James H. Dunlap & Eileen M. Dunlap v. Commissioner

T.C. Summary Opinion 2020-10
UNITED STATES TAX COURT
JAMES H. DUNLAP AND EILEEN M. DUNLAP, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5811-17S. Filed February 18, 2020.
James H. Dunlap and Eileen M. Dunlap, pro sese.
Amy Chang and Gregory Michael Hahn, for respondent.
SUMMARY OPINION
GERBER, Judge: This case was heard pursuant to the provisions of section
7463 of the Internal Revenue Code in effect when the petition was filed.1
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect at all relevant times.
-2-
Pursuant to section 7463(b), the decision to be entered is not reviewable by any
other court, and this opinion shall not be treated as precedent for any other case.
Respondent determined income tax deficiencies of $14,181 and $14,096 for
petitioners’ 2014 and 2015 tax years, respectively. The sole issue for our
consideration is whether payments received by petitioner Eileen Dunlap are
subject to self-employment tax.
Background
When their petition was timely filed, petitioners resided in Washington
State. Ms. Dunlap received $115,260.96 in payments from Mary Kay Cosmetics,
Inc. (Mary Kay), during each of 2014 and 2015. Mary Kay issued Form 1099-
MISC, Miscellaneous Income, to her for each year designating the income as
nonemployee compensation. She reported the payments as “Other Income”.
Respondent’s determination that the payments were also subject to self-
employment tax gave rise to the tax deficiencies for 2014 and 2015.
Ms. Dunlap began her career with Mary Kay, a manufacturer and seller of
cosmetics and related products, as a beauty consultant. Mary Kay consultants are
independent contractors and are not employees. Initially, she conducted skin care
classes in order to sell Mary Kay products. Any products she sold were purchased
at wholesale and sold at retail. She received commissions and bonuses from Mary
-3-
Kay for the products sold based on the volume of product purchases from Mary
Kay: the larger the volume of purchases, the higher the percentage of
commissions and bonuses. Mary Kay’s remuneration approach with consultants
and directors is designed to be an incentive commission and bonus program.
Ms. Dunlap became a Mary Kay sales director during 1981. Once sales
skills are acquired, a beauty consultant can take the next step, which is to recruit
and train others to sell Mary Kay products. The sales directors make commissions
on the sales of the Mary Kay beauty consultants who work under their guidance.
Mary Kay encourages this approach to exponentially expand the company’s sales
by providing incentives to motivate sales directors to continually expand their tiers
of business. Mary Kay would make monthly payments to its independent
contractors, and no taxes were withheld from the payments. If one of Ms.
Dunlap’s beauty consultants decided to no longer sell the products and returned
them to Mary Kay, a reduction would be made to her monthly payment to account
for the returned products.
As a sales director, Ms. Dunlap had a written agreement with Mary Kay that
set forth her duties, rights, and commission structure. She did not have a written
agreement with the consultants that she recruited. The recruited consultants had
agreements with Mary Kay.
-4-
A sales director can achieve the next level, national sales director, and in
that position would be involved with a third tier of business. In order to achieve
that level Ms. Dunlap was required to recruit a certain number of sales directors.
National sales directors have sales directors and consultants in their tiered
operation but have no direct authority over them. Mary Kay decided the terms of
the relationship between national sales directors, sales directors, and consultants.
Each person’s contractual agreement was between her and Mary Kay. The terms
of the agreements were “dictated” by Mary Kay, and either consultants or sales
directors agreed or there was no relationship. The relationship between Mary Kay
and national sales directors, sales directors, and consultants was not that of
employer-employee.
Once she became a national sales director, Ms. Dunlap could participate in
the Family Security Program (FSP). Mary Kay consultants and sales directors
were not entitled to participate in the FSP. The benefit of the FSP was that it
provided a national sales director with financial security should she retire or be
unable to work. Under the FSP, at 65 years of age, Ms. Dunlap’s relationship with
Mary Kay and any payments for sales or commissions from Mary Kay would end.
At 65 she was eligible to receive FSP payments, but she could no longer be
involved in a tiered business relationship under Mary Kay. In other words her
-5-
business relationship with Mary Kay terminated, but under the FSP she or her
estate would receive 15 years of payments based on her high average tiered sales
activity. The terms of the FSP are set by Mary Kay, and there is no negotiation of
the FSP terms.
