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Retail Industry ATG - Chapter 3: Examination Techniques for Specific Industries (Direct Sellers)

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


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Chapter 3: Examination Techniques for Specific Industries
(Direct Sellers)


Introduction

Direct selling provides important benefits to individuals who desire an opportunity to earn an income and build a business of their own; to consumers who enjoy an alternative to shopping centers, department stores or the like; and to the consumer products market. It offers an alternative to traditional employment for those who desire a flexible income earning opportunity to supplement their household income, or whose responsibilities or circumstances do not allow for regular part-time or full-time employment.

The cost for an individual to start an independent direct selling business is typically very low (which is a major selling point for entering into this type of self-employment business).  Usually, a modestly priced sales kit is all that is required for one to get started, and there is little or no required inventory or other cash commitments to begin.   This stands in sharp contrast to franchise and other business investment opportunities that may require substantial expenditures and expose the investor to a significant risk of loss.

Direct selling companies market their products through person to person contact away from a fixed retail location through a network of independent sellers.  Frequently these sales presentations are in the home, in the form of a sales “party,” or through door to door solicitations, or sometimes, as part of a get-together – one person to one person.  In any case, these approaches are all considered direct sales. In addition, direct selling provides a channel of distribution for companies with innovative or distinctive products not readily available in traditional retail stores, or who cannot afford to compete with the enormous advertising and promotion costs associated with gaining space on retail shelves. 

This selling method should not be confused with terms such as direct marketing or distance selling which may be described as an interactive system of marketing that uses one or more advertising media to affect a measurable response and/or transaction at any location, with this activity being stored on a database.  Some commonly known types of direct marketing and distance selling techniques are telemarketing, direct mail, and direct response.   Direct selling is sharply contrasted to this type of sales as it concentrates on face to face or personal presentation which is always an aspect of their selling relationship.

Types of Direct Selling Companies

There are two types of direct selling companies – single level marketing (SLM) or multilevel marketing (MLM).  Single level marketing (SLM) companies reward direct sellers for their own personal sales activity.  SLM direct sellers cannot take on other distributors or sales representatives. Income comes from commission or bonus on sales.

In a multi-level marketing company, sales representatives are able to sponsor other distributors or sales representatives and receive a commission or bonus on the sales made by their underlying resellers.  This recruitment of down liners is necessary to increase a sales representative’s sales force and thus generate a greater number of sales.  MLM’s are often referred to as network marketing companies.

Multi-level marketing differs from an activity called a “pyramid scheme.”  Pyramid schemes are illegal scams in which large numbers of people at the bottom of the pyramid pay money to a few people at the top.  The success of a pyramid scheme relies upon a never-ending supply of new participants.

Pyramid schemes seek to make money quickly.  Multi-level marketing companies seek to make money with their representatives as the business grows by selling their consumer products.  Multi-level marketing companies have a start-up fee that is small with a starting sales kit being sold at or below the company cost.  Multi-level marketing depends upon sales to the consumer and establishing a market.

Demographics of Direct Sellers

Direct selling is a rapidly growing industry.  U.S. sales totaled $29.55 billion in 2003, up from $28.69 billion in 2002, with more than 55 percent of the American public having purchased goods or services through direct selling.  Direct selling globally has grown to more than $85.04 billion dollars as well.  For the 19th year in a row, this industry has grown in both the area of sales and sales force.  The $29.55 billion dollar of sales is more than the amount that was purchased through television shopping and on-line computer services combined.
 
Currently, there are an estimated 13.3 million people who are involved in direct selling in the United States and more than 47.3 million people worldwide.  Most are women, though nearly a third are men or two-person teams such as husband and wife (couples).  The vast majority is independent business people - they are micro-entrepreneurs whose purpose is to sell the product and/or services of the company they voluntarily choose to represent -- not employees of the company.  Of these 13.3 million people for 2003, approximately 90 percent of them operate their businesses part-time. The Small Business/Self-Employed Division serves each and every one of these 13.3 million direct sellers.  
 
Why are Americans so interested in becoming direct sellers?  Most are independent contractors; they have the ability to work part-time or full-time and can choose when and how many hours they want to devote to their business.  In other words, an individual can earn in proportion to their efforts.  The level of success is limited only by their willingness to work hard.  And a person can own their own business with very little or no capital investment.  

Since direct sellers do not need any specific amount of education, knowledge, or any specific requirement in order to be successful, they only need the desire and self-motivation to grow their business and make it profitable for them.

What Direct Sellers Do

Just about every consumer product or service can be purchased through direct selling.  But where is this direct selling taking place?

