T.C. Memo. 2003-142
UNITED STATES TAX COURT
JORGE N. LOPEZ AND VIVIAN LOPEZ, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8612-01. Filed May 20, 2003.
Jorge N. Lopez and Vivian Lopez, pro sese.
David B. Mora, for respondent.
MEMORANDUM OPINION
CARLUZZO, Special Trial Judge: Respondent determined
deficiencies of $3,833 and $3,810 in petitioners’ Federal income
taxes for the years 1998 and 1999, respectively. The issue for
decision for each year is whether petitioners are entitled to
deductions for expenses incurred in connection with the sale and
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distribution of Amway Corp. (Amway) products. The resolution of
this issue for each year depends upon whether petitioners’ Amway
distributorship was a trade or business within the meaning of
section 162.1
Background
Some of the facts have been stipulated and are so found.
Petitioners are husband and wife. They filed a timely joint
Federal income tax return for each year in issue. At the time
the petition was filed, petitioners resided in Houston, Texas.
Jorge Lopez holds a bachelor’s and a master’s degree in
petroleum engineering. At all relevant times he was employed
full time as a petroleum engineer by Altura Energy, Ltd. Vivian
Lopez described her occupation as housewife and homemaker.
In 1996, an “upline”2 distributor of Amway products
recruited petitioners to act as “downline” distributors.
Petitioners maintained this status throughout the years in issue.
Some time after 1999, petitioners ceased their Amway activity and
became involved in Quixtar, Inc., an Amway affiliate.
1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.
2
The term “upline” simply refers to one’s relative position
in a particular distribution chain of Amway products. One
becomes an upline distributor after successfully recruiting one
or more “downline” distributors.
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Amway is widely known as a marketer and supplier of various
personal and household products. Amway relies on distributors
to purchase such products for personal consumption and for
resale to customers and downline distributors.3 In general, a
distributor’s gross income is based on profit from retail sales,
plus a “performance bonus” that is controlled by Amway and is
influenced by the type and quantity of products the distributor
purchases from Amway.
Profit from retail sales is determined by the difference
between the wholesale price, which is set by Amway, and the
retail price, which is set by the distributor. On average,
Amway’s suggested retail price for each product is approximately
25 percent above wholesale, but distributors are entitled to sell
a product at whatever price they choose, even if a sale at that
price produces a loss. Petitioners’ practice was to sell
products to their customers and downline distributors at cost,
thereby eliminating product sales as a source of profit.
A distributor’s performance bonus is determined by his or
her “point value” and “business volume”. Point value is a
unitless number that corresponds to a particular tier in the
Amway “performance bonus schedule”. Business volume is a dollar
amount generally equivalent to 87 percent of the suggested retail
3
A customer purchases Amway products for personal
consumption, but a distributor purchases Amway products intending
to resell them to customers or other distributors.
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price of a particular product. Amway assigns a given point value
and business volume to each product it sells but may change these
figures at any time for any reason it chooses.4 Consequently, it
is difficult to predict a performance bonus on the basis of the
present point value and business volume of Amway products. The
performance bonus is calculated by multiplying a distributor’s
monthly business volume by a percentage that is listed in the
performance bonus schedule and corresponds to the distributor’s
monthly point value.5 This percentage ranges from 3 to 25
percent and increases in steps as a function of point value.
Petitioners’ Amway activities may be summarized as follows.
Petitioners were recruited by an upline distributor of Amway
products in 1996. Petitioners had no prior experience with Amway
and no prior experience running a business. Before becoming
Amway distributors, petitioners received advice from other Away
distributors but did not seek the advice of independent business
consultants. During the course of their affiliation with Amway,
petitioners relied on the advice of certain celebrated upline
4
According to petitioners’ exhibits, the ratio of business
volume to point value ranges from 2.00 to 2.62.
