally is allowed for personal, living, or family expenses.
Example 1: York 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
them from her company or in becoming a direct seller themselves. York 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
If the direct seller has a product that is used as a demonstrator for one year or less and that demonstrator itself is
not available for purchase by the direct seller’s customers, its cost is considered a business expense. However, if
the demonstrator is available for purchase by a customer, then it is to be considered part of the direct seller’s
Example 2: Lucida 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.
Lucida 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
When Lucida 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. If Lucida qualifies under the small business
exception for inventory, then that item is to be removed from her list of items available for sale (or whatever method
she uses to track the items to be expensed once they are sold) and the cost of that item can NEVER be used as a
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