Location of Sales:

 

  2000 2001 2002 2003
Face-to-face selling: 78.26% 77.3%  76.1% 73.1%
  In the home 64.4% 63.5% 62.8% 61.9%
  In the workplace 8.7% 8.8% 8.9% 6.7%
  At a temporary location: (Fair, exhibition, etc.) 4.1% 4.2% 3.7% 3.9% 
  Other locations 1.0% 0.8% 0.7% 0.6%
         
Remote selling: 21.8% 22.7% 23.9% 26.9%
  Phone 14.7% 14.4% 15.1% 15.6%
  Internet (www or email) 5.5% 7.2% 8.2% 10.8%
  Other (mail, fax) 1.6% 1.1% 0.6% 0.5%

Source:  2001, 2002, 2003, 2004 Direct Selling Association’s Fact Sheet Growth & Outlook Surveys.

It is impossible to estimate the number of direct selling companies operating at any given moment.  This is a result of several different factors.  First, most states do not require direct selling companies to register as such.  Second, as with any business, many direct selling companies do not thrive in the direct selling market and have a relatively short life span.

NAICS Codes and the Direct Selling Industry

The North American Industry Classification System (NAICS) has replaced the U.S. Standard Industrial Classification (SIC) system.  NAICS groups the economy into 20 broad sectors, up from the 10 divisions of the SIC system.  The Code 44-45 is specifically for the Retail Trade sector.

The NAICS definition emphasizes what the establishment does, rather than to whom it sells.  Retailers are defined as those establishments that sell merchandise, generally without transformation, and attract customers using methods such as advertising, point-of-sale location, and display of merchandise.  A store retailer has a selling place open to the public; merchandise on display or available through sales clerks; facilities for making cash or credit card transactions; and services provided to retail customers.

Taxpayers are instructed to enter on the Schedule C or Schedule C-EZ a code which best describes the type of business activity that they participate in.  Currently, a 6-digit NAICS code is entered.

The instructions to Schedule C list several NAICS codes relating to nonstore retailers.  As discussed in this audit technique guide, NAICS #454390 is probably the most appropriate code for direct selling businesses.

NAICS #454390 – Other Direct Selling Establishments (Including Door-to-Door Retailing, Frozen Food Plan Providers, Party Plan Merchandisers, and Coffee-Break Service Providers)
These establishments are primarily engaged in retailing merchandise (except food for immediate consumption and fuel) via direct sale to the customer by means such as in-house sales (i.e., party plan merchandising), truck or wagon sales, and portable stalls (i.e., street vendors).

Examples:
Direct selling bottled water providers
Direct selling coffee-break service providers
Direct selling frozen food and freezer plan providers
Direct selling home delivery newspaper routes
Direct selling locker meat providers
Direct selling party plan merchandisers


Exhibit 1-1                   Industry Organizations

  1. Direct Selling Association   www.dsa.org
  2. World Federation of Direct Selling Associations   www.wfdsa.org
  3. Direct Selling Education Foundation   www.dsef.org

Income Issues

Gross Receipts
A direct seller prides himself in naming his own hours and has the luxury of deciding how much or how little time is spent on running the business.  Typically, direct sellers spend approximately:

  • 44% of their time on selling the product or service,
  • 20% of their time on administration and paperwork,
  • 15% of their time on recruiting or sponsoring others,
  • 10% of their time on either training someone else or receiving training themselves, and
  • 9% of their time on miscellaneous other duties.

The above percentages are only estimates.  A direct seller may spend more or less time on each activity depending upon where the seller is in developing the business and whether the seller is engaged in a single or multi-level effort.

In order to know how much commission a direct seller is earning we must know when the direct seller is eligible for a commission. Each company has its own specific method of determining commissions.  Some examples of when commissions are paid include:

  • At the time the order is placed with the company for shipment,
  • At a later specified date, even though the customer pays the full merchandise price upfront, and
  • A portion of the commission is paid upfront and the remainder paid at a later specified date.

There are two ways that a direct seller can earn income/profits:  They can sell the product and they can sponsor/recruit new representatives.  Each company has its own set percentage of commission on direct sales, as well as additional percentages of additional income from their “down-line” sales.  These percentages are generally smaller but are based on sales produced by that recruit.

Example:  A direct salesperson/consultant would receive a 25% commission on personal sales.  Once they sponsor/recruit two new consultants, they receive an additional 2% of the recruits’ sales each month.  If they sponsor/recruit four to six new consultants, this percentage increases to 7%.  Both the original consultant and the recruits start earning additional income.  In addition, if one of their recruits sponsors two new consultants, they can earn 4% of the sales of those new recruits.  Below is a chart comparing the commissions paid by a few well-known companies:

The companies listed below are only examples.  For a more complete listing of companies, visit the Direct Selling Association - Membership Directory.

