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June 22, 2004
Amway, Quixtar and Taxes
By QBlog in
I discovered (thanks to a site visitor) an interesting tax case involving the IRS and a married couple in Amway (and later Quixtar). The summary opinion (pdf) deals with whether their tax deductions as Amway/Quixtar participants were in compliance with sections of the U.S. tax law.
The entire summary is a good read but I want to point out a couple of things that especially caught my attention.
1. The summary is written by a judge (no surprise there). According to Quixtar's own Web site (quixtarfacts.com) the opinions of lawyers are seemingly more important than the opinions of the co-founder of the company. Well, this isn't just the opinion of a lawyer, it's the opinion of a judge. That's like a lawyer and a half.
2. The summary stresses, among other things, the lack of outside business advice. The married couple did not seek or obtain independent business advice. All their advice was from their Amway/Quixtar business which can hardly be characterized as independent or neutral.
Below you'll find various excerpts from the summary opinion. Each is without comment though I've bolded some portions for emphasis. Yes, it's a lot to read but I tried to break it up into bit-sized nuggets. Hope you enjoy.
The Tax Problem
"...Respondent determined deficiencies in petitioners' Federal income taxes of $ 3,976, $ 3,790, and $ 5,420 for 1996, 1997, and 1998, respectively. The issue for decision for each year is whether petitioners are entitled to deductions for expenses incurred in connection with the sale and distribution of Amway Corp. (Amway) products. The resolution of this issue for each year depends upon whether petitioners' Amway distributorship was a trade or business within the meaning of section 162..."
Less Than $90 Gross
"...Amway has about 360,000 independent [*4] distributors. During the years in issue, an Amway distributor's average monthly gross income from Amway-related activities was less than $ 90. Amway does not assign its distributors exclusive territories. As best we can determine from the record, there is no contractual relationship between an upline distributor and his or her downline distributors. A downline distributor is not obligated to remain in the distribution network of an upline distributor and is not obligated to achieve any minimum sales levels..."
No Independent Advice
"...Petitioners' Amway activities may be summarized as follows. Petitioners were recruited by an upline distributor of Amway products in 1995. They had no prior experience with Amway [*6] and no prior experience running a business. Before becoming Amway distributors, petitioners received advice from other Amway distributors but did not solicit business advice from those outside the Amway community; nor did petitioners seek independent business advice during the course of their affiliation with Amway..."
Recruit Family, Friends and Acquaintances
"...During the years in issue, petitioners spent little time or effort attempting to sell Amway products; instead they intended to develop a network of distributors. Consequently, their potential for profit depended almost entirely on Amway's performance bonus program and the sales efforts of their downline distributors. Recruiting productive downline distributors, therefore, was the key to petitioners' profit potential. In this regard, petitioners compiled an extensive list of family members, friends, and acquaintances that they used to identify and recruit potential downline Amway distributors. Typically, petitioners made contact with these individuals either by telephone or by traveling to wherever these individuals lived to meet with them. Nothing in the record suggests that petitioners made any effort to develop a profile of a successful downline distributor on which [*7] basis they would recruit; instead, petitioners recruited family, friends, and acquaintances..."
No Contracts. Competition. Varying Point Value
"...The relationship between petitioners and their downline distributors was, at best, informal. There were no contracts or minimum sales agreements. Downline distributors were free to leave petitioners' distribution network at will, and, if they desired, could even join another Amway distributorship under a different upline distributor. Petitioners were not assigned a sales territory, and, like their downline distributors, they presumably had to compete with some of the roughly 360,000 Amway distributors for sales and recruits. Petitioners' lack of control over their downline distributors hampered their ability to predict sales [*8] and, in turn, performance bonuses. Their difficulty in predicting performance bonuses was compounded by Amway's practice of varying the point value it assigned to a given product. Petitioners' lack of control over these key components of their distributorship caused any predictions of performance bonuses that they might have made to be, at best, uncertain..."
CPA In Amway
"...Each return was prepared by a certified public account who also was an Amway distributor..."
Lacked Profit Objective
"...Respondent argues that petitioners were not carrying on a trade or business because they lacked the requisite profit objective, and petitioners are not, therefore, entitled to the deductions they claim, except to the extent allowed by section 183.n6 For the following reasons, we agree with respondent..."
