Originally published on Forbes.com. April 28th, 2014
It’s been a while since I’ve seen a Tax Court decision about Amway losses. Several years ago I did a study of all Amway cases. The taxpayers almost always lost and generally for the same reasons. The case of Samer and Mariana Mikhail, decided this month, does not break any new ground. The taxpayers were representing themselves and the stakes were fairly low – deficiency of $8,286 for the year 2009.
What is Amway all about?
I attended an Amway presentation many years ago. Apparently things have not changed that much. Amway markets a variety of consumer products through a direct marketing system. The participants are referred to as IBOs (Independent Business Owners). According to its website, Amway has paid out over $40 billion in bonuses and incentives to IBOs since 1959. The key to success as an Amway IBO is not so much selling the product yourself as it is recruiting other people (your down-line), who recruit other people and so on. You get a piece of the action for everybody down line to you just as your upline gets a piece of the action from the sales you generate.
The Tax Court explains it this way.
Amway’s compensation system for distributors results in a pyramidlike network of distributors. Under this system an “upline” or “sponsor” distributor is encouraged to recruit new “downline” distributors to become part of his or her organization. “Downline” distributors likewise are encouraged to recruit new distributors who in turn become “legs” of the original “upline” distributor’s organization. “Downline” distributors recruited by the same “upline” distributor are referred to as “crossline” distributors. An “upline” distributor receives bonus payments from Amway based on the volume of sales (as opposed to profits) generated by the “downline” distributors who are part of his or her organization.
How did it work for the Mikhails?
Dr. Samar Mikhail is a physician employed by the US Department of Veterans Affairs. In 2007, the final year of his residency, he earned about $64,000. From 2008 to 2011, his earnings went from about $145,000 to about $165,000. Mrs. Mikhail has had some short-term part-time jobs but has mainly been a homemaker.
Dr. Mikhail was recruited in 2004 by his dentist. He did some research and concluded that the negative assessments you will read about Amway are attributable to individuals “who did not follow the system”. Apparently the Mikhails decided that they would “follow the system”.
Petitioners conducted their Amway activities in accordance with instructions from their “upline” distributors, educational materials obtained from an Amway-related educational system known as Leadership Development (LTD), and information obtained while attending Amway seminars, workshops, and conferences. Petitioners did not seek advice from disinterested professionals, develop a business plan, prepare profit projections, or undertake any type of market analysis.
Petitioners attended weekly and monthly Amway meetings held locally and elsewhere in Florida. During 2009 they attended five national Amway.
The part I highlighted is a tip-off that the case is not going to go well for the Mikhails. Tax Court judges are big believers in business plans.
Dr. Mikhail testified that the time he devotes to Amway activities is largely directed at recruiting new distributors. He further testified that he usually spends his lunch hour, as well as an hour or two after work, and approximately three hours every weekend on Amway activities and that Amway is always “at the forefront” of his mind. Dr. Mikhail spent more time on Amway activities than Mrs. Mikhail.
Mrs. Mikhail testified that she is responsible for bookkeeping, business management, and organization of Amway parties and events. During 2009 she maintained records of the couple’s Amway-related expenses including a mileage log, a spreadsheet listing monthly expenses, and credit card statements. Petitioners did not use their Amway records to prepare a formal budget or conduct a break-even analysis.
Petitioners initially attempted to recruit family members and friends as “downline” distributors but found that most of them were unable to “overcome their life circumstances and continue to build Amway with us”. Petitioners later altered their recruitment strategy by frequenting upscale restaurants and shopping areas and striking up conversations with people they encountered with the aim of identifying what they termed “learners”. Petitioners purchased books and CDs from LTD and gave them to potential recruits.
The Mikhails posted losses in every year from 2005 through 2011. All in, there was less than $30,000 in revenue and a total net loss of $192,427
The Decision
The Court starts off with the classic nine factors.
These factors are: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the taxpayer’s success in carrying on other similar or 4 dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) any elements indicating personal pleasure or recreation.
They pretty much went 0 for 9.
Although petitioners kept records of their Amway expenses, they did not use those records to analyze their business performance or to prepare profit projections, a break-even analysis, or a formal budget.
Petitioners obtained advice only from “upline” distributors—persons who had a direct financial interest in the maximization of petitioners’ sales volume, without regard to whether they would realize a profit.
Under the circumstances, we conclude petitioners did not spend a significant amount of time on the Amway activity.
Petitioners had no prior experience engaging in a direct marketing distributorship or managing a small business of any sort.
Although petitioners testified that they believe the Amway activity will eventually generate profits, we cannot discern on this record any definitive trend to the upside for petitioners, and there certainly is no indication that they are on their way to the level of profitability that would allow them to recoup the substantial cumulative losses they have incurred to date.
The record shows that petitioners used their Amway distributorship as a means to generate deductions for essentially personal expenditures and to enjoy discounts on items they purchased for personal consumption. The availability of consumer product discounts for personal use merchandise is a factor supporting the conclusion that petitioners lacked a profit objective.
We also note that petitioners (1) traveled together to attend Amway seminars and conferences in various cities, (2) took trips to New York and Texas to discuss Amway with family and friends, and (3) hosted meetings that had a social component. All things considered, we conclude that petitioners derived personal benefits and pleasure from the Amway activity. This factor weighs against petitioners.
About Being An Amway IBO
It is not hard to find a lot of criticism of the Amway IBO experience. According to the critics, most people don’t make any money and the big earners make most of their money from selling motivational tools to the wannabees. Then you will find critics of the critics. I have determined to remain agnostic on that issue. The record in Tax Court is somewhat supportive of the critics, but of course, there is a sampling problem. Successful Amway IBOs will not end up in Tax Court defending year after year losses.
The most colorful critic is probably the author of Married To An Ambot. Of course, there are those who question her sincerity. I have decided not to have a dog in that fight, but to stick with what I read in original tax documents, which allows me to formulate some advice that is sound regardless of what the “truth about Amway” is. It boils down to two suggestions.
My Suggestions.
My first suggestion is that if you want to have a side business to make personal expenses deductible (which is something that you should not do at all, by the way), Amway is about the worst thing to pick. People with persistent Amway losses do not do well in Tax Court. The other is that if you expect that a side activity will ultimately be profitable, you might want to consider suspending the losses under Code Section 469. Although in principle, this does not immunize you from being attacked under Section 183, as a practical matter it does since you are not getting a current benefit. You will get the benefit when the activity becomes profitable or you abandon it.
You can follow me on twitter @peterreillycpa.
Note
The case has not attracted much notice. Joe Kristan wrote
I avoid multi-level marketing clients because their “profit” so often comes from putting personal expenses on Schedule C. It sure seems that way here.
The Tax Court declined to impose penalties, citing taxpayer maintenance of good records and reliance on a CPA to prepare their returns. Considering that the Tax Court has upheld penalties for taxpayers who are more sympathetic than a doctor deducting his car, it’s somewhat surprising. It shows that even if you can’t show a profit motive, using good records and a preparer can at least help avoid penalties.
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