 

Company

Products

Base Commission

Average Show

Mary Kay Skin care/cosmetics

50%

$250.00

Avon Health/beauty supplies

20%

 

Tupperware Kitchenware

35%

 

Party Lite Candles & accessories

25%

$400.00

Pampered Chef Kitchen tools

20%

$470.00

Longaberger Baskets & pottery

25%

$350.00

Home and Garden Party Home decorations

40%

$350.00

Creative Memories Scrap booking

30%

$300.00

Stampin Up Rubber stamping

35%

$300.00

Discovery Toys Educational toys

25%

$300.00

In addition to the base commission and the additional commission earned on a down-line, there is an added benefit of personal discounts.

 

Company

Products

Personal Discount

Members

Mary Kay Skin care/cosmetics

50%

900,000

Avon Health/beauty supplies

 

3.3M

Tupperware Kitchenware

45%

 

Party Lite Candles & accessories

50%

11,000

Pampered Chef Kitchen tools

20%

67,000

Longaberger Baskets & pottery

45%

70,000

Home and Garden Party Home decorations

40%

30,000

Creative Memories Scrap booking

30%

50,000

Stampin Up Rubber stamping

20%

22,000

Discovery Toys Educational toys

20%

 

The personal discounts in the above examples show an average of 36% savings on personal purchases of the products that are offered by the companies. The discounts range from 20% (Pampered Chef) all the way up to 50% (Mary Kay).

All income that is received as a result of direct sales is taxable under IRC Section 61 and should be reported as gross receipts. There is a misconception that if the income is not reported on Form 1099-MISC it is not taxable. Direct sellers may receive income in several different forms, including:

  • Income from sales - these are payments received from their customers for product purchases.
  • Commissions, bonuses, or percentages of income received as a result of sales from others who work under them (commonly referred to as their “down-line”).
  • Prizes and awards received from the selling business, taxable under IRC Section 74.
  • Income also includes products received as a result of meeting certain sales quotas (for example, receiving all products displayed on the front page of the new catalogue in exchange for selling at a certain level for that month).
  • Typically, the hostess, not the direct seller, receives gifts. However, gifts received by the direct seller are considered payments to help the direct seller make sales. The fair market value of these gifts must be reported as income under IRC Section 61.

Form 1099-MISC

IRC Section 6041A(b) and Proposed Regulation Section 1.6041A-1(b) require information reporting on Form 1099-MISC if: (1) any person engaged in a trade or business during any calendar year sells consumer products to any buyer on a buy-sell, deposit-commission, or similar basis for resale (by the buyer or any other person) in the home or otherwise than in a permanent retail establishment; and (2) the aggregate amount of the sales to such buyer during such calendar year is $5,000 or more.

A person is considered to sell a product to a buyer for resale even though the buyer does not acquire title to the product prior to selling it to the consumer.  For example, a person paid on a commission basis who does not acquire title to a product before selling it to the consumer is considered to have bought the product for resale for purposes of IRC Section 6041A(b).

In the direct selling industry, gross receipts are generally based on “commissionable sales.”  Commissionable sales are retail sales of products for which the sales representative earns a commission.  Sales may include items that are sold specifically on a non-profit basis, whether for a charitable purpose or as a reward for hitting a certain pre-set sales figure per customer. 

Example:  A customer who purchases a minimum of $30 worth of retail products receives the opportunity to purchase a specific item at a special sales price of $6.75.  The sales representative earns a base commission on the $30.00 retail sale, but does not earn anything on the special sales price item.  This is used as a “carrot” to entice customers to purchase enough to receive the opportunity to purchase the special sales price item.

It is important to remember that compensation in a direct seller marketing plan is derived primarily from the sale of consumer products to ultimate consumers and users.  Ultimate consumers include those direct sellers who purchase products for their personal, family, or household use.  No compensation is earned merely from the act of recruiting additional participants to the plan.

Expense Issues

Start-Up Expenses

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 election –

  • 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 doing business.

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 inventory.

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 business receipts.

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 business expense.

Partnership v. Sole Proprietorship

The majority of direct sellers are sole proprietors who file a Form 1040 Schedule C.  A sole proprietorship is an unincorporated business owned by one individual.  It is the simplest type of business organization.  The business does not exist apart from the proprietor (owner).  The proprietor assumes the risks of the business to the extent of all of his/her assets, whether or not the assets are used in the business.  Members of a family can be partners.  So, if a husband and wife jointly own and operate a business, a partnership exists.
   