Motivational Advice
"...Before becoming Amway distributors, petitioners had neither experience with Amway nor experience in running a business. Nevertheless, they did not seek independent business advice at the outset, and they did not seek independent [*13] business advice afterwards even though losses were sustained year after year. Instead, they relied upon other Amway distributors whose advice is more accurately characterized as personal motivational advice than strategic business advice. Under the circumstances, petitioners' failure to seek independent business advice strongly suggests that they were distributing and using Amway products for purposes other than profit..."
Expenses and Lack of Sales
"...For the most part, [*14] the losses that petitioners incurred year after year are attributable to automobile and travel expenses (including the expenses incurred in attending various seminars). Petitioners did not concentrate on selling Amway products to customers, thereby eliminating sales as a potential source of profit. A substantial portion of the income earned from bonuses they received each year was paid out to their downline distributors. Other components of income were completely offset by matching expenses for the same items. Against the slim margin for profit, petitioners haphazardly incurred significant expenditures for automobile and other travel expenses in order to recruit downline distributors primarily from the ranks of family, friends, and acquaintances, some of whom lived considerable distances from petitioners. Such behavior suggests the absence of a profit objective..."
4,000 PV
"...In closing, we note that even if petitioners had maintained their monthly point value goal of 4,000, their expenses would still have exceeded their income from performance bonuses and retail sales..."
UPDATE
Scott Larsen has pointed out his extensive collection of Amway and Quixtar tax cases in both the U.S. and Canada.
Comments
Oh, it was no 'friend' of theirs that prepared this couple's taxes. Tax prep is one of the many cottage industries surrounding the whole A/Q 'tools' businesses. I know BWW offers it (at a premium price, cause hey, you're gonna be rich, right?)
The IRS has written specific guidelines for dealing with amway returns, because the fraud is so widely prommulgated. IBOs are constatntly told that all their expenses (like that 3AM breakfast at Denny's after an 'open') are tax deductible, when clearly they are not.
In another ruling against an IBO couple re: federal taxes, the couple were themselves involved in the finance industry (if I recall correctly, one was a CPA), and the court ruled that they either knew or (and this is the salient point) 'should have known' that there was 'no reasonable expectation of profit', one of the criterion necessary to distinguish a 'business or trade' from a social hobby or leisure activity.
"Reasonable expectation of profit" was stresses over and over in the decision, and I had to ask myself the question: If all prospective IBOs are shown the info that they are supposed to be shown, including the information on how few IBOs ever make any money, wouldn't it stand to reason that NO expenses are deductible, since there can be no reasonable expectation of profit?
I was even told that you could deduct your product. I was told that if you bought a box of detergent, gave one of the tablets out as a sample, you could deduct the whole box.
Thank god, I got out before any of it got to my head.
IRS postion paper on Amway businesses according to Sidney Schwartz:
http://www-2.cs.cmu.edu/~dst/Amway/AUS/irs.htm
DEVELOPMENT OF THE AMWAY CASE
Business history should be developed and documented in the examiner's workpapers. (See Figure RS 3-1 from Unit III Tax Auditor Distributorships Workshop for examples of questions to ask.) If Section 183 is indicated, the examiner should obtain copies of the prior year Schedule C's from the inception of the activity. These should be summarized by (1) sales (retail and wholesale should be differentiated), (2) Cost of sales, (3) Commissions from PV bonuses, (4) gross profit, (5} travel and entertainment (including separately stated items), (6) auto expense and ACRS/MACRS, (7) commissions paid out, (8) total expenses, and (9) net profit or loss. Also, primary sources of income should be scheduled (wages and/or primary Schedule C, Etc.), to illustrate the offsetting of income by personal expenses. Each of the nine factors of Section 183 should be developed.
GROSS INCOME should include gross receipts less cost of goods sold and net bonuses (bonuses received less bonuses paid). Cost of Goods Sold should be reduced by personal use items. If a taxpayer has purchased enough personal items to qualify for a discount, then the purchase discount on personal items should be removed from income for any given month to which the "bonus" would apply: Some taxpayers may include personal items purchased in gross receipts and cost of goods sold to give the appearance of more business activity than actually exists. This distortion is for the purpose of making expenses appear more reasonable.
