Is multi-level direct selling a hobby or a business?

Last week, in discussing the distinction between a hobby and a business, I wrote "Some businesses are less likely than others to come under IRS scrutiny as suspected hobbies. People seldom take up plumbing repair or bookkeeping for the sheer fun of it."

Selling vitamins and cosmetics probably does not show up very often on lists of fun and exciting leisure-time activities, but neither IRS nor the Tax Court has been kind to taxpayers in the direct selling business — Amway/Quixtar distributors seem to have suffered more than their share of audits, and when the cases go to court, IRS invariably wins on the grounds that the distributors were not motivated by profit.

IRS has put much effort and creativity into finding the fun in selling Amway products — the "congenial sense of family," the "gratifying motivation feeling," the warm, fuzzy pleasure one gets from the "opportunities to generate business deductions for essentially personal expenditures."

But the real kicker, the one the Tax Court seems to take most seriously is not the fun and pleasure but the lack of profit motive evidenced by distributors incurring ever greater losses year after year. For example, Amway IBO´s Randall and Kay Ollet showed the following net losses from their Amway business on their tax returns:

1996 ($1,615)

1997 ($13,177)

1998 ($16,879)

1999 ($17,384)

2000 ($19,766)

The highest amount of gross sales reported for any year was $3225 in 2000, and IRS claimed that much of this was for products purchased by the Ollets for their own personal use.

IRS pointed out that Mr. Ollet had a degree in electrical engineering from Princeton and an MBA from Lamar University. Did it make sense, IRS asked the Court, for an obviously intelligent and well-educated man to incur greater and greater annual losses, with no apparent prospect of future profits?

I am not aware of any Amway or Quixtar distributor who has won in Tax Court. On the other hand, there are thousands of direct sellers who are not challenged by IRS. The following is a list of "bads" IRS has used against distributors, and what you can do about them:

1. Failure to use financial records analytically.

WHAT YOU CAN DO: Use your financial statements to track the progress of your business. For example, if your spending on advertising increases by $1000 from one year to the next, your sales should increase by at least that much. If this has not happened, write down possible reasons for the failure of your advertising dollars to pay off. Think of things you could change in order to get more bang for your advertising buck.

2. Combining business travel with out-of-town visits to family members or vacations and writing the trips off as business expenses.

WHAT YOU CAN DO: Make sure you can justify the business purpose of every trip for which you deduct some or all of the expenses. If you combine business and pleasure, keep track of the amount of time you spend for each (I´ll write about how to allocate travel expenses between travel and personal in a future entry).

3. Lack of a realistic business plan.

WHAT YOU CAN DO: If your expenses are increasing as a % of sales, make a real effort to determine what´s wrong. Consult a third party (you can get low-cost or free advice from the Small Business Administration). The Tax Court has ruled that consultations with your upline do not "count" as evidence that you are making a real effort to make your direct selling business profitable.

4. A substantial portion of gross revenue comes from product sales made by the distributor to himself or herself.

WHAT YOU CAN DO: If you find yourself in this situation, you need to come up with a realistic marketing plan to increase product sales and develop your downline, so that you´re not your best customer. If you are not able to come up with such a plan, given your experience with the company structure, you should probably consider going with a different MLM company.