The Internal Revenue Code taxes “self-employment income.” I.R.C. § 1401(a), (b). The tax “is the counterpart of the taxes imposed on wages of employees by the Federal Insurance Contributions Act.” Steffens v. Comm’r, 707 F.2d 478, 481 (11th Cir. 1983) (citations omitted). Recently, the 11th Circuit addressed an unusual issue: whether distributions from retirement plans maintained by Mary Kay, Inc. for its independent contractors are subject to self-employment tax. Peterson v. Comm’r, Nos. 14-15773; 14-15774; 2016 U.S. App. LEXIS 12574 (11th Cir. July 8, 2016).
The Taxpayer, Christine Peterson, was a Mary Kay sales consultant who started to work for the company in the summer of 1982 and earned a pink Cadillac by the following year. Peterson, 2016 U.S. App. LEXIS 12574 at *31-*32. Ultimately, she worked her way up to the highest level in the Mary Kay system, becoming a National Sales Director or NSD in 1991. Id.at *32.
All Mary Kay salespeople work as independent contractors and are paid on a commission basis. Id. at *2-*3. As the top level in the Mary Kay network, NSDs were subject to some special contractual provisions, which included a non-compete; in addition, their contract with Mary Kay explicitly indicated that NSDs were independent contractors who would file tax returns as self-employed individuals. Id. at *7.
Mary Kay NSDs were eligible to participate in two post-retirement compensation plans. The first, known as the “Family Program,” paid benefits in the event of death or disability; it also provided fifteen years of payments once an NSD accepted “emeritus status.” Id. at *14 (emphasis in the original). These payments were based upon a percentage of the NSD’s network commissions from domestic sales activity, specifically, the average commissions in the three highest years of the NSD’s last five years of activity in the Mary Kay network. Id. at *16 & n. 10. A condition of the benefits was an ongoing noncompetition agreement. Id. at *17. The second deferred compensation plan was known as the “Futures Program,” which provided benefits on the basis of a percentage of non-domestic network commissions. Id. at *21. The documents for both programs indicated that they were not employment agreements and that NSDs were independent contractors. Id. at *16-*17, *27.
After becoming an NSD, the Taxpayer entered the Family Program, executing the agreement in November of 1992. Id. at *33. She signed the Futures Program agreement in July of 2005. Id. In 2008, Ms. Peterson received a notice from Mary Kay that it was amending the two programs to assure that they complied with Section 409A of the Code, thereby precluding the acceleration of the taxation of the benefits and exposure to potential penalties. Id. at *34-*35. This material noted that Section 409A of the Code explicitly targeted deferred compensation paid to independent contractors. Id. at *35.
In 2009, Ms. Peterson retired, and she received $489,707 in payments from the Family Program and the Futures Program. Id. at *41. She did not pay self-employment tax on those amounts. After the Tax Court ruled that payments were subject to self-employment tax, the Taxpayer and her husband appealed.
The Eleventh Circuit initially focused its analysis on the definition of “self-employment income,” noting that income was derived from self-employment if there was “a nexus between the income received and a trade or business that is, or was, actually carried on.” Id. at *50 (quoting Newberry v. Comm’r, 76 T.C. 441, 444 (1981)) (emphasis by the Peterson Court).
The court then turned to the impact of Section 409A and the 2008 amendments to Mary Kay’s plans. Here it noted the Tax Court’s determination that the Taxpayer did not dispute the fact that the amendments to the plans characterized them as deferred compensation arrangements. Id. at * 51. In the court’s view, the “Danielson rule” applied, binding the Taxpayer to the characterization of the programs as deferred compensation under Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967) (en banc), and Spector v. Commissioner, 641 F.2d 376, 384-86 (5th Cir. Unit A Apr. 1981) absent a showing of mistake, undue influence, fraud or duress. 2016 U.S. App. LEXIS 12574 at *52.
Specifically, the court held that Ms. Peterson was bound by Mary Kay’s 2008 characterization of the programs as “deferred compensation” arrangements because the agreements that she had signed authorized Mary Kay to amend the programs: “Because Peterson had signed the retirement Program Agreements respectively in 1992 and 2005 permitting Mary Kay to amend them prospectively, she necessarily had consented to the 2008 Amendments that expressly characterized the Family Program and Futures Program payments as ‘deferred compensation’ under a nonqualified compensation plan.” Id. at *52-*53. This rather sweeping conclusion triggered a partial dissent, which argued that this was an unwarranted extension of the Danielson rule because the Taxpayer herself had not characterized the programs as “deferred compensation.” Id. at *74-*75 (Rosenbaum, J. dissenting in part and concurring in part).
