Background
Earlier this year I saw an article come across my emails stating that the IRS was once again taking aim at Direct Sales (aka Multi-Level Marketing, or MLM) and targeting them as Hobbies vs. Business. In addition to being your Tax Dude, I’m also involved in Direct Sales (insert shameless plug here… visit my website www.crossgroup.isagenix.com if you are interested in learning more about weight loss or overall cellular level nutrition) …. My blog, my rules, remember? If you want to see something or get a shameless plug, provide me with a useful topic to write about. i.e. 1031 Exchanges, or something totally not boring like that, and I’ll throw your name and business out there! Or, you can just comment on this blog, and put your business in the comments, because I'm easy like that, and I want to see my friends be successful. Anyway, this struck home not only because of my personal interest in the MLM business model, but also because I have a significant number of very close friends who are also involved (and quite successful) in various MLM businesses.
Anyway, back on topic… If you have a Facebook, Twitter, Instagram, or any other social media account, you have probably been bombarded with about as many MLM companies as you can handle, and I guarantee that you’ve probably thought that they are all Pyramid Schemes, or something fishy. I guarantee that most of them are legit businesses because of laws on the books regarding how commissions are paid out.
Let’s start at the beginning, shall we.
A Pyramid Scheme is illegal. These are what give the MLM business structure a bad name. Someone joins at the bottom rank, pays a lot of money, and does not receive any income in return until they sign up people under them, who all pay a lot of money to become part of the program. They are required to sign up a number of people before they get promoted. The money goes to the top of the pyramid, and they in turn receive nothing until everyone below them does the same thing. Their paychecks depend on the number of people they recruit.
Direct Sales (MLM) actually sell something, whether it’s from home, online, at social gatherings, or parties. They also sign people up under them who in turn sell the products. They make money by buying wholesale and selling retail. As they sign more people up, their share of the pie gets bigger. Think of it as a franchise owner (like the founder of McDonalds…. Ok, maybe they aren’t a great example because they are in the real estate business to make burgers, and it gets confusing….). They get a cut of every piece of the pie from all of the franchises (i.e. individual business owners). The paychecks that consultants received are based off the volume of product sold, and not on the number of people signed up. See the difference?
The problem.
You can look at any number of the MLM business models, listen to anyone talk about deductions, and you’ll see any variety of answers. This often results in the consultants having business losses for many years, and most never result in income, even though in the eye of the member, they are acting like a legitimate business. Regarding deductions, some information may be correct, some may be totally wrong, and some are in the middle. This often results in an understatement of income or even business losses which subtract from your overall income if you have another full-time job where you have payroll taxes. Which of course, the IRS does not like because they aren’t getting their share of the pie. That car you receive from the company for meeting certain goals…. That’s compensation, not a gift, and it's taxable. You’d better set aside money for the tax bill. And since you are an independent contractor, you need to reserve more money for the self-employment taxes.
How many people involved in MLM have sat down with a Tax Nerd (hint, hint), and had discussions about what is taxable, what is not taxable, what is a deduction, how to take the deductions, how to keep your books, etc, etc…. If you haven’t, you should do it. Not knowing how is not an acceptable answer with the IRS.
Bottom Line: Consult with a Tax Dude (or Dudette) who understands what’s going on, and don’t totally rely on the internet for answers. I don’t know about you, but I couldn’t live very long if I continued to lose money every year. The IRS will begin to see it as a hobby instead of a business. And then…. All those previous years of losses? They will want those deductions repaid. And you say “But Mr./Ms. IRS Person, I’ve had so many losses over the years, I don’t have the money to repay you….” That’s a whole other story (and engagement) to discuss with your favorite Tax Dude who is either an Enrolled Agent, CPA, or Attorney so that they can call the IRS on your behalf to work with the them to get those debts negotiated. But once again, I digress……
Hobby vs. Business:
If the IRS sees your operation as a hobby, you will only be able to deduct your expenses up to the amount of your income…. So, all that money you spent on expenses that the IRS now views your business as a hobby? It’s just money you spent that cannot be recovered.
What can you do?