Ms. Dunlap became a national sales director during 1988, around the time
that Mary Kay began the FSP. Mary Kay established the FSP as a retirement
program for national sales directors. The FSP agreement required 15 years of
national sales directorship and attainment of the age of 65. She attained that age
with sufficient years of service allowing her to receive FSP payments beginning in
January 2006. Under the agreement she was entitled to 60% of her final average
of commissions during her last 15 years of service. The FSP agreement stated that
she was not an employee of Mary Kay.
A preamble to a July 1, 1991, FSP restatement specifically prepared for Ms.
Dunlap states that her participation in the program is in recognition of her
“valuable contribution” as a national sales director. It further states:
[E]ach National Sales Director desires to participate in this program
in exchange for the offer by Mary Kay Cosmetics, Inc. to acquire at
retirement the valuable goodwill and all other rights associated with
the business, including future goodwill generated by her continued
support and loyalty to Mary Kay Cosmetics, Inc.
-6-
Any election under the program was irrevocable. Payments under the plan were
based on the high average tiered sales activity for a prescribed period. Ms. Dunlap
had a “normal” retirement under the FSP, which means that she had attained age
65. The payment amounts under the FSP were fixed based on her Mary Kay
business activity, and resulted from her efforts and services before retirement. The
payments did not represent income that had previously been reported as gross
income or subjected to self-employment tax.
The FSP plan was funded on the basis of a contractual obligation of Mary
Kay from the general assets of the firm. FSP participants do not acquire any
interest greater than an unsecured creditor’s. The FSP board appointed by the
company was empowered to “amend, modify or terminate the Plan at any time and
in any manner.” If it were terminated, national sales directors who are being paid
under the plan would be paid as scheduled in accord with the plan. The plan is
construed in accord with the law of the State of Texas.
A July 1, 2001, restatement of the FSP plan stated: “The Plan is intended to
be a non-qualified deferred compensation arrangement and is not intended to meet
the requirements of Section 401(a) of the [Internal Revenue] Code. The Plan is
intended to meet the requirements of Section 409A of the Code and shall be
construed and interpreted in accordance with such intent.”
-7-
In December 2008 an addendum restating the FSP plan became effective.
The central document of the addendum, dated July 1, 2005, applied to individuals
who were national sales directors on December 31, 1987, including Ms. Dunlap.
The addendum’s preamble expressed, in similar terms as older versions, Mary
Kay’s motivation for establishing the FSP, including the reference to goodwill.
The addendum stated that the plan was intended to be a nonqualified deferred
compensation arrangement and not intended to meet the requirements of section
401(a). It further stated that the plan was intended to meet the requirements of
section 409A.
In an October 25, 1995, letter to national sales directors, Mary Kay advised
that the receipt of FSP payments would not reduce any Social Security benefits to
which the participants might be entitled. On September 26, 2008, the FSP was
amended to comply with changes in the Internal Revenue Code. Mary Kay
advised that changes to section 409A “are likely” applicable to the FSP. Mary
Kay characterized section 409A as generally providing “that unless specified
requirements are met, all amounts deferred under a nonqualified deferred
compensation plan * * * are subject to taxation.” In the opinion of Mary Kay
management the FSP came within the provisions of section 409A. In particular
the amendments to section 409A were, as per Mary Kay, to affect the start date of
-8-
FSP payments. The materials sent to national sales directors reiterated that the
FSP was intended to be a nonqualified deferred compensation arrangement and
not intended to meet the requirements of section 401(a).
Petitioner remained retired during 2014 and 2015 and did not have a trade
or business during those years. It was the opinion of Mary Kay, as expressed to
national sales directors on October 25, 1995, that FSP payments were subject to
self-employment tax when paid to a retired national sales director.
Discussion
The question under consideration is whether payments Ms. Dunlap received
from Mary Kay during 2014 and 2015 are subject to self-employment tax.
Respondent relies heavily on Peterson v. Commissioner, 827 F.3d 968 (11th Cir.
2016), aff’g T.C. Memo. 2013-271. Petitioners’ primary argument is that Ms.
