T.C. Memo. 1998-354

UNITED STATES TAX COURT

SANDY KAY JONES AND CLINT JOSEPH JONES, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 116-97. Filed October 5, 1998.

Sandy Kay Jones and Clint Joseph Jones, pro sese.

Jeremy L. McPherson, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, Judge: Respondent determined a deficiency in, and a

penalty on, the Federal income tax for 1994 of Sandy Kay Jones

(Mrs. Jones) and Clint Joseph Jones (petitioner) as follows:

Accuracy-Related Penalty

Year Deficiency Sec. 6662(a)

1994 $45,673 $13,543
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1 In the notice of deficiency, respondent disallowed for

lack of substantiation deductions for the cost of goods sold and

several expenses of petitioners' business, including returns and

allowances, commissions expense, and additional Schedule C

expenses. Respondent concedes that petitioners paid the expenses

disallowed in the notice of deficiency. Respondent further

concedes that petitioners are not liable for the accuracy-related

penalty under sec. 6662(a). 

The parties agree that if this Court decides that the

reported royalties are income subject to self-employment tax,

then petitioner's 1994 self-employment tax liability is $10,632,

and petitioners are liable for a deficiency in that year of

$9,026.

In light of these concessions, and the parties' agreement, a

Rule 155 computation is necessary. 

All section references are to the Internal Revenue Code in

effect for the year in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise

indicated. All dollar amounts are rounded to the nearest dollar,

unless otherwise indicated.

After concessions by the parties,1 the issues for decision

are: (1) Whether the amounts reported by petitioners as

royalties are gross receipts from petitioners' trade or business. 

We hold they are. (2) Whether the net profit from petitioners'

trade or business is subject to self-employment tax. We hold it

is.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. 

The stipulated facts and accompanying exhibits are incorporated

into our findings by this reference. At the time the petition in
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this case was filed, petitioners resided in Placerville,

California. 

 Petitioner is a self-employed salesman and distributor for

several multilevel marketing companies (companies) and has been

engaged continuously in this activity since 1982. Petitioner has

sold products for many companies, including Omnitrition

International, Inc., Herbalife, Biometrics, Nutrition Express,

Matol, New Vision, and TMI International. Mrs. Jones has not

been involved with petitioner's sales or distributor activities

since 1982.

 The companies petitioner is involved with all have a similar

multilevel marketing system (the system). Under the system,

petitioner finds customers for a company's products and then

recruits customers who are enthusiastic about the products as

distributors. To become a distributor, the customer completes an

application, which petitioner supplies, and mails it to the

company. On the application form, petitioner's name is entered

as the sponsor or "up-line distributor" for the applicant. The

distributors recruited by petitioner may repeat the process of

finding customers and recruiting them as distributors. The

distributors recruited by petitioner are considered first-level

distributors. The distributors recruited by the first-level

distributors are, with reference to petitioner, second-level
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2 The companies refer to these payments as "royalties". We

use this word in describing the payments for convenience without

accepting this categorization in a legal context. Yoakum v.

Commissioner, 82 T.C. 128, 140 (1984) (the language used may

indicate the form of the payment but does not control the

character).

distributors. These lower level distributors are collectively

referred to as petitioner's down-line distributors.

Petitioner sells products directly to his customers at the

regular retail price, and he sells products to his distributors

at a discounted price. Petitioner is paid a commission on the

sales he makes directly to his customers, and he is paid a

commission, called a "royalty" by the companies,2 on the sales

made by his first-level distributors. Once a distributor sells a

certain dollar value of products, the distributor becomes a

"breakaway distributor". The breakaway distributor buys products

directly from the company, rather than from petitioner. Although

the breakaway distributor is no longer under the supervision of

petitioner and no longer purchases the company's products through

petitioner, petitioner receives royalty payments from the company

on the purchases made by the breakaway distributor.

Petitioner's first-level distributor, who recruits a secondlevel distributor, receives a royalty for all of the sales by

that second-level distributor. Petitioner also receives a

royalty for each sale by the second-level distributor. The

number of distributor levels below petitioner for which he
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receives royalty payments depends upon the particular company.

For instance, New Vision pays royalties for six levels of downline distributors, and Herbalife pays royalties for three levels. 

Petitioner receives substantially more income from royalty

payments than he does from his direct sales. In the year at

issue, petitioner reported a loss on the direct sales, due to the 

costs of promoting his business. Promoting his business included

developing distributors who would break away and generate royalty

income for him.

For the year at issue, petitioner reported the receipts from

his direct sales, $23,464, on Form 1040 Schedule C, Profit or

Loss From Business, as gross receipts from sales, and claimed

$72,027 as business expenses. Petitioner reported the royalty

income he received, $190,485, on Form 1040 Schedule E,

Supplemental Income and Loss, and claimed $7,438 as commissions

expenses. 