A partnership is an association of two or more persons to carry on as co-owners a business for profit.  Each person contributes money, property, labor, or skill and expects to share in the profits and losses. For federal income tax purposes, IRC Sections 761(a) and 7701(a) (2) defines the term “partnership” to include a syndicate, group, pool, joint venture, or similar organization carrying on a trade or business and not classified as a trust, estate, or corporation. Whether a partnership exists for tax purposes depends on the parties’ intent, which is determined by looking at all the facts and circumstances of the business relationship.

Members of a family can be partners.  So, a partnership exists if a husband and wife jointly own and operate a business.  In the direct selling business, one spouse often signs up as the company’s representative and the other spouse “helps” out with the selling, bookkeeping, other duties, and activities.  In most instances, the spouse that is not the registered representative is treated as a non-employee.  In other words, they are not paid a salary, nor are they issued a Form 1099-MISC for their services rendered.  Even so, a partnership may exist for tax purposes.

Partnerships generally file a return on Form 1065, U.S. Return of Partnership Income.  The return shows the income and deductions of the partnership, the name and address of each partner, and each partner’s distributive share of the partnership’s income, gains, losses, deductions, and credits.  The Form 1065 is not required until the first tax year the partnership has income or deductions.  In addition, a return is not required for any tax year a partnership neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.

Each partner’s distributive share of the partnership’s income, gains, losses, deductions, and credits is reported on the Schedule K-1 for the Form 1065 and must be included on the partner’s tax return, even if the items being reported were not distributed.

Unless the direct seller is a limited partner, the distributive share of income from a partnership is self-employment income.  If a husband and wife are partners, they each should report their share of partnership income or loss on a separate Schedule SE (Form 1040), Self-Employment Tax.   Reporting the partnership income on separate Schedules SE will give each spouse credit for social security earnings, on which retirement benefits are based.

Employee v. Independent Contractor

The services of a direct seller are any services that customarily are directly related to the trade or business of selling (or soliciting the sale of) consumer products in the home or in any other location that does not constitute a permanent retail establishment.  Such services include any activity to increase the productivity of other individuals engaged in such sales, such as recruiting, training, motivating and counseling such individuals.

A direct seller usually signs up with a particular company to sell its product line.  The company may refer to the direct seller by one of the following titles:

  • Consultant
  • Coordinator
  • Dealer
  • Demonstrator
  • Designer
  • Director
  • Distributor or direct distributor
  • Instructor
  • Manager or supervisor
  • Representative or sales representative
  • Independent business owner

The above list of titles is not all inclusive.

Direct sellers are self-employed.  This generally means that they have to pay self-employment tax.  They must be in business for themselves.  Selling consumer products as a company employee does not make them direct sellers.  Likewise, working under another direct seller does not make them an employee of that direct seller.

An individual may be engaged in the trade or business of selling or soliciting the sale of consumer products if they attempt to increase the sales of direct sellers who work under them (their down-line group) and their earnings depend in part on how much that person sells.  Recruiting, motivating, and training are examples of attempts to increase direct seller sales.  An individual is not a direct seller if they simply host a party at which sales are made.

IRC Section 3508(b) (2) defines the term “direct seller” to mean any person if –

  • such person
    • is engaged in the trade or business of selling (or soliciting the sale of) consumer products to any buyer on a buy-sell or deposit-commission basis for resale by the buyer or any other person in the home or in some other place that does not constitute a permanent retail establishment, or
    • is engaged in the trade or business of selling (or soliciting the sale of) consumer products in the home or in some other place that does not constitute a permanent retail establishment;
  • substantially all the remuneration (whether or not paid in cash) for the performance of the services described above is directly related to sales or other output (including the performance of services) rather than to the number of hours worked; and
  • Such person performs the services pursuant to a written contract between such person and the service-recipient and the contract provides that such person will not be treated as an employee with respect to such services for federal tax purposes.

According to the Direct Selling Association (DSA), a vast majority (99.9%) of all direct sellers are classified for federal tax purposes as independent contractors.  These independent business people are micro-entrepreneurs whose purpose is to sell the product and/or services of the company they voluntarily choose to represent.  

IRS Publication 15-A, Employer’s Supplemental Tax Guide, states that direct sellers are in the category of statutory non-employees and are treated as self-employed for all federal tax purposes, including income and employment taxes, if:

  • substantially all payments for their services as direct sellers are directly related to sales or other output, rather than to the number of hours worked, and
  • Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.

Revenue Ruling 85-63, 1985-1 C.B. 292, holds that an individual who performs services as a direct seller, as defined in IRC Section 3508, is liable for the tax on self-employment income.  Proposed Regulations Section 31.3508-1(a) provides generally that an individual who performs services as a direct seller after December 31, 1982, shall not be treated as an employee with respect to such services, and the person for whom such services are performed shall not be treated as an employer, for federal income and employment tax purposes.