Dunlap sold her business or goodwill to Mary Kay and that the FSP payments
were for the sale of a capital asset. They further argue that Peterson was affirmed
by the Circuit Court of Appeals for the Eleventh Circuit and that she resides in
Washington State where any appeal would be to the Court of Appeals for the
Ninth Circuit. Petitioners also make several arguments relying on statutes and
regulations, each of which are considered in this opinion. Finally, per the parties’
stipulation, the payments “are deferred compensation payments from Mary Kay
-9-
paid pursuant to a non-qualified deferred compensation non-account balance plan
described in either Treas. Reg. section 1.409A-1(c)(2)(i)(C)(1) or (2).”
The Statutes. Section 409A provides for the inclusion in gross income of
deferred compensation from a nonqualified deferred compensation plan. The
parties disagree about the application of section 1.409A-1(c)(2)(i)(C), Income Tax
Regs., to the Mary Kay FSP payments. The regulation contains definitions and
further explains which plans come within the purview of section 409A.
Petitioners favor subdivision (i)(C)(1) and respondent subdivision (i)(C)(2) of
section 1.409A-1(c)(2), Income Tax Regs. The parties agree that the Mary Kay
plan was a nonaccount balance plan. The regulation contains alternative
definitions for the term “nonaccount balance plan”. Subdivision (i)(C)(1) refers to
a situation where the recipient was an employee of the company making the
deferred payments. Subdivision (i)(C)(2) refers to a situation where the recipient
was an independent contractor, such as Ms. Dunlap. We can only speculate that
Ms. Dunlap chose subdivision (i)(C)(1) because it contains a reference to section
31.3121(v)(2)-1(c)(2)(i) and (1)(iii)(B), Employment Tax Regs., which she relies
on in one of her arguments. See infra p. 16.
The other applicable statutes are sections 1401 and 1402, which provide for
the imposition of self-employment tax and definitions, respectively. Section
- 10 -
1.1402(a)-1, Income Tax Regs., provides additional definitions and detail of
earnings from self-employment. Section 1.1402(a)-1(c), Income Tax Regs.,
provides:
Gross income derived by an individual from a trade or business
includes gross income received (in the case of an individual reporting
income on the cash receipts and disbursements method) or accrued (in
the case of an individual reporting income on the accrual method) in
the taxable year from a trade or business even though such income
may be attributable in whole or in part to services rendered or other
acts performed in a prior taxable year as to which the individual was
not subject to the tax on self-employment income.
This definition places Mary Kay’s FSP payments to Ms. Dunlap clearly within the
statutory framework for income that is subject to self-employment tax. Ms.
Dunlap, however, makes several additional arguments, which are addressed for
completeness.
Case Precedents. The focal point of respondent’s position is Peterson, the
facts of which are in all important respects the same as those we consider in
petitioners’ case. Mrs. Peterson was a national sales director who entered into an
FSP agreement with Mary Kay and received payments that the Commissioner
determined were subject to self-employment tax. Mrs. Peterson, like Ms. Dunlap,
argued that the FSP payments were made in exchange for the sale of her Mary Kay
business back to Mary Kay. There are two differences in the facts of these cases:
- 11 -
(1) Mrs. Peterson retired during 2009 and Ms. Dunlap retired during 2006 and
(2) the Court of Appeals for the Eleventh Circuit affirmed this Court’s opinion in
Peterson whereas Ms. Dunlap resided in the Ninth Circuit when the petition was
filed. See Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th
Cir. 1971).
In Peterson v. Commissioner, T.C. Memo. 2013-271, this Court decided that
the FSP payments were subject to self-employment tax. In pertinent part the Court
explained:
Section 1401 imposes a tax on a taxpayer’s self-employment
income. Self-employment income consists of gross income derived
by an individual from any trade or business carried on by that
individual. See sec. 1402(a) and (b). Mrs. Peterson formerly carried
on a trade or business. Therefore, Mary Kay’s 2009 distributions
pursuant to the FSP * * * agreements are subject to self-employment
tax if they were “derived” from Mrs. Peterson’s business (i.e., “‘tied
to the quantity or quality of * * * [her] prior labor’”). See Jackson v.