OPINION

Respondent determined that the income petitioner received

from the companies on the sales made by his down-line

distributors is income from petitioner's trade or business and is

subject to self-employment tax under section 1401. Petitioners

assert that the royalty income is not earned income nor income

from petitioner's trade or business and is therefore not subject

to self-employment tax. Respondent's determination is presumed
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3 In Abraham v. Commissioner, T.C. Memo. 1988-412, the

multilevel-marketing companies used the terms "bonus" or

"commission payments" to describe the commissions they paid the

taxpayer for the sales made by his down-line distributors. 

correct, and petitioners bear the burden of proving that

respondent's determination is erroneous. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).

Issue 1. Whether the Amounts Reported by Petitioners as 

Royalties Are Gross Receipts From Petitioner's 

Trade or Business

The instant case is almost identical factually to Abraham v.

Commissioner, T.C. Memo. 1988-412. In holding that the payments3

to the taxpayer in Abraham for sales made by his down-line

distributors were self-employment income, this Court focused on

the activities the taxpayer performed in his business. We found

that the taxpayer, realizing that his income was dependent upon

the sales activities of his distributors, devoted substantial

time and energy to training and developing these individuals. 

All of the taxpayer's activities, which included providing the

distributors with motivation and encouragement, imparting to them

his skills, knowledge, and experience with the products, and

counseling them on selecting successful recruits, were conducted

in an attempt to increase the productivity of the distributors at

all levels. Therefore, the fact that the taxpayer had no

personal contact with the down-line distributors at the second

and lower levels made no difference; he devoted his time with the
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expectation that well-trained first-level distributors would

develop successful second-level distributors, who in turn were

likely to develop third-level distributors. 

Petitioner argues that the facts of Abraham v. Commissioner,

supra, are different from the facts of the instant case.

Petitioner testified that the multilevel-marketing industry has

undergone a big transition since we decided Abraham v.

Commissioner, supra. According to petitioner, the training and

motivation of distributors is now done by the companies with

video and conference calls. Petitioner, however, called no

witnesses nor produced any other evidence to corroborate his

testimony. We cannot assume the testimony of absent witnesses

would have been favorable to petitioner. Rather, the normal

inference is that it would have been unfavorable. Pollack v.

Commissioner, 47 T.C. 92, 108 (1966), affd. 392 F.2d 409 (5th

Cir. 1968); Wichita Terminal Elevator Co. v. Commissioner, 6 T.C.

1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947). 

Furthermore, we find that petitioner's own testimony does not

support his argument that this case is distinguishable from

Abraham v. Commissioner, supra. 

Petitioner testified that in the year at issue he sustained

a loss on his own efforts to sell the companies' products, but

that he did so "with a view of developing distributors who will

break away and * * * generate more income * * * in a royalty."
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4 Petitioner reported that he spent $6,882 on meals and

entertainment in 1994. He took the deduction for this expense on

Form 1040 Schedule C, Profit or Loss From Business.

Petitioner spent a great amount of time, effort, and money on

developing customers into distributors. For example, petitioner

spent $3,274 in placing newspaper advertisements, and printing

and distributing flyers to find new customers for the companies'

products. Practically every day, petitioner took people to lunch

or dinner so they would become his friends, because "people tend

to buy from their friends."4 Petitioner held meetings in his

home and hotel rooms for customers, and distributors who were not

yet breakaway distributors, to share product result stories and

introduce the people to the products, which he often provided as

samples at no cost. At every opportunity, petitioner would

propose to enthusiastic customers that they become distributors. 

If enthusiastic customers agreed to become distributors,

petitioner provided them with application forms on which he was

designated as the sponsor or up-line distributor.

Petitioner has been regularly and continuously engaged in

selling products for multilevel marketing companies since 1982. 

All of the multilevel marketing systems with which petitioner is

involved include a royalty payment structure. Furthermore,

petitioner is involved in this business with the primary purpose
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5 At trial, petitioner gave the following testimony in

response to respondent's questions:

Q. And your primary purpose was for income or profit from

the whole--the whole operation; your sales and the down-line

distributor sales? That was your motive?

A. Well, it's a little bit leading, there, Counselor, but

basically--

Q. I'm entitled to lead.

A. Are you? We can lead around here, huh?

The Court: On cross-examination, you can lead.

A. Okay. Allright. But, yeah, well, obviously, you know,

my real motivation in life is to help people but to make a

profit as I do it is not against my principles.

of making a profit.5 However, it is clear from petitioners'

return, and petitioner's testimony, that without the royalty

payments, petitioner had no honest objective of making a profit

from this activity. Thus, we conclude that recruiting and

developing distributors is an integral part of petitioner's

business. See Commissioner v. Groetzinger, 480 U.S. 23, 35

(1987).