TRAVEL AND ENTERTAINMENT have always been areas of abuse. Sections 162, 262, and 274 are always applicable and sometimes Section 183. Since most of the travel is primarily to attend social gatherings for entertainment and motivational purposes, any real business purpose is suspect. Unless the taxpayer can show that attending seminars, meetings, etc., meets the requirement of Section 162, the travel should be disallowed. Amway people have been unable to show that attending these meetinqs increased their sales. The agendas of these meetings appear to be primarily for entertainment, socializing, and listening to motivational speeches. The meetings have nothing to do with promoting the sale of Amway products to the general public. In fact, Amway distributors are specifically warned aqainst mentioning either Amway or selling when recruitinq potential downline people. Since it is not likely that the taxpayer will increase his sales by attending these functions, then there is not a reasonable business purpose for the trips.
Amway people frequently deduct MEALS AND GIFTS to friends and relatives as business expense. There is little justification for entertaining one's downline or potential downlines. This is one area where documentation is lacking. In some cases the entertainment is reciprocal. Most people entertain their friends and relatives; therefore, this is not an ordinary and necessary expense. Gifts are frequently disguised as "advertising" or "promotions." The examiner should be alert to these ploys. Amway people frequently deduct their own meals when attending local meetings with other Amway people. {See RIA L-5805, the "butter" rule). Local meals are not allowable.
CAR EXPENSE is another area of abuse. Occasionally, the taxpayer will deduct commuting expense to his primary job claiming that he is going to a second job since his Amway business is located in the house; however, this is rarely seen anymore. An Amway distributor usually picks up the products from the upline once a week. Once a certain volume of purchase is reached, the distributor may purchase products directly from the company. Transportation expense related to picking up the product should be minimal. If the vast majority of purchases is for personal use, then the car expense should also be personal. The taxpayer may incur car expense recruiting other downlines, but care should be taken to determine if the primary purpose is to visit friends or relatives. If the taxpayer is selling retail, he may have to deliver the products. The examiner should be alert to the taxpayer writing off trips to visit friends or relatives in distant cities and claiming the purpose of the trip was to deliver products or recruit. The taxpayer may also deduct vacation trips. It appears that Amway distributors think that they only have to mention Amway to make any visit, trip, etc. a deductible business expense.
When examining GIFTS (under whatever name the taxpayer uses), Section 162, 262, and 274 should be considered. Most gifts are for close friends or family members and are personal in most cases.
ADVERTISING often includes gifts to friends and relatives. Any demonstration of Amway products would have a minimal cost to the distributor and should be well documented as to when, where, why, and who. The demo products should be kept separate. Using a small sample of a product for demonstration and then using the rest for personal use is a personal expense.
TELEPHONE EXPENSE is an area of abuse. Taxpayers frequently write off long distance calls to friends and refatives claiming they were trying to sign up downlines or sell product. Many taxpayers try to write off their entire phone bill.
OFFICE IN THE HOME limitation should always be considered. In most cases, use of the home is not allowed because of the loss. The examiner should be aware that expenses may be disguised to avoid the limitation.
TAPES, TOOLS, ETC. are a few of the categories used to write off motivational tapes and baoks. Most of the tapes do not have anything to do with selling Amway products. Unless the taxpayer can furnish specific information showing the tapes or books are for the purpose of promoting and selling the products, they should not be allowed as a business deduction. The taxpayer should have a list of all tapes, books, etc. used as an expense on his/her return. As with all Amway products deducted as an expense, the examiner should verify these items have been removed from purchases in the Cost of Goods Sold. It is not unusual to find these items deducted in both places. (See Exhibit B for list of tapes and books.)
Here are a bunch more tax cases.
http://www.amquix.info/Amway_Tax_Scam.html
I'm intrigued by the 360,000 distributor/IBO figure. Figures I have seen, which have allegedly come from the corporation, put the figure at 500,000.
Here's my guess: 360,000 is the figure according to IRS estimates, based on their records of people filing taxes.
Which may therefore indicate that 140,000, or 28% of IBOs do not report their quixtar income/loss on their taxes.
The amounts they reported as business losses compared to the amounts the IRS calculated as deficiencies indicates that they were just barely over the 15% tax bracket threshold in 1996 & 1997. They spent $26,000 and $24,000 on Amway expenses at a time that they had just a little bit over $42,000 in adjusted gross income. Either their CPA friend was padding their losses or they maxed out credit cards to run up those kind of expenses. Either way, it's pretty sad.
Posted by: Waymee | June 22, 2004 1:16 PM