With tax season quickly approaching, owners of direct selling businesses might be wondering what they should consider as they file for next year. Unfortunately, taxes are a necessary evil, but understanding the various accounting components available for your business and maximizing your deductions can make for a seamless and stress-free experience. Below are seven tax tips to consider for all direct selling businesses and how they might affect you.
1 / Self-Employment Tax
Self-employment tax laws apply to self-employed direct sellers in the same way as other taxpayers. This generally means that the income and expenses of the business are reported on Schedule C as self-employment income. When this is listed as ‘self-employment’ income, any net profit is subject to 15.3 percent as of 2020, which functions similarly to corporate employees who have social security and Medicare taxes withheld from their wages.
2 / Product Taxability
Another important factor to understand in tackling sales tax is learning how your products are taxed in different states. What is their taxability? For example, clothing will be taxed differently in California, Massachusetts and Texas. There may be tax exemptions for your product in some states but not others, and there may be special rules such as a taxable threshold. One example of this is that New York exempts footwear if the item costs less than $110. Certain states also hold sales tax holidays on different products annually. A timely example of this is the emergency sales tax holiday that Puerto Rico declared on necessary items to help relieve tax burdens on its citizens dealing with COVID-19 impacts. Understanding the general taxability of your products matters.
3 / Exempt Customers
If business is humming along and a customer presents you with a sales tax exemption certificate, do you know what you are receiving and how to handle it? Is it required to honor a sales tax exemption certificate? Is this correct documentation? Is it complete? This kind of detail may not seem important until you’re faced with this scenario or a sales tax audit. Knowing the general rules and pitfalls can save a lot of time. Save your customer service team from this headache. Tax exemption documentation is important from a purchasing standpoint and a sales perspective. Learn and know the basics.
4 / Home Office Deductions
If you use your residence for your business, you may be able to claim a home office deduction for the portion of your home that is used. In order to qualify for this deduction, this area of the home must be used exclusively for business purposes. With so many workers now conducting businesses remotely, it is important to recognize, multi-purpose spaces such as the kitchen table, guest room, etc., may not meet the criteria. For example, if you use a specific area in your home to store inventory, you may be able to claim that. However, if you spend your personal time in your living room, which is also where your inventory is, you would not be able to claim this as a deduction because the room is also being used for personal reasons.
If you meet the criteria for this deduction, you must then choose a method. There are two different methods of home office deductions, regular and simplified. The simplified method was introduced in 2013 to reduce the burden on small business owners. Both methods base the calculation on the square footage of the home used for the business. The simplified method uses a standard of five dollars per square foot to a maximum of 300 square feet. Under the simplified method, there is also no depreciation to track nor later recapture as well as limits to the home gain exclusion when the home is sold. The regular method allows a deduction of home office expenses proportionately based on the home’s total square footage. Evaluating the facts and circumstances of your business will help you determine which is the most beneficial method for your direct selling business.
5 / Cost of Goods Sold Calculation
Direct selling businesses may deduct the Cost of Goods Sold from their business income. When computing this calculation for your business, you must consider the following things: Inventory at the beginning of the year, purchases for personal use, labor costs, materials and supplies, other manufacturing costs, as well as inventory at the end of the year. All of these play a factor in computing the cost of goods sold that you will be able to claim on your taxes. This can be a complex calculation; the IRS encourages businesses to establish reliable record-keeping systems to accurately report all income.
6 / Inventory Location
Many direct selling businesses will ship inventory to their independent contractors to later be sold. Who is the legal owner of the inventory when it is delivered? Is the business keeping track of where inventory is located? These questions are important to take into consideration when putting together your contractor agreements as inventory may trigger income tax nexus requiring the business to file an income tax return in every state it owns and holds inventory. To avoid this issue, consider transferring legal ownership of inventory to the contractor when it is delivered.
7 / 1099-NEC Reporting
It is common that direct selling companies have hundreds to thousands of independent contractors. The IRS requires businesses to file informational returns every year, known as Form 1099-NECs (Non-Employee Compensation) to report the amount paid to each independent contractor. This form is filed with the IRS and a copy is sent to the contractor for them to use to file their tax return. A 1099 is required for payments made to contractors that exceed $600 in a taxable year. Information that is required on the 1099 is the contractors’ legal name reported to the Social Security Administration; taxpayer identification number such as an SSN, EIN or ITIN; address; and total amounts paid in a tax year. The name and taxpayer identification number must match IRS records, or it will be flagged for a penalty as not reporting correct information.
The best practice is to require Form W-9s from each independent contractor as part of the company’s onboarding process. The information on the W-9 should then be matched with the IRS system to ensure it is correct. Having good processes in place will ensure the company’s ability to abate potential filing penalties.
Documentation is Everything
One of the most critical steps to help you with your tax deductions is to document everything. Having proper documentation can help you maximize your potential tax deductions each year and set your business up for success in 2022.
We hope that as this tax season approaches, these tips can help your business thrive into the new year. For direct selling business owners, consider talking to a tax advisor about what these tips could mean for your business.
Shara Sumnall is a Sales Tax Manager at Squire & Company. Shara works with a growing team of Sales Tax Account managers in their registration, filing and support responsibilities. Shara spends time advising clients with multi-state sales tax obligations and onboarding them to Squire’s sales tax services.
Joe Hillstead is a Tax Partner at Squire & Company. Joe specializes in U.S. taxation of international transactions and corporate income tax matters. He provides tax consulting and tax compliance services. Joe leads Squire’s sales tax team and he is a leader in Squire’s direct selling industry group.
From the January 2022 issue of Direct Selling News magazine.