Commissioner, 108 T.C. 130, 135-136 (1997) (quoting Milligan v.
Commissioner, 38 F.3d 1094, 1098 (9th Cir. 1994), rev’g T.C. Memo.
1992-655). The Mary Kay distributions were “tied to” the quantity
and quality of Mrs. Peterson’s prior labor. See id. Pursuant to the
FSP agreement, Mrs. Peterson’s distributions were based on her
average commissions over the five years prior to her retirement. * * *
In addition, Mary Kay’s distributions pursuant to both plans were
based on Mrs. Peterson’s age at retirement and minimum years of
service. Moreover, the FSP * * * agreements expressly provided that
the distributions were deferred compensation (i.e., related to Mrs.
Peterson’s prior labor). Petitioners failed to adduce proof sufficient
to alter the construction of these unambiguous agreements or show
that they were unenforceable. See Plante v. Commissioner, 168 F.3d
- 12 -
1279, 1280-1281 (11th Cir. 1999), aff’g T.C. Memo. 1997-386;
Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967),
vacating and remanding 44 T.C. 549 (1965). Accordingly, the 2009
FSP * * * distributions are subject to self-employment tax pursuant to
section 1401. [Id. at *8-*9.]
In Peterson the Court of Appeals for the Eleventh Circuit affirmed this
Court’s ruling that the 2009 Mary Kay FSP payments were subject to self-
employment tax. The Court of Appeals’ opinion detailed all of the information
that the parties in that case had established in the lower Court record. Those
details are, with limited and insignificant exceptions, the same as are included in
the record of petitioners’ case. The Court of Appeals employed the holding in
Commissioner v. Danielson, 378 F.2d at 775, to decide that Mrs. Peterson had not
shown that the documentary designation of the payments as deferred
compensation by Mary Kay was incorrect.
The Court of Appeals explained the rule in Danielson as follows:
When a taxpayer characterizes a transaction in a certain form,
the Commissioner may bind the taxpayer to that form for tax
purposes. This is the rule: “a party can challenge the tax
consequences of his agreement as construed by the Commissioner
only by adducing proof which in an action between the parties [to the
agreement] would be admissible to alter that construction or to show
its unenforceability because of mistake, undue influence, fraud,
duress, et cetera.” [Peterson v. Commissioner, 827 F.3d at 987
(quoting Plante v. Commissioner, 168 F.3d at 1280-1281).]
- 13 -
The fact that Ms. Dunlap and Mrs. Peterson were both national sales
directors and contemporaries in the Mary Kay business under the same agreements
and terms presents Ms. Dunlap with a difficult burden to show that the result in
her case should not be the same. Her basic argument is that she resides in the
Ninth Circuit and that she is not bound by the Court of Appeals for the Eleventh
Circuit’s holding. Ms. Dunlap, however, overlooks the fact that this Court is a
court of national jurisdiction and our holdings would be applied equally to all
taxpayers, unless they reside in a State where the Court of Appeals for that circuit
has held otherwise in a decision “which is squarely in point”. Golsen v.
Commissioner, 54 T.C. 757.
In an attempt to show that the result in the Court of Appeals for the Ninth
Circuit would be different, petitioners cite Milligan v. Commissioner 38 F.3d 1094
(9th Cir. 1994), rev’g T.C. Memo. 1992- 655. That case involved self-
employment tax determined by the Commissioner for an insurance agent’s
termination payments. Mr. Milligan had been an insurance agent from 1949 until
he retired in 1983 at age 62. Upon retirement the insurance company made
“termination” payments to him that were based on a complex formula contained in
a termination agreement.
- 14 -
The Court of Appeals for the Ninth Circuit, in reversing this Court’s
decision, held:
We are not prepared to characterize the precise relationship
between the Termination Payments and Milligan’s prior business
activity. Ambiguities in the Agent’s Agreement prevent us from
doing so. But, despite the ambiguities, we can see that the
Termination Payments did not “derive” from Milligan’s prior
business activity within the meaning of the self-employment tax. To
be taxable as self-employment income, earnings must be tied to the
quantity or quality of the taxpayer’s prior labor, rather than the mere
fact that the taxpayer worked or works for the payor. [Id. at 1098; fn.
ref. omitted.]
