Payments Made to Former Independent Contractor Under Agreement Found to Be Subject to Self-Employment Tax

The Eleventh Circuit Court of Appeals found that payments received by a former independent Mary Kay beauty consultant under a nonqualified plan after her retirement was subject to self-employment tax (Petersen v. Commissioner, CA11, Nos. 14-15773, 14-15774, aff’d TC Memo 2013-271).

The Mary Kay plan in question had been modified in 2008 in response to the addition of IRC §409A by Congress.  In doing so, the plan documents now clearly referred to the plan as being one granting nonqualified deferred compensation to the participants to be paid after they retired. 

Nan Smoot, Mary Kay’s Director of Taxes, in testimony in the original Tax Court case explained the reasons for the change as follows:

Smoot testified she was involved in drafting the Mary Kay Amendments for the Family Program and Futures Program in 2008 to ensure they complied with IRS regulation 409A. She explained the IRS “did not want a receiver of income to be able to manipulate what year they received the income”; “if . . . deferred compensation plans were not compliant with the 409A rules, . . . the person who would be receiving the payments, would be subject to a 20 percent penalty on the plan amounts” plus “100 percent of all amounts under the plan to be paid in the future, that amount would be subject to tax up front.” Trial Tr. 285, 286. Consequently, Smoot testified the 2008 Amendments to the Family and Futures Programs were favorable to a participating NSD, because, instead of the 20 percent penalty, the regular income tax rate would have applied “on all future payments covered under the contract.” Id. at 286. As the Tax Court judge clarified with Smoot, this penalty tax would have been imposed “before receipt . . . , if the Program did “not comply with [the IRS] rules,” which Smoot testified would be “pretty onerous” to the NSD participants. Id. at 286, 287 (emphasis added).

Through the 2008 Amendments, Smoot testified the intent of Mary Kay was to make “extremely clear to the IRS” that the 409A rules applied, which was to the benefit of the NSDs participating in the Family Program and Futures Program. Id. at 289.

In response to the judge’s inquiry as to the significance of a nonqualified-deferred-compensation arrangement, Smoot responded the participant NSDs are “independent contractors,” and “there’s no way to have a qualified pension plan for a non-employee. So, it had to be a non-qualified plan. It’s not a pension arrangement under 401.” Id. at 288 (emphasis added). For tax purposes, Smoot explained Mary Kay treated payments to NSDs under the Family Program and Futures Program as deferred compensation based on past services, making them ordinary deductions for Mary Kay. She testified the 2008 Amendments did not change Mary Kay’s tax reporting regarding these Programs: “We have always treated the [Program] payments as payments for past services” or deferred compensation. Id. at 293. This deferred-compensation treatment for payments under the Family Program and Futures Program is shown by Mary Kay on its books, tax returns, and reported to the IRS as nonemployee compensation on Form 1099-MISC.

The panel explained the self-employment tax as follows:

To be self-employment income, “there must be a nexus between the income received and a trade or business that is, or was, actually carried on.” Newberry, 76 T.C. at 444 (emphasis added). In addition, the income “must arise from some actual (whether present, past, or future) income-producing activity of the taxpayer before such income becomes subject to . . . self-employment taxes.” Id. (emphasis added). “The self-employment tax provisions are broadly construed to favor treatment of income as earnings from self-employment.” Bot v. Comm’r, 353 F.3d 595, 599 (8th Cir. 2003).

The Tax Court had found that this deferred compensation program represented amounts earned by the taxpayer in a prior year from her business which was being paid out in a later year and thus was subject to self-employment tax.

The taxpayers argued first that the structure, which included a non-compete agreement, was actually a sale of her business and thus should not be subject to self-employment tax.  The court did not find any evidence that this was really a sale rather than deferred compensation.  As was noted earlier, the plan now stated it was a deferred compensation arrangement. 

Nowhere did it provide for a sale of the taxpayer’s Mary Kay business and, as well, the taxpayer had actually violated the non-compete agreement yet payments continued to be made under the program.

The major argument of the taxpayers, and that was also endorsed in amici briefs filed with the Court, is that the case should be governed by prior cases in other circuit that dealt with payments to insurance salesmen.  As the court noted:

They primarily rely on two nonbinding circuit cases involving insurance salesmen, whose payments after terminating their relationships with their insurance companies were found not to be subject to self-employment tax. Gump v. United States, 86 F.3d 1126 (Fed. Cir. 1996); Milligan v. Comm’r, 38 F.3d 1094 (9th Cir.1994)42; but see Schelble v. Comm’r, 130 F.3d 1388 (10th Cir. 1997) (concluding insurance salesman’s after-termination-of-employment payments were subject to self-employment tax). We distinguish these insurance cases on at least four bases. First, their products are different. Insurance policies, whether they are for life, automobiles, fire and casualty, or general coverage involve contracts with a customer for a specific time period; they have to be renewed, when that term expires. That is not the case with fungible cosmetic sales, which do not involve contracts with customers or renewals. Second, the calculation of after-termination-of-business payments for insurance salesmen is based on methods and concepts, such as renewals, adjustments, and deductions, which are germane to the insurance business. Third, while insurance salesmen and Mary Kay NSDs are independent contractors, their means of operation are entirely different. Insurance salesmen work singularly; the commissions they garner are the result of each salesman’s individual work. In contrast, Mary Kay NSDs no longer are selling cosmetics but lead and train their ever increasing networks, whose sales generate the NSDs’ commissions before and after their retirement, which meet the requirement under a nonqualified plan for deferred compensation, derived from previous work as an independent contractor. Fourth and most distinctive, the Mary Kay Family Program, for percentages of commissions from NSDs’ domestic networks, and Futures Program, for percentages of commissions from their foreign networks, are one of a kind. As Jill Wedding, Mary Kay Director of Consultants, testified at the Tax Court trial, the Family Program and Futures Program are “unique” concerning after-retirement programs for direct-sales companies. For these reasons, we do not consider the after-termination payments of insurance salesmen to be comparable to the Mary Kay Family Program and Futures Program for the purpose of determining whether commission payments received by NSDs in retirement are subject to self-employment tax as deferred compensation under a nonqualified plan. The Petersons “failed to establish that [Peterson] qualified for an exemption to the [self-employment] tax” imposed on her 2009 deferred payments for the Family Program and Futures Program. Patterson, 740 F.2d at 929.

While the above describes the majority opinion, in this case the panel’s decision was not unanimous.  Judge Rosenbaum found that the 2008 changes, made unilaterally by Mary Kay, should not serve to automatically “brand” the payments as deferred compensation. 

Neither does the dissent agree that the insurance cases are irrelevant, rather finding a more detailed analysis is required.  After conducting such an analysis the dissent found some payments had sufficient nexus to the taxpayer’s services for Mary Kay to be considered self-employment income but others, which depended on production of others, did not meet that test.