Next, the Court of Appeals turned to the Taxpayer’s arguments, which focused primarily on her contention that the payments were compensation for her termination of her business and her post-retirement noncompetition agreement. The court noted that there was no evidence of a formal sale of the Taxpayer’s business. Id. at *58. The majority also concluded that the noncompetition agreements “were not determinative in Peterson’s receiving her post-retirement commissions.” Id. at *59.
The majority then addressed two cases involving insurance agents that the Taxpayer had relied upon, Gump v. United States, 86 F.3d 1126 (Fed. Cir. 1996), and Milligan v. Commissioner, 38 F.3d 1094 (9th Cir. 1994). After noting that the Tenth Circuit reached a different result in Scheible v. Commissioner, 130 F.3d 1388 (10th Cir. 1997), the majority proceeded to distinguish the insurance cases on several grounds:
- Initially, the court cited the differences between the relevant products, commenting that the insurance business involved contracts of a stated duration that were subject to renewal, while sales of cosmetics did not. 2016 U.S. App. LEXIS 12574 at *68.
- Next, the majority noted that the calculation of post-termination payments in the insurance cases involved concepts “such as renewals, adjustments, and deductions, which are germane to the insurance business.” Id.
- The court then noted a functional difference between the roles of the insurance agents, who were involved directly in sales activity, and the Mary Kay NSDs, who managed other Mary Kay sales personnel and received a portion of their commission income. Id. at *68-*69.
- Finally, the court cited testimony from a Mary Kay official who indicated that the Mary Kay programs were “unique.” Id. at *69.
Frankly, the majority’s distinctions are underwhelming. The Mary Kay programs and the insurance programs bear a strong family resemblance:
- Both arrangements provide post-termination payments that are calculated under a formula that is driven by prior commission levels; and
- Both arrangements involve service requirements and an agreement not to compete.
The court did offer, in a footnote, a better argument: Congress amended Section 1402 of the Code to codify the outcome in Milligan and limited that provision to the insurance industry. Id. at *68 n. 42.
There also was another salient difference between the Mary Kay programs and the insurance arrangements in Gump and Milligan: while one of the Mary Kay programs offered payments that were determinable as of the date the NSD adopted emeritus status, the agents’ payments were subject to adjustment after termination. See Milligan, 39 F.3d at 1096; see also Gump, 85 F.3d at 1127. This feature was one of the factors that led the Tenth Circuit to reach a different result in Scheible. 130 F.3d at 1393-94.
Turning to the dissent, it makes a compelling argument that the Danielson rule should not be applied to bind someone to a characterization adopted by a third party. Id. at *76-*92 (Rosenbaum, J. dissenting in part and concurring in part).
On the merits, Judge Rosenbaum initially concluded that the Mary Kay program payments were not deferred compensation, based upon the rationale of Milligan, Gump, and Jackson v. Commissioner, 108 T.C. 130 (1997), noting there was no agreement by Ms. Peterson to take lower compensation while she was working. Id. at *94-*97 (Rosenbaum, J. dissenting in part and concurring in part). Instead, Judge Rosenbaum focused upon whether there was a sufficient nexus between the payments received and the Taxpayer’s prior labor. Id. at *98 (Rosenbaum, J. dissenting in part and concurring in part). Here she distinguished between the Family Program payments, which were based upon domestic commissions, and the Futures Program payments, which were calculated on the basis of foreign commissions. Id. at *110 (Rosenbaum, J. dissenting in part and concurring in part).
Judge Rosenbaum distinguished between the two programs based on the structure of the payments:
- The Family Program payments were calculated based upon the Taxpayer’s prior commission history and were not subject to adjustment. Consequently, they had the requisite nexus to her prior self-employment for the self-employment tax to apply. Id. at *112-*113 (Rosenbaum, J. dissenting in part and concurring in part).
- In contrast, Judge Rosenbaum concluded that the Futures Program payments lacked the requisite nexus because they were calculated based upon the commissions that Ms. Peterson would have received if she were still an NSD. Id. at *113-*114 (Rosenbaum, J. dissenting in part and concurring in part). Consequently, “the amount of Futures Program payments Peterson is entitled to receive is entirely dependent on the quality of other, non-retired Mary Kay laborers. Id. at *114 (Rosenbaum, J. dissenting in part and concurring in part).
This is a case in which the reasoning of the dissent is far more compelling than that of the majority. It appears that Judge Rosenbaum made the correct call.