Initially, we note that the Mary Kay documents and agreements are not
ambiguous on this point. Applying the “quantity or quality” reasoning to
petitioners’ facts, we continue to conclude that the payments Ms. Dunlap received
during 2014 and 2015 are subject to self-employment tax. In the Ninth Circuit
Ms. Dunlap is not bound by the Danielson rule, and she may present evidence to
show that the substance of her relationship with Mary Kay, as opposed to Mrs.
Peterson’s, was different from the form set forth in the agreements. The record
here shows that the FSP agreement characterizes the payments as deferred
compensation, which she has stipulated and therefore conceded. Moreover, the
payments were calculated and derived on the basis of her prior work and income
activity with Mary Kay and are, unlike those in Milligan, tied to the quantity and
- 15 -
quality of that service. In this case Ms. Dunlap receives a fixed payment for 15
years based on her prior sales and commissions. Accordingly, the FSP payments
were fixed on the basis of prior business activity. Finally, petitioners have not
shown that the record contradicts the terminology in the documents and
agreements.
Sale of Goodwill. Petitioners argue that, in effect, Ms. Dunlap sold the
goodwill of her trade or business to Mary Kay. The argument derives from some
of the preamble text in various agreement documents concerning the FSP program.
The following text is in the preamble to the July 1, 1991, Mary Kay FSP
agreement: “[E]ach National Sales Director desires to participate in this program
in exchange for the offer by Mary Kay Cosmetics, Inc. to acquire at retirement the
valuable goodwill and all other rights associated with the business, including
future goodwill generated by her continued support and loyalty to Mary Kay
Cosmetics, Inc.”
Petitioners contends that the above text is evidence that Mary Kay FSP
payments were made in exchange for Ms. Dunlap’s business and/or goodwill.
They further argue that Ms. Dunlap should be entitled to capital gains tax rates on
the income. On the 2014 and 2015 returns, however, she reported the payments as
ordinary income.
- 16 -
The facts here belie petitioners’ sale argument. There was no agreement
between Mary Kay and Ms. Dunlap with respect to any sale of a business or
goodwill. Other than the reference to goodwill in the preamble to some
documents, there is no evidence in the record that would support a sale of a
business interest. The payments under the FSP are calculated on the basis of sales
and commissions and are being paid at a rate of 60% of a high average tiered sales
activity. Lastly, Ms. Dunlap had no rights or legal relationship with the
consultants and sales directors in her tiered Mary Kay activity. Accordingly, her
goodwill argument does not change the outcome of this case.
Deferred Compensation Plan. Petitioners make several technical arguments
that the FSP is not, in reality, a deferred compensation plan. They make this
argument even though the parties stipulated that Ms. Dunlap received “deferred
compensation payments from Mary Kay paid pursuant to a nonqualified deferred
compensation non-account balance plan.” The basis for their position appears
based in reliance on section 31.3121(v)(2)-1(c)(2)(i) and (1)(iii)(B), Employment
Tax Regs., which is referenced in section 1.409A-1(c)(2)(i)(C)(1), Income Tax
Regs. As we have already explained, in order for Ms. Dunlap to come within
subdivision (i)(C)(1) of that regulation, she would have to have been an employee
of Mary Kay. As part of her reasoning she points out that there was no tax
- 17 -
withholding from Mary Kay income before her retirement. She also notes that
some of her income was attributable to the efforts of others, i.e., consultants and
sales directors within her tiers as a national sales director. From these
postulations, she concludes that there must be a present value calculation to
determine the amount includible for 2014 and 2015. Using this line of reasoning,
she ultimately calculated that her present value annual self-employment tax would
be $702. Ms. Dunlap’s approach depends several premises which are not founded
in the record or law.
The record is clear that Ms. Dunlap’s prior earnings were the basis for the
annual FSP payments and that the quantity and quality of her labor were the
reason for the postretirement payments. In addition her FSP payments were not
subject to postretirement adjustments and were fixed on the basis of her prior
labor. Finally, the payments had not previously been reported as income or
subjected to self-employment tax. Stated another way, the FSP payments are
being paid contemporaneously although they were earned in prior years.
To reflect the foregoing,
Decision will be entered for
respondent.