5
For example, assume that, in a given month, a distributor
accumulates a point value of 1,000 and a business volume of
$2,500. According to Amway’s performance bonus schedule, at a
point value of 1,000, the performance bonus equals 12 percent of
business volume. Thus, in this example, the gross performance
bonus is $300 (i.e., $2,500 x 0.12). To determine the
distributor’s net performance bonus, this amount must be reduced
by the dollar amount of bonuses owed to downline distributors.
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distributors of Amway products. Petitioners also received
unsolicited, independent advice from their accountant, but
apparently the advice was negative.
Instead of attempting to sell Amway products at a profit to
customers/users, petitioners chose to concentrate on developing a
network of distributors. Consequently, their potential for
profit was almost entirely dependent upon Amway’s performance
bonus program and the sales efforts of their downline
distributors. Recruiting productive downline distributors,
therefore, was the key to petitioners’ profit potential.
Nevertheless, they made no effort to develop a profile of a
successful downline distributor on which basis they would
recruit; instead, petitioners recruited indiscriminately from
family, friends, and acquaintances. By the end of 1999, it
appears that petitioners had recruited between 10 and 25 downline
distributors but had only two regular customers--their neighbor
and Mr. Lopez’s mother.
The relationship between petitioners and their downline
distributors was an informal one. There were no contracts or
minimum sales agreements. Downline distributors were free to
leave petitioners’ distribution network at will and, if they
desired, could even join another Amway distributorship under a
different upline distributor. Petitioners were not assigned a
sales territory, and, like their downline distributors, they had
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to compete with other Amway affiliates for sales and recruits.
Petitioners’ lack of control over their downline distributors
hampered their ability to predict sales and, in turn, performance
bonuses. Their difficulty in predicting performance bonuses was
compounded by Amway’s practice of varying the point value it
assigned to a given product. Petitioners’ lack of control over
these key components of their distributorship caused any
predictions of performance bonuses that they might have made to
be, at best, uncertain.
Given their practice of selling Amway products at cost,
petitioners’ Amway distributorship could be profitable only if
their performance bonuses exceeded their expenses. In order for
this to occur, petitioners estimated that they would need to
achieve and maintain a monthly point value of 4,000. However,
petitioners had not actually made this determination for
themselves; rather, they relied on statements to this effect
by other Amway distributors and hypothetical examples in
Amway brochures. During the years in issue, it appears that
petitioners’ point value did not exceed 372 in any given month.
As noted, petitioners filed a timely joint Federal income
tax return for each year in issue. Included with each return is
a Schedule C, Profit or Loss From Business. Petitioners’
Schedule C for 1998 lists their principal business as “Amway
Sales and Distribution”. For 1999, petitioners’ Schedule C lists
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their principal business as “Sales:Distribution”. Petitioners
reported their Schedule C income and expenses for the years in
issue as follows:
Income: 1998 1999
Gross receipts or sales $7,139 $7,061
Less: cost of goods sold 3,439 6,368
Gross income 3,700 693
Expenses:
Car/truck expenses $6,901 $6,238
Supplies 500 503
Travel 911 2,172
Meals/entertainment 742 868
Utilities 2,248 2,130
Other expenses:
Misc. business expense 325 330
Tools 7,774 4,752
Functions 2,687 2,060
Total expenses 22,088 19,053
Net profit or (loss) (18,388) (18,360)
Petitioners prepared a budget applicable to both years in
issue. According to the budget, which consists of a single
handwritten page, financing petitioners’ Amway activity would
cost $737 per month, or $8,844 per year. The expenses deducted
on petitioners’ returns are more than double the budgeted amount.
In the notice of deficiency, respondent disallowed
petitioners’ Schedule C expenses on the ground that petitioners’
Amway activity was not entered into for profit. However, to
the extent of income realized from this activity, respondent
allowed these expenses as miscellaneous itemized deductions on
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Schedule A, Itemized Deductions. Other adjustments made in the
notice of deficiency are not in dispute.