First, make sure that you are in it to make money (i.e. PROFIT). There are nine items the IRS looks for to determine if you are operating a hobby or a business. Though not all apply to every business owner, here is the list. (Taken from IRS Section 183-2 (b)).
1. Does the taxpayer carry on the activity in a business-like manner, including the maintenance of complete and accurate books and records? I’ll add-Are you using the books to make decisions and adjustments to make your business better? Although only one step in the process, this may be the most important step.
2. Does the person have the knowledge or expertise needed to carry on the activity as a successful business? Most of the companies I’ve looked at have extensive trainings, support groups, and conferences.
3. Does the time and effort put into the activity indicate an intention to make a profit?
4. Does the taxpayer expect to make a profit in the future from the appreciation of assets in the activity? This may apply more to land or property than in MLM businesses.
5. Has the taxpayer made a profit or been successful at similar activities in the past?
6. What is the taxpayer’s history of income or losses? Are any losses due to circumstances beyond their control? Are losses normal in the startup phase of this type of business?
7. Does the activity make a profit in some years?
8. Does the taxpayer depend on income from the activity for his or her livelihood?
9. How significant is the element of personal pleasure or recreation in the activity?
Sit down with your Tax Dude to run through the list of questions to see how they believe you are operating. Just be prepared to face the reality if you have honest communications with him. After all, it is our job as tax professionals to use the information you give us and keep you out of trouble.
The nuts and bolts: Bookkeeping
Income:
All income received is taxable under IRC section 61, and is reported in gross receipts. This includes (but possibly not all inclusive):
1. Income from sales
2. Commissions, bonuses, or percentages of income received because of sales by others (i.e. downline)
3. Prizes and awards (taxable under IRC section 74)
4. The value of products received as a result of meeting certain sales quotas
5. The fair market value of gifts received by the direct seller are considered payments to help the direct seller make sales.
There are some special circumstances regarding those who buy more than $5,000 in products for resale. A cost of goods calculation will need to be performed to determine the gross profit. If you don’t know how to do this, call your favorite Tax Dude to help.
Expenses:
Any expense that is ordinary and reasonable to run your business is normally deductible. Again, keeping good records, and allowing your tax preparer to determine what is an acceptable deduction will help you during an audit if it happens. Some deductions, again not all inclusive:
Certain costs that must be Capitalized and recovered through depreciation:
1. Startup Expenses
2. Business assets
Operating Expenses
1. Salaries and wages you pay to others
2. Licenses and regulatory fees
3. Catalogs (if used more than 1 year these must be capitalized)
4. Journal subscriptions
5. Samples and promotional items. Personally used items are not deductible, even if you buy them to strategically place them throughout your home for showing to others to try and entice them to join your team or purchase the products.
6. Demonstrator items (if used as a demonstrator for 1 year or less). If a demonstrator item is eventually purchased by a customer, then it is considered part of inventory, and the sale must be recorded as income.
7. Commissions you pay to others
8. Sales tax paid (this gets a little involved, so hopefully the company provides this service for you)
9. Travel/Meals/Entertainment. Please talk to your Tax Dude to get an understanding of this.
10. Business use of home: There are certain rules to follow to be sure it is being deducted properly.
11. Expenses for home meetings
12. Mileage (please keep a log).
13. Depreciation….. Please see your Tax Dude
14. Home Office Deduction…. Again, you guessed it, please see your favorite Tax Dude.
In Short:
Record all income you receive and expenses you pay out. A simple notebook (or spreadsheet) will work. Record the date, Income you receive in the form of payment, a description of what was sold, cost of the item, the amount you received for the it, and any expenses that you pay. If you don’t know if it’s deductible or not, record it, and let your Tax Dude figure it out for you. If you are lucky enough to be involved with a company where every transaction is done online, and the company pays your sales and use taxes, just record the income you receive. The company is only required to issue a 1099 if you make over $600, but, you are required to report all income received.
Make sure you keep all your receipts (in a shoebox if you must). These may come in handy later, or you may never use them and throw them all out after seven years! If your Tax Dude prepares your tax returns, they may only use your books or spreadsheets, but will remind you that it’s YOUR responsibility to be able to provide proof for every line item with a receipt.