Revenue Ruling 85-63 discusses the following factual situation:

B, an individual, performs services selling consumer household products door-to-door for Y, a corporation.  These services are performed under a written agreement which provides that, for federal tax purposes, Y will not treat B as an employee.  B is paid solely on a commission basis.  B thus meets the description of a direct seller contained in section 3508(b) (2) of the Code.
 
The direction and control that Y exercises over B in the performance of B’s services would establish the relationship of employer and employee under applicable common-law rules.  Thus, but for the application of section 3508(a) of the Code, B would be Y’s employee within the meaning of section 3121(d) (2).  Y does not withhold FICA or federal income tax from the remuneration paid to B.

The Revenue Ruling holds that B is liable for the self-employment income taxes imposed by IRC Section 1401.

Questions to ask on this issue:

  • Schedule C.  Is the business properly being reported on the Schedule C, with net income being subject to self-employment tax?
  • Commissions, etc.  Is the business expensing commissions, management fees, etc.?  This could indicate that family members are working for the business.  Is a Form 1099 being issued for those individuals being [paid $600 or more] for any calendar year?  Is the working family member the subject of an employee/employer relationship, using the three classification issues of behavioral control, financial control and relationship/intent?
  • Spouse Is the spouse working for the business and being treated as an independent contractor or employee?  Does the spouse receive any compensation at all?  Is there proper treatment of spousal activity?

Profit v. Not-For-Profit Issue

IRC Section 162(a) generally allows taxpayers to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including the business of direct sellers.  IRC Section 212 further allows taxpayers who are individuals to deduct all the ordinary and necessary expenses paid or incurred during the taxable year for (1) the production or collection of income, or (2) the management, conservation, or maintenance of property held for the production of income.  Under IRC Section 262, however, no deduction generally is allowed for personal, living, or family expenses.

IRC Section 183(a) generally limits deductions, in the case of an activity engaged in by an individual or an S corporation, if the activity is not engaged in for profit.  The term “activity not engaged in for profit” is defined by IRC Section 183(c) to mean any activity, other than one with respect to which deductions are allowable for the taxable year under IRC Section 162 or under paragraphs (1) or (2) of IRC Section 212.

If an activity is not engaged in for profit, IRC Section 183(b) allows a taxpayer the deductions that would be allowable without regard to whether or not the activity is engaged in for profit.  If the gross income derived from the activity for the taxable year exceeds these deductions, IRC Section 183(b) also allows a taxpayer to deduct the amounts that would be allowable as deductions if the activity were engaged in for profit, to the extent of any remaining gross income.

Under IRC Section 183(d), an activity is presumed to be engaged in for profit if the gross income derived from the activity exceeds the deductions attributable to the activity for three or more of five consecutive taxable years.  This presumption is rebuttable; that is, the IRS may establish that, despite the fact that the gross income exceeded the deductions for the requisite time period; the activity is not engaged in for profit.  On the other hand, if the gross income does not exceed the deductions for the requisite time period, there is no presumption that the activity was not engaged in for profit; that is, examiners cannot rely on IRC Section 183 (d) as the basis for disallowing losses.

The test to determine whether a taxpayer conducted an activity for profit is whether they engaged in that activity with an objective of earning a profit.  Although a reasonable expectation of profit is not required, the profit objective must be bona fide, as determined from a consideration of all the facts and circumstances.

The regulations under IRC Section 183 provide nine factors to be used in determining whether a taxpayer is conducting an activity with the intent to make a profit.  No single factor controls, some are more important than others in given circumstances, and other factors may be considered.  The mere fact that the number of factors indicating the lack of a profit objective exceeds the number indicating the presence of a profit objective (or vice versa) is not conclusive.

Past court cases that have considered whether the taxpayer is engaged in a trade or business and whether an activity is engaged in for profit include:

  • Commissioner v. Groetzinger, 480 U.S. 23 (1987)
  • Higgins v. Commissioner, 312 U.S. 212 (1941)
  • City Bank Farmers Trust Co. v. Helvering, 313 U.S. 121 (1941)
  • Owen v. Commissioner, 23 T.C. 377 (1954)
  • Haft v. Commissioner, 40 T.C. 2 (1963)
  • Schwinn v. Commissioner, 9 B.T.A. 1304 (1928)
  • Schott v. Commissioner, T.C. Memo. 1964-272
  • Engdahl v. Commissioner, 72 T.C. 659 (1979)
  • Boyer v. Commissioner, 69 T.C. 521 (1977)
  • Herrick v. Commissioner, 85 T.C. 237 (1985)
  • Elizabeth Giles v. Commissioner, T.C. Memo. 2005-28

Nine Factors and Analyses

Using Minnick v. Commissioner, T. C. Summary Opinion 2002-147, this section will briefly review how one court evaluated each of the nine factors in deciding whether an activity was engaged in for profit.  The taxpayer operated a home-based direct selling business, but the principles involved are generic; that is, they apply in the same way to any business. 