Discussion
Burden of Proof
As a general rule, determinations made by the Commissioner
in the notice of deficiency are presumed to be correct, and the
taxpayer bears the burden of proving otherwise. See Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). Moreover, it is
settled that “‘an income tax deduction is a matter of legislative
grace and that the burden of clearly showing the right to the
claimed deduction is on the taxpayer.’” INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992) (quoting Interstate Transit
Lines v. Commissioner, 319 U.S. 590, 593 (1943)). Pursuant to
section 7491(a), if the taxpayer introduces credible evidence
with respect to any factual issue relevant to ascertaining the
taxpayer’s liability for tax, the burden of proof is placed on
the Commissioner with respect to that issue. For the burden of
proof to shift to the Commissioner, however, the taxpayer must
cooperate with reasonable requests by the Commissioner for
witnesses, information, documents, meetings, and interviews.
See sec. 7491(a)(2)(B); Higbee v. Commissioner, 116 T.C. 438,
441 (2001). Petitioners failed to satisfy this requirement
insofar as they refused to meet with respondent’s counsel before
trial, refused to provide respondent’s counsel with copies of
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documents on which they intended to rely at trial, and refused to
participate in the stipulation process contemplated by Rule 91.6
Trade or Business
According to petitioners, their Amway activity, at all
relevant times, was a trade or business. Therefore, petitioners
argue, the expenses they incurred in carrying on this activity
should be allowed as deductions. See sec. 162(a).7 Respondent
argues that petitioners were not carrying on a trade or business
because they lacked the requisite profit objective, and
petitioners are not, therefore, entitled to the deductions
they claim, except to the extent allowed by section 183.8
6
Petitioners explained that their refusal to cooperate with
respondent’s counsel was caused by their mistaken beliefs that
(1) they elected to have this case heard as a small tax case
pursuant to sec. 7463, and (2) the parties in a small tax case
are not required to meet in order to properly prepare for trial.
7
In general, sec. 162(a) allows a deduction for the
ordinary and necessary expenses paid or incurred during the
taxable year in carrying on any trade or business.
8
In relevant part, sec. 183 provides:
SEC. 183(a). General Rule.–-In the case of an
activity engaged in by an individual or an S
corporation, if such activity is not engaged in for
profit, no deduction attributable to such activity
shall be allowed under this chapter except as
provided in this section.
(b) Deductions Allowable.–-In the case of an
activity not engaged in for profit to which subsection
(a) applies, there shall be allowed--
(continued...)
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For the following reasons, we agree with respondent.
The term “trade or business” is not precisely defined in
section 162 or the regulations promulgated thereunder; however,
it is well established that in order for an activity to be
considered a taxpayer’s trade or business for purposes relevant
here, the activity must be conducted “with continuity and
regularity” and “the taxpayer’s primary purpose for engaging in
the activity must be for income or profit.” Commissioner v.
Groetzinger, 480 U.S. 23, 35 (1987).
The test for whether a taxpayer conducted an activity for
profit is whether he or she entered into, or continued, the
activity with the actual or honest objective of making a profit.
See Keanini v. Commissioner, 94 T.C. 41, 46 (1990); Dreicer v.
Commissioner, 78 T.C. 642, 644-645 (1982), affd. without
published opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-
2(a), Income Tax Regs. The taxpayer’s profit objective for each
8
(...continued)
(1) the deductions which would be allowable under
this chapter for the taxable year without regard to
whether or not such activity is engaged in for profit,
and
(2) a deduction equal to the amount of the
deductions which would be allowable under this chapter
for the taxable year only if such activity were engaged
in for profit, but only to the extent that the gross
income derived from such activity for the taxable year
exceeds the deductions allowable by reason of paragraph
(1).
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year in which the activity is conducted must be bona fide, taking
into account all of the facts and circumstances. See Keanini v.
Commissioner, supra at 46; Dreicer v. Commissioner, supra at 645;
Golanty v. Commissioner, 72 T.C. 411, 426 (1979), affd. without
published opinion 647 F.2d 170 (9th Cir. 1981); Bessenyey v.