Petitioner also argues that as he has hundreds of down-line

distributors who he has never met and who sell products over a

broad geographical area, the sales made by his breakaway

distributors are earned income to the companies, not to him. 

With respect to the payments from the lower-level distributors,

we can see no distinguishable difference between this case and
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Abraham v. Commissioner, T.C. Memo. 1988-412, despite

petitioner's arguments to the contrary. Petitioner devoted his

time and effort to increasing the productivity of the

distributors at all levels; it was his expectation that welltrained first-level distributors would develop successful lower

level distributors who were likely to generate commission income

for him. 

During the year under consideration petitioner regularly and

continuously engaged in selling the companies' products, and

especially, recruiting distributors. Accordingly, we find that

the payments that petitioner received from the companies for

sales made by the down-line distributors are gross receipts from

petitioner's trade or business.

Issue 2. Whether the Net Profit From Petitioners' Trade or 

Business Is Subject to Self-Employment Tax

Section 1401 imposes a tax on an individual's net earnings

from self-employment. In general, self-employment income

consists of the net earnings derived by an individual from a

trade or business carried on by him as a sole proprietor, or by a

partnership of which he is a member. Sec. 1.1401-1(c), Income

Tax Regs. The term "net earnings from self-employment" is

defined as the gross income derived by an individual from any

trade or business less any allowable deductions attributable to

the trade or business. Sec. 1402(a). The term "trade or

business", when used with reference to self-employment income or
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6 Secs. 1401 and 1402 are contained in subtit. A of the

Internal Revenue Code.

net earnings from self-employment, has the same meaning as when

used in section 162 (relating to trade or business expenses). 

Sec. 1402(c). The Supreme Court has interpreted the "trade or

business" terminology of section 162 as follows: "the taxpayer

must be involved in the activity with continuity and regularity

and that taxpayer's primary purpose for engaging in the activity

must be for income or profit." Commissioner v. Groetzinger,

supra at 35.

At trial, petitioner argued that the payments were like

dividends. Dividends on any share of stock are excluded from

gross income and deductions in computing net income from selfemployment. Sec. 1402(a)(2). The term "dividend" is defined for

purposes of subtitle A6 as any distribution of property made by a

corporation to its shareholders out of its earnings and profits

accumulated after February 28, 1913, or out of its earnings and

profits of the taxable year. Sec. 316(a). Petitioner did not

claim to own shares of stock in any of the companies that made

payments to him. Nor did he claim that the payments were made on

account of anything other than the agreements he had with the

companies to pay him a commission on the sales made by his downline distributors.
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We therefore find that the payments petitioner received from

the companies are not dividends excluded from self-employment tax

under section 1402.

Petitioner also referred to the payments as royalties. 

Royalties are defined as payments received for the right to use

intangible property rights, and that definition does not include

payments for services. Sierra Club, Inc. v. Commissioner, 86

F.3d 1526, 1535 (9th Cir. 1996) (defining royalties for the

purposes of section 512(b)), affg. in part and revg. in part 103

T.C. 307 (1994); see also Disabled Am. Veterans v. Commissioner,

94 T.C. 60, 72 (1990) (the regulations define royalties, other

than mineral, oil, or gas royalties, for personal holding company

purposes, as "amounts received for the privilege of using

patents, copyrights, secret processes and formulas, good will,

trade marks, trade brands, franchises, and other like

property."), revd. 942 F.2d 309 (6th Cir. 1991); sec. 1.543-

1(b)(3), Income Tax Regs. Petitioner has not provided any

persuasive evidence that the payments he received from the

companies were for the right to use his intangible property

rights, if any, and not for services. 

We do not need to resolve the question of whether the

payments petitioner received from the companies are royalty

payments to decide this case. Royalty payments, unlike

dividends, are not specifically excepted from self-employment tax
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by section 1402. Furthermore, royalty payments received as selfemployment income from a trade or business are subject to selfemployment tax. Dacey v. Commissioner, T.C. Memo. 1992-187;

Hittleman v. Commissioner, T.C. Memo. 1990-325, affd. without

published opinion 945 F.2d 409 (9th Cir. 1991); Langford v.

Commissioner, T.C. Memo. 1988-300, affd. without published

opinion 881 F.2d 1076 (6th Cir. 1989). 

We have found that petitioner is in the trade or business of

selling the companies' products and recruiting distributors, and

that the payments that petitioner received from the companies for

sales made by his down-line distributors, regardless of whether 

he had personal contact with them, are gross receipts from his

trade or business. Therefore, all such income is self-employment

income to petitioner which is subject to self-employment tax

under section 1401.

For the foregoing reasons,

Decision will be entered 

under Rule 155.