Factor 1 (Manner in Which the Taxpayer Carries On the Activity) – The activities in Minnick were not conducted in a sufficiently businesslike manner.  Petitioners did not maintain their own business records other than notes of meetings in a daily planner.  Petitioners did not present evidence of any formal budgets, profit projections, or break-even analyses that had been prepared in connection with their distributorship. (Factor favors government.)

Analysis:  In addition, the trade or business must be carried on regularly and in a continuous manner to display the intention of a going concern. This intent is noted through the business records, which should include:

  • budgets
  • books and records
    • indicating active management
  • set reasonable goals
    • continuous evaluation of these goals
    • adjust business activities and expenditures based on actual goals

Each person maintains their own books and records in a manner appropriate to their business style.  However, any ongoing business needs books and records that give a picture of where the business is going, whether business methods are profitable, and what changes should or can be made to brighten the picture, at least on a quarterly basis.  Some of the IRS’s concerns are:

  • Not maintaining a separate business checking account
  • Not maintaining a log tracking business miles driven
  • Inability to determine success of business
  • Customer/party files not maintained
  • Continued expenditures in activities that show little or no profit potential (such as craft shows and exhibitions)
  • Bartering transactions that are being done with parties, whether a book party or an in-home party
    • Whenever an individual receives items with a fair market value of $600 or more in any one calendar year, they are to be issued a Form 1099 for the full amount received.  Since direct sellers operate their own business, they are responsible for issuing this form to any host or hostess to whom it applies. 

Factor 2 (The Expertise of the Taxpayer or His Advisors) – In Minnick, petitioners sought the advice of persons who might be considered experts in their business activities.  Petitioners attended various events conducted regularly that they believed would provide the expertise necessary to make their distributorship profitable. (Factor favors taxpayer.)

Analysis:  A direct seller may not have prior sales training or expertise in direct selling, but that does not negate a profit objective.  The examiner should evaluate the direct seller’s willingness to learn the business and gain hands-on experience.  The more the direct seller knows about the business, the better prepared he is to sell the products and represent them. For direct sellers, the most important source of useful business-building information will often be other successful leaders in their business.

Factor 3 (Time and Effort Expended by the Taxpayer) – In Minnick, petitioners devoted approximately two nights per week, and approximately two weekends per month, to the activity.  This time was spent in delivering products and in traveling to other individuals' homes for evening meetings as well as to monthly meetings and quarterly "major functions." (Factor favors taxpayer.)

Analysis:  The fact that a taxpayer carries on employment or more than one business at any given time is not evidence of a lack of a profit motive.  How the time is spent is more important than the amount of time spent on the activity.

  • Does the direct seller show that the use of their time clearly reflects efficiency and growth in their business, rather than just plugging along and working at it haphazardly?
  • Does the direct seller spend time evaluating whether a particular activity that shows very little profit potential should be discarded and a more beneficial activity be picked up?
  • Does the direct seller display a desire to recruit downliners, do they increase the number of sales or opportunity presentations as time goes by, are they seeking out opportunities to make themselves more visible in the public eye? 

There should be several indicators of a desire to grow a business, rather than working at such a pace that the activity may be considered a hobby rather than a true business.

Factor 4 (Expectation That Assets Would Appreciate in Value) – This factor is not relevant in Minnick.  There were no assets subject to significant appreciation.

Analysis:  The fact that most direct sellers typically have few capital assets should not cause one to question the legitimacy or viability of the business.

Factor 5 (Taxpayer’s Success in Other Activities) – In Minnick, no evidence was produced showing that either of petitioners had ever engaged in similar activities, or that either had ever been involved with making other activities profitable. (Factor favors government.)

Analysis:  The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he/she is engaged in the present activity for profit, even though it may not currently be profitable. The fact that the taxpayer has not been engaged in a similar activity in the past does not negate a profit motive in the present activity.

Factor 6 (Taxpayer’s History of Income or Losses) and Factor 7 (Amount of Occasional Profit, If Any) - A profit objective is strongly indicated where the taxpayer has experienced a series of profitable years.  A series of losses incurred during the startup stage of an activity does not necessarily indicate the lack of a profit objective, but it may so indicate if the losses continue beyond the customary startup period and are not otherwise explainable as due to customary business risks.  In Minnick, the taxpayers sustained substantial losses in their distributorship activities for at least six consecutive years, no profits were ever earned from the activity, and there was no indication that the business would eventually become profitable.  (Factors favor government.)