Conclusion:
It’s easy to see how people get caught up in MLMs. The hype and excitement of seeing their friends be successful is a wonderful sales tool. The allure of working for yourself, the exotic vacation packages, spending time with your family, the new car, you’re feeling better because of the new nutritional products you’ve just discovered…. WOW! Who doesn’t want to be part of this?
My non legal advice:
1. Enjoy the business. WORK YOUR ASS OFF TO MAKE IT PROFITABLE! But enjoy the business. I say give it 3 years of devotion (not legal advice of course). Sometime during that time, I truly hope that you are in the money and can begin to enjoy the fruits of your labor, and at the same time, not be on the IRS’ radar. Ok, well, you may be on their radar, but at least you'll be prepared for them.
2. Spend a significant amount of time working on your books. Then, USE your books. Use the data that you have to try different strategies. How can you improve your position? What key performance indicators are you using to determine strategies?
3. If you don’t have time to do your own books? HIRE A PROFESSIONAL. Hopefully your Tax Geek understands Hobby loss rules, can provide insight, not only at tax time, but also in keeping your books up to date. If you are lucky enough, hopefully your Tax Geek is also trained and/or certified in some form of Process or Continuous Improvement such as Lean Six Sigma or similar (this Tax Dude is a Certified Six Sigma Yellow Belt). By providing consulting services, I can help you identify KPIs that are useable targets, and work with you to develop change. I’m happy to sit down with you in person or remotely to discuss ways to keep more money in your bank account at tax time. Who knows, I will probably even learn a thing or two from you (I really hope I do).
4. I didn't touch on paying quarterly estimated taxes, but, I've always been told that if you owe taxes at the end of the year because of the amount of income you've made, that's a very good problem to have!
If you are relying on the advice of those who “have been doing it this way for 20 years”, or you heed the advice of an article you found on the internet just because it fits your agenda, you will be on the fast track to an IRS audit if it is wrong.
Earlier this year I saw an article come across my emails stating that the IRS was once again taking aim at Direct Sales (aka Multi-Level Marketing, or MLM) and targeting them as Hobbies vs. Business. In addition to being your Tax Dude, I’m also involved in Direct Sales (insert shameless plug here… visit my website www.crossgroup.isagenix.com if you are interested in learning more about weight loss or overall cellular level nutrition) …. My blog, my rules, remember? If you want to see something or get a shameless plug, provide me with a useful topic to write about. i.e. 1031 Exchanges, or something totally not boring like that, and I’ll throw your name and business out there! Or, you can just comment on this blog, and put your business in the comments, because I'm easy like that, and I want to see my friends be successful. Anyway, this struck home not only because of my personal interest in the MLM business model, but also because I have a significant number of very close friends who are also involved (and quite successful) in various MLM businesses.
Anyway, back on topic… If you have a Facebook, Twitter, Instagram, or any other social media account, you have probably been bombarded with about as many MLM companies as you can handle, and I guarantee that you’ve probably thought that they are all Pyramid Schemes, or something fishy. I guarantee that most of them are legit businesses because of laws on the books regarding how commissions are paid out.
Let’s start at the beginning, shall we.
A Pyramid Scheme is illegal. These are what give the MLM business structure a bad name. Someone joins at the bottom rank, pays a lot of money, and does not receive any income in return until they sign up people under them, who all pay a lot of money to become part of the program. They are required to sign up a number of people before they get promoted. The money goes to the top of the pyramid, and they in turn receive nothing until everyone below them does the same thing. Their paychecks depend on the number of people they recruit.
Direct Sales (MLM) actually sell something, whether it’s from home, online, at social gatherings, or parties. They also sign people up under them who in turn sell the products. They make money by buying wholesale and selling retail. As they sign more people up, their share of the pie gets bigger. Think of it as a franchise owner (like the founder of McDonalds…. Ok, maybe they aren’t a great example because they are in the real estate business to make burgers, and it gets confusing….). They get a cut of every piece of the pie from all of the franchises (i.e. individual business owners). The paychecks that consultants received are based off the volume of product sold, and not on the number of people signed up. See the difference?
