Explanation and Overview
In August of 2005 the Internal Revenue Service (IRS) published an Audit
Technique Guide for Direct Sellers (“ATG”).
That challenge is, if audited by the IRS, whether or not the IRS considers their home-based business to be a business rather than a tax shelter, hobby or “not-for-profit” activity, as IRS likes to put it.
Audit Technique Guides are published by the IRS for use by its auditors when auditing specific industries or issues.
Just as this “Guide” is an important tool for the IRS auditors auditing Direct Seller businesses, it is also an important tool for use by IBO’s to be able to determine what methods of business operation are necessary to be in compliance with tax laws and IRS rules regarding Direct Seller businesses.
The determination as to whether or not you are a trade or business is primarily based on a nine-factor test contained in the Internal Revenue Code Section.
There are three chapters. Please read the entire “Guide” as it contains very useful information about our industry and tax laws.
Chapter 2, “nine-factor analysis” is the portion I will analyze for you and is also the portion of the “Guide’ with which this site is designed to help you comply.
Factor 1 (Manner in Which the Taxpayer Carries On the Activity)
The activities in Minnick were not conducted in a sufficiently businesslike
manner. Petitioners did not maintain their own business records other
than notes of meetings in a daily planner. Petitioners did not present
evidence of any formal budgets, profit projections, or break-even analyses that
had been prepared in connection with their distributorship. (Factor favors government.)
"Minnick" is a tax-court case being cited to demonstrate the importance
of compliance with the "ATG."
Analysis: In addition, the trade or business must be carried on regularly and in a continuous manner to display the intention of a going concern. This intent is noted through the business records, which should include:
- books and records
- indicating active management
- set reasonable goals
- continuous evaluation of these goals
- adjust business activities and expenditures based on actual goals
Each person maintains their own books and records in a manner appropriate to their business style. However, any ongoing business needs books and records that give a picture of where the business is going, whether business methods are profitable, and what changes should or can be made to brighten the picture, at least on a quarterly basis. Some of the IRS’s concerns are: Not maintaining a separate business checking account
- Not maintaining a log tracking business miles driven
- Inability to determine success of business
- Customer/party files not maintained
- Continued expenditures in activities that show little or no profit potential (such as craft shows and exhibitions)
- Bartering transactions that are being done with parties, whether a book party or an in-home party
- Whenever an individual receives items with a fair market value of $600 or more in any one calendar year, they are to be issued a Form 1099 for the full amount received. Since direct sellers operate their own business, they are responsible for issuing this form to any host or hostess to whom it applies.
Indicators of operating your business in a businesslike manner include monthly bookkeeping, separate bank account, written business plan, good mileage records and changes in the way your conduct business in order to become more profitable.
The following are not only proven business techniques necessary to build any successful business, but are also strong indicators to the IRS that you truly are operating your business with the intent to make a profit.
1. Monthly bookkeeping: Regular bookkeeping is necessary to be able to actively manage and make proper financial decisions regarding your business.
At a minimum, monthly bookkeeping entails recording your income and expenses by category. The categories (or accounts) should then be totaled each month, thereby creating a monthly profit and loss statement.
You should also maintain year-to-date or cumulative totals as well.
Doing both of the above allows you to manage your business on a current and long-term basis.
2. Prepare a written business plan with future projected budgets for your business.
Written business plans are an integral part of managing all businesses properly, large or small, and that includes yours.
GOING PLATINUM, THE ROAD TO PROFITABILITY has been provided for you in Direct Seller Bookkeeping 101 and is also provided as a part of this web site.
Instructions for completing it have been written in such a way that you will be able to complete it without outside help.
Once completed, print it off and put it in your binder.
3. Maintain a separate bank account for your business. Conduct all business transactions through this account.
THESE THREE BUSINESS PRACTICES ARE CRITICAL WHEN ATTEMPTING TO BUILD A SUCCESSFUL BUSINESS AND DEMONSTRATING INTENT TO DO SO.
4. Other important practices that help to grow a successful business and demonstrate profit intent are:
- Maintaining proper travel and auto usage logs.
(See Direct Seller Bookkeeping 101)
- Setting reasonable goals.
- Making and documenting changes in the way you conduct your business to improve profitability on a regular basis. (See Business Booster section)
- Reviewing and tracking downline growth and business activities.