Analysis:  For the Service it is no different for the direct sellers than it is for any other business out there.  A direct seller normally goes into business with the hope and intent that their endeavor will become profitable.  If, after a suitable start-up period, a business shows no profit or trend toward profitability, it is appropriate for the examiner to evaluate the actions the business owner has taken to become profitable.  The examiner should generally expect to see evidence that the seller has adjusted their business in ways that are intended to increase sales, mitigate costs, or both.  This requires a very factually specific inquiry and should consider both the seller’s long and short range plans and actions.  While it should be rare to see a seller stay in business over a long period of time if they do not demonstrate any trend towards profitability, an examiner must also consider the extent to which the seller’s early period activities may constitute an investment in the business’ long-term viability.  It should also be noted that the presumption articulated in Section 183(d) does not stand for a finding that in the absence of the taxpayer realizing at least three profitable years out of five, an activity is prima facie not-for-profit.

If the direct seller is audited in the first or second year after start-up, the direct seller can elect to postpone an IRS determination as to whether the presumption under IRC Section 183(d) applies.  The direct seller may file Form 5213, Election to Postpone Determination, if an activity has not been carried on for a 5-year period.  How does this benefit them?  The IRS will generally postpone its determination of whether the activity is engaged in for profit and will not restrict deductions during the 5-year period.

In order to take advantage of this election, the Form 5213 must be filed within 3 years after the due date of the return for the first year of the activity, or, if earlier, within 60 days after the IRS issues a written notice proposing to disallow deductions attributable to the activity.  Filing the form automatically extends the period of limitations for tax assessment on any year in the 5-year period until 2 years after the due date of the return for the last year of the period.  The period is extended only for deductions attributable to the activity and any deductions that are affected by changes made to adjusted gross income.

Factor 8 (Financial Status of the Taxpayer) – In Minnick, petitioners' separate wage and salary income provided a substantial source of income apart from the distributorship. (Factor favors government.)

Analysis:  While it can be true that the absence of any other substantial source of income may strongly indicate a taxpayer’s profit motive, the presence of income from other sources does not, by itself, negate a profit objective. 

Factor 9 (Elements of Personal Pleasure or Recreation) - Profit need not be the only objective, and personal motives may coexist with an actual and honest intent to derive a profit.  In Minnick, the court found the significance of personal motives difficult to gauge. On the one hand, petitioners expended a substantial amount of time in activities, such as driving long distances that would appear to lack elements of pleasure or recreation.  On the other hand, much of petitioners' activities involved elements that were very personal in nature, such as frequently visiting family members who were also involved in the same business. (Factor determined to be neutral.)

Analysis:  The direct seller can enjoy his/her business and receive personal pleasure from it, but still be engaged in it for profit.  It should be considered whether any significant recreational or entertainment element was ordinary and necessary to grow the business.  (Is the direct seller engaged in the activity for personal pleasure or for the building of a business that will create income?  Is the direct seller engaged in the business because he or she likes the product and all the amenities that go along with it?)

The direct sellers’ business requires meeting people and carrying on active social interaction– recruiting other sellers and selling to ultimate individual purchasers.  Normally, a prudent direct seller organizes various quasi-social environments in which to market its products or connect with ‘prospects,’ which often involves family, friends, and acquaintances.  These business activities should not be discounted on their face if they can be shown to have been appropriate and helpful in developing the business.

The weight of the factors will vary with the taxpayer and with the type of activity.  In Minnick, the court placed great weight on the manner in which the business was carried on (Factor 1) and the history of losses and lack of profits (Factors 6 and 7) in determining that there was a lack of profit motive.

The type of business activity and the taxpayer will dictate which factors are more important in relation to each other. With respect to direct sellers, Factors 1, 3, 6, and 8 are generally dominant, Factors 2, 5, and 9 less important, and Factor 4 rarely will come into play.  Factor 7 (amount of occasional profits) deserves special note and applies in all situations.

More detailed information on examining an IRC 183 Activity Not For Profit issue is available in the Audit Technique Guide for IRC 183 Activities Not Engaged For Profit which includes extensive information on the nine factors, interview questions, examination techniques, etc.

Examination Practices

We want to ensure in our audits that examiners are not prejudicial when considering whether taxpayers are engaged in any particular industry for profit.  Each taxpayer is entitled to be evaluated by a fair, impartial examiner so that a fully reasoned determination can be made.

What an Examiner Should Not Do – An examiner should not tell a taxpayer that, because he is involved in a particular business activity, it is not possible to make a profit and his losses are therefore disallowed.