Commissioner, 45 T.C. 261, 274 (1965), affd. 379 F.2d 252 (2d
Cir. 1967); sec. 1.183-2(a) and (b), Income Tax Regs. More
weight is given to objective facts than to the taxpayer’s
subjective statement of intent. See Engdahl v. Commissioner,
72 T.C. 659, 666 (1979); sec. 1.183-2(a), Income Tax Regs.
The following factors, which are nonexclusive, aid in
determining whether an activity is engaged in for profit:
(1) The manner in which the taxpayer carried on the activity;
(2) the expertise of the taxpayer or his or her advisers; (3) the
time and effort expended by the taxpayer in carrying on the
activity; (4) the expectation that assets used in the activity
may appreciate in value; (5) the success of the taxpayer in
carrying on other similar or dissimilar activities; (6) the
taxpayer’s history of income or losses with respect to the
activity; (7) the amount of occasional profits, if any, which are
earned; (8) the financial status of the taxpayer; and (9)
elements of personal pleasure or recreation. See sec. 1.183-
2(b), Income Tax Regs. No one factor is determinative in and of
itself, and our conclusion with respect to petitioners’ profit
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objective does not depend merely upon the number of factors
satisfied. See id. As discussed above, petitioners bear the
burden of proof. See Rule 142(a); Welch v. Helvering, 290 U.S.
111, 115 (1933).
After careful consideration, we are not persuaded that
petitioners’ primary purpose for engaging in the sale and
distribution of Amway products was for income or profit. The
manner in which petitioners conducted their Amway activity
virtually precluded any possibility of realizing a profit. Cf.
Elliott v. Commissioner, 90 T.C. 960, 971-973 (1988), affd.
without published opinion 899 F.2d 18 (9th Cir. 1990). For
example, petitioners freely incurred expenses with no realistic
plan for how they might recoup those expenses. Although
petitioners maintained detailed records for certain aspects of
their distributorship, the records apparently were kept merely
for substantiation purposes rather than for use as tools to
increase the likelihood of profit. See Hart v. Commissioner,
T.C. Memo. 1995-55; Poast v. Commissioner, T.C. Memo. 1994-399.
Furthermore, petitioners did not maintain the type of records
indicating that they had, for example, analyzed and confirmed the
existence of a potential market for their activity; established
how long it would take to recoup losses incurred during the early
years of their activity; or determined what level of sales would
be necessary for their activity to become profitable.
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Considering their practice of recruiting only family, friends,
and acquaintances to be downline distributors, petitioners’
goal of achieving a monthly point value of 4,000, which they
considered to be the break-even point, strikes us as unrealistic,
at best. Despite 4 years of losses, petitioners failed to change
tactics to increase the likelihood of earning a profit.
Petitioners had no prior experience in business and no prior
experience as Amway distributors. They accepted the advice of
upline distributors who stood to benefit by petitioners’
participation in an Amway distributorship but failed to solicit
advice from independent business advisers. See Ogden v.
Commissioner, T.C. Memo. 1999-397, affd. 244 F.3d 970 (5th Cir.
2001). When they received unsolicited advice from their
accountant, they rejected it. Petitioners’ restrictive method
of recruiting downline distributors continued from year to year
regardless of the ineffectiveness of that method.
During the years in issue, Jorge Lopez continued his full-
time employment as an engineer. Consequently, petitioners’
ability to maintain their financial status did not depend on the
profitability of their Amway distributorship. It also appears
that a substantial portion of the time petitioners spent on their
Amway activity involved socializing with family and friends.
See Connor-Nissley v. Commissioner, T.C. Memo. 2000-178.
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Having considered all of the relevant facts and
circumstances, we conclude that petitioners are not entitled
to the deductions here in dispute because their Amway
distributorship was not a trade or business within the meaning
of section 162(a) for either year in issue. Respondent’s
determinations in this regard are, therefore, sustained.
To reflect the foregoing,
Decision will be
entered for respondent.