IBO’s, each of you have the power to build a successful business if you use all of the tools made available to you to do so.
The above tools are not the most appealing part of building a business, but are absolutely critical.
If you have not done the above, GET BUSY and build your business properly.
FACTOR 2 (The Expertise of the Tax Payer or His Advisors)
In Minnick, petitioners sought the advice of persons who might be considered experts in their business activities. Petitioners attended various events conducted regularly that they believed would provide the expertise necessary to make their distributorship profitable. (Factor favors taxpayer.)
Analysis: A direct seller may not have prior sales training or expertise in direct selling, but that does not negate a profit objective. The examiner should evaluate the direct seller’s willingness to learn the business and gain hands-on experience. The more the direct seller knows about the business, the better prepared he is to sell the products and represent them. For direct sellers, the most important source of useful business-building information will often be other successful leaders in their business.
Does knowing what you are doing and employing the best technique and methods available matter when building a business?
Sure they do!
The necessity of training and keeping up with changes and advances in your business or profession is recognized by the fact that to maintain most professional licenses, training is mandated.
It is not mandated in your business, but that does not take away from the importance of continuing education and training for both you and your downline.
The IRS also recognizes the importance of reaching out for continuing education and training in the new Direct Sellers Audit Technique Guide.
Petitioners sought the advice of persons who might be considered experts in their business activities. Petitioners attended various events conducted regularly that they believed would provide the expertise necessary to make their distributorship profitable.
The examiner should evaluate the direct seller’s willingness to learn the business and gain hands-on experience. The more the direct seller knows about the business, the better prepared he is to sell the products and represent them. For direct sellers, the most important source of useful business-building information will often be other successful leaders in their business.
Question and Answer Time
Question: What is the best way to increase the odds that your business will be successful?
Answer: Hard work, of course. But equally as important is knowing what you are doing. So, reach up to your upline and reach out to the training system.
Remember to document upline council sessions, attendance of open meetings and functions. Use training materials to sharpen your business building skills.
FACTOR 3 (Time and Effort Expended by Taxpayer)
In Minnick, petitioners devoted approximately two nights per week, and approximately two weekends per month, to the activity. This time was spent in delivering products and in traveling to other individuals' homes for evening meetings as well as to monthly meetings and quarterly "major functions." (Factor favors taxpayer.)
Analysis: The fact that a taxpayer carries on employment or more than one business at any given time is not evidence of a lack of a profit motive. How the time is spent is more important than the amount of time spent on the activity.
- Does the direct seller show that the use of their time clearly reflects efficiency and growth in their business, rather than just plugging along and working at it haphazardly?
- Does the direct seller spend time evaluating whether a particular activity that shows very little profit potential should be discarded and a more beneficial activity be picked up?
- Does the direct seller display a desire to recruit downliners, do they increase the number of sales or opportunity presentations as time goes by, are they seeking out opportunities to make themselves more visible in the public eye?
There should be several indicators of a desire to grow a business, rather than working at such a pace that the activity may be considered a hobby rather than a true business.
If it’s your dream to walk into your boss’s office and say, “I ain’t workin’ here NO MORE,” you’re going to have to earn it.
You should all know by now that there is no free lunch out there. Your business will not prosper if you do not put the proper amount of time and effort into it.
Just going to quarterly conferences and showing the plan once or twice a month won’t get you where you want to be.
The IRS views whether or not you are in a trade or business by not only the time spent building your business, but also by how you go about it.
Per the “ATG,” the following are important indicators that your business is a for profit activity.
1. Time Spent 15 to 20 hours per week is reasonable, especially if you have other employment.
2. The “ATG” states, “How the time is spent is more important than the amount of time spent on the activity.”
Try not to get stuck in a rut of doing the same old thing over and over again when it is not producing the results you need and want.
Quoting the “ATG” - “Does the direct seller spend time evaluating whether a particular activity that shows very little profit potential should be discarded and a more beneficial activity picked up?”
Learn from your own experience what is and isn’t working and be creative with new building techniques. However, don’t forget your best source for new and innovating building techniques is likely to be your upline.
Attendance at monthly and quarterly major functions as well as plugging in to all available training material (where you learn the latest and greatest techniques for building your business) helps demonstrate prudent use of your time.
Quoting the IRS “ATG” Factor 3
“Traveling to other individuals’ homes for evening meetings as well to monthly meetings and quarterly major functions favors the taxpayer.”