What an Examiner Should Do – An examiner should thoroughly interview the taxpayer to gather the factual information to evaluate each of the nine factors outlined above.  If it is determined that there is no profit motive and the taxpayer does not agree, the examiner should also consider an alternative position in the event that it is later determined that the taxpayer was engaged in the activity for profit.  Expense items of a material nature should be examined.  The taxpayer should be informed of the dual nature of our approach. 

Fair and consistent treatment of taxpayers is a cornerstone of tax administration.  We must always be concerned with the perception by taxpayers of inequitable treatment.

Web Sites For More Information:

 

Direct Selling Company

Mary Kay Cosmetics
Avon
Tupperware Corporation
PartyLite Candles
The Pampered Chef Ltd.
The Longaberger Company
Home and Garden Party
Creative Memories
Stampin Up
Discovery Toys
Amway Corporation
NuSkin

Note that Quixtar, which is the sister company of and successor to Amway in North America, represents a large constituency within the direct selling universe.  Examiners are likely to encounter the name more frequently perhaps than some others.

The above is not an all inclusive list of direct selling opportunities.  You may also wish to visit the Direct Selling Association - Membership Directory.

Code Sections, Revenue Rulings and Court Cases

Code Section

Description

Page
IRC § 61 Gross income consists of all income, from all sources, such as compensation for services, business income, interest, rents, dividends and gains from the sale of property.  Only items specifically exempt may be excluded.  Gross income is the starting point in determining tax liability and is broadly defined. 2-2

IRC § 74(a)

 

Except as otherwise provided in this section or in section 117 (relating to scholarships), gross income includes amounts received as prizes and awards. 2-3
IRC § 162 Specifically focuses on the issue of trade or business expenses 2-10
IRC § 183 In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section. 2-10
IRC § 183(d) If the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years which ends with the taxable year exceeds the deductions attributable to such activity (determined without regard to whether or not such activity is engaged in for profit), then, unless the Secretary establishes to the contrary, such activity shall be presumed for purposes of this chapter for such taxable year to be an activity engaged in for profit. In the case of an activity which consists in major part of the breeding, training, showing, or racing of horses, the preceding sentence shall be applied by substituting “2” for “3” and “7” for “5”. 2-10

IRC § 195

 

Start-up expenditures may, at the election of the taxpayer, is treated as deferred expenses.  2-4, 2-5
IRC § 212 Defines business activities 2-10
IRC § 262 Addresses the disallowance of personal, living and family expenses 2-6
IRC § 471 Accrual Method 2-4
IRC § 761(a) Defines partnership 2-7

IRC § 1401

 

Imposes taxes upon the self-employment income of every individual. 2-10
IRC § 3121(d)(2) Defines employees 2-9
IRC § 3508(b) (2) Provides in part that the term “direct seller” includes a person only if such person (i)  is engaged in the trade or business of selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis which the Secretary prescribes by regulations, for resale (by the buyer or any other person) in the home or otherwise than in a permanent retail establishment, or (ii)  is engaged in the trade or business of selling (or soliciting the sale of) consumer products in the home or otherwise than in a permanent retail establishment. 2-8, 2-9
IRC § 6041A(b) Requires information reporting on form 1099 MISC  2-3
IRC § 7701(a)(2) Defines partnerships   2-7


 

Revenue Rulings

Chapter Section

Page

Rev. Rul. 85-63 Self-employment tax deduction 2-9


 

Court Cases

Cite

Page

Boyer v. Commissioner, 69 T.C. 521 (1977) 2-11
Commissioner v. Groetzinger 480 U.S. 23 (1987) 2-11
City Bank Farmers Trust Co. v. Helvering 313 U.S.121 (1941) 2-11
Elizabeth Giles v. Commissioner T.C. Memo. 2005-28 2-11
Engdahl v. Commissioner 72 T.C. 659 (1979) 2-11
Haft v. Commissioner 40 T.C. 2 (1963) 2-11
Herrick v. Commissioner 85 T.C. 237 (1985) 2-11
Higgins v. Commissioner 312 U.S. 212 (1941) 2-11
Minnick v. Commissioner T.C. Summary Opinion 2002-147 2-11
Owen v. Commissioner 23 T.C. 377 (1954) 2-11
Schott v. Commissioner T.C. Memo. 1964-272 2-11
Schwinn v. Commissioner 9 B.T.A. 1304 (1928) 2-11


 

Publication

Topic

Page

Publication 15-A Employer’s Supplement Tax Guide: Wages for the services of an individual who works for his or her spouse in a trade or business are subject to income tax withholding and social security and Medicare, but not to FUTA tax
 
2-9

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Page Last Reviewed or Updated: 24-Sep-2014