Capital Expenses

You must capitalize some costs rather than deduct them. These costs are a part of your investment in your business and are called "capital expenses." When you capitalize a cost, you add it to the basis of the property to which it relates.

Although you generally cannot take a current deduction for a capital expense, you may be able to take deductions for these costs over a period of years as explained later under Cost Recovery.

Kinds of Capital Expenses

You must capitalize the following costs.

• Going into business. The costs of getting started in business, before you are authorized to start selling your company's products, are capital expenses. These "start up costs" include the cost of exploring different direct-selling opportunities, the cost of any training you must have before becoming a direct seller for your product line, any fees you must pay to the company to become a direct seller, and similar costs. See chapter 9 of Publication 535 for information on how to treat these costs.
• Business assets. The cost of any asset (property) that will last substantially beyond the tax year it is placed in service is a capital expense. Examples of business assets include: office furniture, business vehicles, and storage shelves. See Cost Recovery, later.
• Improvements. The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. However, normal repair expenses are deducted as current business expenses and are not capitalized. For example, if you have a car you use only for business, maintenance and repair costs, such as tune-ups, new headlights, or brake repairs, are business expenses. The cost of overhauling the engine, however, would be a capital expense.

Demonstrators

If you keep your company's products on hand to show to potential customers, their cost may be part of the cost of goods sold, a capital expense, a business expense, or a personal expense, depending on the circumstances. The cost of a product you use yourself is a personal expense, even if you occasionally show it to prospective customers.

Example. Sheila 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 from her company or in becoming direct sellers themselves.

Sheila 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 doing business.

Used one year or less. 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.

Example 1. Constance 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.

Constance 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 business receipts.

When Constance 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 as discussed under Cost of Goods Sold, earlier.

Example 2. Lydia sells needlework kits at sales parties. She has catalogs and a number of kits to show customers. She uses these kits to demonstrate various needlework techniques.

The demonstrator kits last less than one year and are not sold to customers. Some are ruined and thrown away. Their cost is a business expense.

More than one year of use. 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.

Example 1. Mike sells educational books door-to-door. He carries copies of the books to show. If someone wants a book, he takes a deposit and delivers the book at a later time.

Because his product line changes little from year to year, Mike can use a book as a demonstrator for a long time. Although he periodically replaces his demonstrators with new ones and sells the old ones at a discount, he has kept some books as demonstrators for up to 3 years.

Because Mike eventually sells his demonstrators, they remain part of his inventory of goods for sale.

Example 2. Janet sells the same line of educational books as Mike in Example 1. She tries to use her demonstrators as long as possible. She puts the books in plastic jackets to protect them, and ordinarily only stops using them as demonstrators when the company comes out with a new edition. Janet never sells the old demonstrators. She can recover the cost of the books she uses as demonstrators as discussed under Cost Recovery, next.