“The direct seller should be willing to learn the business and gain hands on experience.”
One last very important factor regarding the use of your time suggests the questions, “How do you normally succeed at sponsoring someone into your business?” The answer is SHOWING THE PLAN.
It should, therefore, be a no-brainer that the more times you show the plan, the faster your business will grow.
The IRS thinks so also.
Again quoting the “ATG”
“Does the direct seller display a desire to recruit downliners, do they increase the number of shows as time goes by?”
And now, last but not least, remember you must document all of your prospecting and plan show activity. Also, document any changes you make in the way you conduct your activity in order to become more profitable and efficient.
Factor 4 (Expectations that Assets Would Increase in Value)
This factor is not relevant in Minnick. There were no assets subject to significant appreciation.
Analysis: The fact that most direct sellers typically have few capital assets should not cause one to question the legitimacy or viability of the business.
This factor deals with appreciation of or increases in the value of assets you might use in your business and their potential to increase in value.
This value increase would be considered profit earned by your business in addition to profits earned from normal business operations.
The Direct Seller Audit Technique Guide states, “the fact most direct sellers typically have few capital assets should not cause one to question the validity of the business.”
This statement indicates that this factor should be deemed neutral when analyzing the nine factors.
It is my opinion, however, that this factor is tipped in favor of the Direct Seller when you consider the fact that Direct Seller can sell or will their businesses.
The value of an Direct Seller’s business is based on their pin level and revenue stream.
The higher the pin and greater the revenue stream the more potential value attaches to your business.
Therefore, the revenue stream from your business is an intangible asset that can be sold or willed, and as it grows, so does its value.
Factor 5 (Taxpayer’s Success in Other Activities)
In Minnick, no evidence was produced showing that either of petitioners had ever engaged in similar activities, or that either had ever been involved with making other activities profitable. (Factor favors government.)
Analysis: The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he/she is engaged in the present activity for profit, even though it may not currently be profitable. The fact that the taxpayer has not been engaged in a similar activity in the past does not negate a profit motive in the present activity.
When it comes to Factor 5, the IRS used to deem the fact that a taxpayer had not been involved in an activity like this in the past a negative.
Per the Audit Technique Guide, this is now a neutral factor if you have never been in a direct selling business before.
However, if you have been in direct seller activities previously, and they were profitable, this becomes a positive factor for the taxpayer.
Factors 6 (Taxpayers History of Income or Losses) and Factor 7 (Amount of Occasional Profit, If Any)
A profit objective is strongly indicated where the taxpayer has experienced a series of profitable years. A series of losses incurred during the startup stage of an activity does not necessarily indicate the lack of a profit objective, but it may so indicate if the losses continue beyond the customary startup period and are not otherwise explainable as due to customary business risks. In Minnick, the taxpayers sustained substantial losses in their distributorship activities for at least six consecutive years, no profits were ever earned from the activity, and there was no indication that the business would eventually become profitable. (Factors favor government.)
Analysis: For the Service it is no different for the direct sellers than it is for any other business out there. A direct seller normally goes into business with the hope and intent that their endeavor will become profitable. If, after a suitable start-up period, a business shows no profit or trend toward profitability, it is appropriate for the examiner to evaluate the actions the business owner has taken to become profitable. The examiner should generally expect to see evidence that the seller has adjusted their business in ways that are intended to increase sales, mitigate costs, or both. This requires a very factually specific inquiry and should consider both the seller’s long and short range plans and actions. While it should be rare to see a seller stay in business over a long period of time if they do not demonstrate any trend towards profitability, an examiner must also consider the extent to which the seller’s early period activities may constitute an investment in the business’ long-term viability. It should also be noted that the presumption articulated in Section 183(d) does not stand for a finding that in the absence of the taxpayer realizing at least three profitable years out of five, an activity is prima facie not-for-profit.
If the direct seller is audited in the first or second year after start-up, the direct seller can elect to postpone an IRS determination as to whether the presumption under IRC Section 183(d) applies. The direct seller may file Form 5213, Election to Postpone Determination, if an activity has not been carried on for a 5-year period. How does this benefit them? The IRS will generally postpone its determination of whether the activity is engaged in for profit and will not restrict deductions during the 5-year period.