The problem.
You can look at any number of the MLM business models, listen to anyone talk about deductions, and you’ll see any variety of answers. This often results in the consultants having business losses for many years, and most never result in income, even though in the eye of the member, they are acting like a legitimate business. Regarding deductions, some information may be correct, some may be totally wrong, and some are in the middle. This often results in an understatement of income or even business losses which subtract from your overall income if you have another full-time job where you have payroll taxes. Which of course, the IRS does not like because they aren’t getting their share of the pie. That car you receive from the company for meeting certain goals…. That’s compensation, not a gift, and it's taxable. You’d better set aside money for the tax bill. And since you are an independent contractor, you need to reserve more money for the self-employment taxes.
How many people involved in MLM have sat down with a Tax Nerd (hint, hint), and had discussions about what is taxable, what is not taxable, what is a deduction, how to take the deductions, how to keep your books, etc, etc…. If you haven’t, you should do it. Not knowing how is not an acceptable answer with the IRS.
Bottom Line: Consult with a Tax Dude (or Dudette) who understands what’s going on, and don’t totally rely on the internet for answers. I don’t know about you, but I couldn’t live very long if I continued to lose money every year. The IRS will begin to see it as a hobby instead of a business. And then…. All those previous years of losses? They will want those deductions repaid. And you say “But Mr./Ms. IRS Person, I’ve had so many losses over the years, I don’t have the money to repay you….” That’s a whole other story (and engagement) to discuss with your favorite Tax Dude who is either an Enrolled Agent, CPA, or Attorney so that they can call the IRS on your behalf to work with the them to get those debts negotiated. But once again, I digress……
Hobby vs. Business:
If the IRS sees your operation as a hobby, you will only be able to deduct your expenses up to the amount of your income…. So, all that money you spent on expenses that the IRS now views your business as a hobby? It’s just money you spent that cannot be recovered.
What can you do?
First, make sure that you are in it to make money (i.e. PROFIT). There are nine items the IRS looks for to determine if you are operating a hobby or a business. Though not all apply to every business owner, here is the list. (Taken from IRS Section 183-2 (b)).
1. Does the taxpayer carry on the activity in a business-like manner, including the maintenance of complete and accurate books and records? I’ll add-Are you using the books to make decisions and adjustments to make your business better? Although only one step in the process, this may be the most important step.
2. Does the person have the knowledge or expertise needed to carry on the activity as a successful business? Most of the companies I’ve looked at have extensive trainings, support groups, and conferences.
3. Does the time and effort put into the activity indicate an intention to make a profit?
4. Does the taxpayer expect to make a profit in the future from the appreciation of assets in the activity? This may apply more to land or property than in MLM businesses.
5. Has the taxpayer made a profit or been successful at similar activities in the past?
6. What is the taxpayer’s history of income or losses? Are any losses due to circumstances beyond their control? Are losses normal in the startup phase of this type of business?
7. Does the activity make a profit in some years?
8. Does the taxpayer depend on income from the activity for his or her livelihood?
9. How significant is the element of personal pleasure or recreation in the activity?
Sit down with your Tax Dude to run through the list of questions to see how they believe you are operating. Just be prepared to face the reality if you have honest communications with him. After all, it is our job as tax professionals to use the information you give us and keep you out of trouble.
The nuts and bolts: Bookkeeping
Income:
All income received is taxable under IRC section 61, and is reported in gross receipts. This includes (but possibly not all inclusive):
1. Income from sales
2. Commissions, bonuses, or percentages of income received because of sales by others (i.e. downline)
3. Prizes and awards (taxable under IRC section 74)
4. The value of products received as a result of meeting certain sales quotas
5. The fair market value of gifts received by the direct seller are considered payments to help the direct seller make sales.
There are some special circumstances regarding those who buy more than $5,000 in products for resale. A cost of goods calculation will need to be performed to determine the gross profit. If you don’t know how to do this, call your favorite Tax Dude to help.
