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:: Retail Industry Audit Technique Guide (ATG) - Chapter 3: Examination Techniques for Secific Industries (Direct Sellers)   Table of Contents Chapter 3: Examination Techniques for Specific Industries (Direct Sellers) Introduction Income Expenses Start up Expenses IRC 195 Inventory Cost of Goods Sold Partnership v. Sole Proprietorship Employee v. Independent Contractor Profit v. Not-For-Profit Issue Nine Factors and Analysis Examination Practices Web Sites for Assistance   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. Back To Top 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. Back To Top   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. Back To Top 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? 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. Back To Top 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 Direct Selling Association   www.dsa.org Direct Selling Opportunities   www.directsellingopportunities.com World Federation of Direct Selling Associations   www.wfdsa.org 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. In addition to the base commission and the additional commission earned on a down-line, there is an added benefit of personal discounts. 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. Back To Top 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. Back To Top 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. Back To Top 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. Back To Top 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. Back To Top 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