In order to take advantage of this election, the Form 5213 must be filed within 3 years after the due date of the return for the first year of the activity, or, if earlier, within 60 days after the IRS issues a written notice proposing to disallow deductions attributable to the activity. Filing the form automatically extends the period of limitations for tax assessment on any year in the 5-year period until 2 years after the due date of the return for the last year of the period. The period is extended only for deductions attributable to the activity and any deductions that are affected by changes made to adjusted gross income.
Folks, this is the big one. Making a profit is what it’s all about.
Most start-up businesses are not profitable in their first year or years of operation.
The IRS recognizes in the Audit Technique Guide when it says, “A series of losses incurred during the start-up stage of an activity does not necessarily indicate the lack of a profit objective, but it may so indicate if the losses continue beyond the customary start-up period and are not otherwise explainable due to customary business risks.”
The average time it takes a person to achieve the platinum level in their business is four to five years.
As you know, there is typically significant profit associated with the platinum pin level.
Therefore, even though you are trying hard, if you have not turned the corner to profitability by the fourth or fifth year that you have been in business, I recommend that you show a break-even position for your business for tax purposes.
Prudent business people who start new businesses that lose money initially are always looking for ways to enhance efficiency, reduce costs and increase revenue in order to become profitable.
Please note that in the “ATG” the IRS examiners are asked to look for “evidence that the seller has adjusted their business in ways that are intended to increase sales, mitigate costs, or both.”
Increasing revenue and decreasing costs are what we all strive for in our businesses.
Because you are a direct seller and are subjected to the nine-factor test, I am discussing here that you need to document your efforts to increase sales and reduce costs.
The Business Booster section of this web site is provided for this purpose..
Every time you learn or develop a new technique for boosting your profits, document it here.
Also, this web site has a feature that will automatically compare your financial results to those projected in your business plan and ask you to document what you plan to do about reaching your projected goals, if you have not achieved your projected financial success on time.
Use of information, gleaned from the results shown in your profit and loss statements and business plan to adjust business practices, is a positive indicator of intent to make a profit.
NOTE: There is a discussion by the IRS in the “ATG” about IRS form 5213 (Election to Postpone Determination).
This form, if filed with the IRS within the first or second year of your business, allows you to postpone a determination from the IRS as to whether or not your business is profitable or not until after the fifth year of your business activity.
The IRS normally can only audit a return for up to three years after it has been filed and taxes assessed by the IRS.
The downside to filing form 5213 with the IRS is that it “automatically extends the period of limitations for the tax assessment on any year in the five year period until two years after the due date of the return for the last year of the period.”
For this reason, I strongly recommend that you DO NOT take this route.
Doing this leaves five years of tax returns open to audit, and should you fail to convince the IRS that your business is a for-profit activity under the nine factor test, you will subject yourself not only to a potentially big tax bill, you could be charged significant penalties and interest for the five-year period.
Factor 8 (Financial Status of the Taxpayer)
In Minnick, petitioners' separate wage and salary income provided a substantial source of income apart from the distributorship. (Factor favors government.)
Analysis: While it can be true that the absence of any other substantial source of income may strongly indicate a taxpayer’s profit motive, the presence of income from other sources does not, by itself, negate a profit objective.
Factor 9 (Elements of Personal Pleasure or Recreation)
Profit need not be the only objective, and personal motives may coexist with an actual and honest intent to derive a profit. In Minnick, the court found the significance of personal motives difficult to gauge. On the one hand, petitioners expended a substantial amount of time in activities, such as driving long distances that would appear to lack elements of pleasure or recreation. On the other hand, much of petitioners' activities involved elements that were very personal in nature, such as frequently visiting family members who were also involved in the same business. (Factor determined to be neutral.)
Analysis: The direct seller can enjoy his/her business and receive personal pleasure from it, but still be engaged in it for profit. It should be considered whether any significant recreational or entertainment element was ordinary and necessary to grow the business. (Is the direct seller engaged in the activity for personal pleasure or for the building of a business that will create income? Is the direct seller engaged in the business because he or she likes the product and all the amenities that go along with it?)
The direct sellers’ business requires meeting people and carrying on active social interaction recruiting other sellers and selling to ultimate individual purchasers. Normally, a prudent direct seller organizes various quasi-social environments in which to market its products or connect with ‘prospects,’ which often involves family, friends, and acquaintances. These business activities should not be discounted on their face if they can be shown to have been appropriate and helpful in developing the business.
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