Expenses:
Any expense that is ordinary and reasonable to run your business is normally deductible. Again, keeping good records, and allowing your tax preparer to determine what is an acceptable deduction will help you during an audit if it happens. Some deductions, again not all inclusive:
Certain costs that must be Capitalized and recovered through depreciation:
1. Startup Expenses
2. Business assets
Operating Expenses
1. Salaries and wages you pay to others
2. Licenses and regulatory fees
3. Catalogs (if used more than 1 year these must be capitalized)
4. Journal subscriptions
5. Samples and promotional items. Personally used items are not deductible, even if you buy them to strategically place them throughout your home for showing to others to try and entice them to join your team or purchase the products.
6. Demonstrator items (if used as a demonstrator for 1 year or less). If a demonstrator item is eventually purchased by a customer, then it is considered part of inventory, and the sale must be recorded as income.
7. Commissions you pay to others
8. Sales tax paid (this gets a little involved, so hopefully the company provides this service for you)
9. Travel/Meals/Entertainment. Please talk to your Tax Dude to get an understanding of this.
10. Business use of home: There are certain rules to follow to be sure it is being deducted properly.
11. Expenses for home meetings
12. Mileage (please keep a log).
13. Depreciation….. Please see your Tax Dude
14. Home Office Deduction…. Again, you guessed it, please see your favorite Tax Dude.
In Short:
Record all income you receive and expenses you pay out. A simple notebook (or spreadsheet) will work. Record the date, Income you receive in the form of payment, a description of what was sold, cost of the item, the amount you received for the it, and any expenses that you pay. If you don’t know if it’s deductible or not, record it, and let your Tax Dude figure it out for you. If you are lucky enough to be involved with a company where every transaction is done online, and the company pays your sales and use taxes, just record the income you receive. The company is only required to issue a 1099 if you make over $600, but, you are required to report all income received.
Make sure you keep all your receipts (in a shoebox if you must). These may come in handy later, or you may never use them and throw them all out after seven years! If your Tax Dude prepares your tax returns, they may only use your books or spreadsheets, but will remind you that it’s YOUR responsibility to be able to provide proof for every line item with a receipt.
Conclusion:
It’s easy to see how people get caught up in MLMs. The hype and excitement of seeing their friends be successful is a wonderful sales tool. The allure of working for yourself, the exotic vacation packages, spending time with your family, the new car, you’re feeling better because of the new nutritional products you’ve just discovered…. WOW! Who doesn’t want to be part of this?
My non legal advice:
1. Enjoy the business. WORK YOUR ASS OFF TO MAKE IT PROFITABLE! But enjoy the business. I say give it 3 years of devotion (not legal advice of course). Sometime during that time, I truly hope that you are in the money and can begin to enjoy the fruits of your labor, and at the same time, not be on the IRS’ radar. Ok, well, you may be on their radar, but at least you'll be prepared for them.
2. Spend a significant amount of time working on your books. Then, USE your books. Use the data that you have to try different strategies. How can you improve your position? What key performance indicators are you using to determine strategies?
3. If you don’t have time to do your own books? HIRE A PROFESSIONAL. Hopefully your Tax Geek understands Hobby loss rules, can provide insight, not only at tax time, but also in keeping your books up to date. If you are lucky enough, hopefully your Tax Geek is also trained and/or certified in some form of Process or Continuous Improvement such as Lean Six Sigma or similar (this Tax Dude is a Certified Six Sigma Yellow Belt). By providing consulting services, I can help you identify KPIs that are useable targets, and work with you to develop change. I’m happy to sit down with you in person or remotely to discuss ways to keep more money in your bank account at tax time. Who knows, I will probably even learn a thing or two from you (I really hope I do).
4. I didn't touch on paying quarterly estimated taxes, but, I've always been told that if you owe taxes at the end of the year because of the amount of income you've made, that's a very good problem to have!
If you are relying on the advice of those who “have been doing it this way for 20 years”, or you heed the advice of an article you found on the internet just because it fits your agenda, you will be on the fast track to an IRS audit if it is wrong.
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