T.C. Summary Opinion 2016-27
UNITED STATES TAX COURT
JAMES E. HESS AND ROBYN J. HESS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6084-14S. Filed June 20, 2016.
James E. Hess and Robyn J. Hess, pro se.
Steven I. Josephy, for respondent.
SUMMARY OPINION
PARIS, 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 for the year at issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
-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.
In a notice of deficiency dated December 20, 2013, respondent determined a
Federal income tax deficiency of $3,818 for petitioners’ 2010 taxable year.
The issue for decision is whether petitioners engaged in their Amway Corp.
(Amway) activity for profit. The Court holds that they did not.
Background
Some of the facts are stipulated and are so found. The stipulation of facts
and the exhibits attached thereto are incorporated herein by this reference.
Petitioners lived in Colorado when the petition was filed.
Petitioner James Hess received a bachelor’s degree in management from the
University of Phoenix and was employed as a software manager for Verizon
Business Network Services, Inc. (Verizon), in 2010. Before that he had worked as
a software engineer for MCI, Inc., a company that Verizon acquired in 2006.
Petitioner Robyn Hess described herself as a housewife who looked after
petitioners’ six children.
I. Amway in General
The issue in this case concerns petitioners’ activities with regard to Amway.
Amway is a supplier of household, health, and cosmetic products that are sold by
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individual distributors through direct marketing. Amway distributors are able to
purchase Amway products at a wholesale rate and then sell those products at
normal retail prices to earn a profit.
Amway distributors can generate revenue by: (1) selling products directly
to consumers; (2) earning points through Amway’s reward point system; and (3)
sponsoring other individuals who join Amway as distributors. In the latter case,
the original distributor is called an “upline” distributor, or a sponsor, in relation to
his new recruit, the “downline” distributor. The upline distributor receives points
when any member of his downline sells Amway products even though he does not
participate in the sale. Those points can then be redeemed for cash in the form of
a bonus check. If a downline distributor engages another individual to be his
downline distributor, the original upline distributor takes a percentage of the sales
of both downline distributors even though he had nothing to do with the activities
of the new downline distributor. Thus, to maximize Amway-related income, a
distributor must sell Amway products and also try to enlist other individuals as
Amway distributors.
II. Petitioners’ Amway Distributorship
Petitioners were sponsored as Amway distributors in 2005. Amway was
petitioners’ first independent business venture, and they did not consult with
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anyone other than their sponsoring distributors before deciding to become Amway
distributors. Petitioners conducted their Amway activity in their free time on
evenings and weekends.
Petitioners attended Amway training functions organized by Worldwide
Group, LLC (Worldwide Group). Worldwide Group is operated by several
Amway distributors specifically to coordinate training and motivational seminars
for other Amway distributors. Mr. Hess testified that the meetings provided
petitioners with training that was necessary for them to start, and eventually grow,
their Amway business. Each year petitioners attended each of Amway’s quarterly
meetings, and they also attended local monthly meetings.
Petitioners met with prospective distributors and showed them promotional
materials in an effort to have them become members of petitioners’ downline.2
Mr. Hess testified that petitioners met with prospective downline distributors 2 to
3 times per month during 2005-20093 and “increased * * * [their] pace” to 5 to 7
2
Petitioners refer to the process of meeting with prospective distributors,
showing them promotional materials, and attempting to enlist them as members of
their downline as “showing the plan”.
3
Specifically, Mr. Hess testified that they met with prospective distributors
“two to three times a month” in 2005 and “about the same as we did in 2005” in
2006; that he did not know how many times per month in 2007; that they met “two
to three” times per month in 2008; and that they “still maintained about the same
(continued...)
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times per month during 2010, but their records indicate that they met with
prospective distributors 10 times total during 2010. Mr. Hess testified that they
added two to four distributors to their downline each year from 2005 to 2010.4
Several times during his testimony Mr. Hess stated that Amway was a “people
business” and that people were petitioners’ greatest assets. When asked for the
names of the distributors that petitioners had added to their downline, however,
Mr. Hess was unable to definitively provide the Court with names or any other
evidence to show who they added as members of their downline.5
Petitioners did not create a business plan before beginning their Amway
activity or for any of the years that followed. Instead, petitioners used a document
3
(...continued)
pace” in 2009.
4
Specifically, “closer to two to three” in 2005; “somewhere between two to
four” in 2006; “somewhere between two to four” in 2007; “about two to four” in
2008; “two to four” in 2009; and “I’m thinking there was four” in 2010.
5
For example, after Mr. Hess testified that petitioners “probably” added two
to three downline distributors in 2005, respondent’s counsel asked him who those
downline distributors were, to which Mr. Hess responded: “Well, you know, I
specifically don’t remember those from 2005.” Similarly, after Mr. Hess testified
that petitioners added four downline distributors in 2010, respondent’s counsel
asked him who they were, to which he responded: “One of them was the--I
believe it was the Baileys that year. What was that gal’s name? I can’t remember
that gal. I can see a picture of her, but I can’t remember her name * * * And then
if I recall, I think that was the first time that we actually did sponsor family
members. Some of our children might have actually signed up that year.”
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that Worldwide Group had distributed to them as their business plan for each year
in which they conducted their Amway activity. The document distributed by
Worldwide Group did not contain information that is generally found in a formal
business plan. Rather, the document promoted a performance-bonus-generated
structure whereby an upline distributor receives performance bonuses from
Amway based on the volume--not profitability--of merchandise he or she sells to
his or her downline distributors. The percentage increased as sales volume
exceeded certain thresholds. These performance bonuses created an incentive for
members of an initial upline distributor’s downline to themselves become upline
distributors of additional downline distributors in order to earn performance
bonuses on the sales of distributors who were downline to them--thus creating a
pyramid of distributors below the initial upline distributor.
Petitioners did not create a budget, an estimate of revenues or expenses, or a
profit and loss statement or maintain a general ledger before beginning their
Amway activity or for any of the years that followed. Instead, petitioners carefully
maintained receipts to substantiate all expenses they had incurred for their Amway
activity. Although petitioners maintained records of their expenses, they did not
introduce any records showing how much product they sold, to whom they sold
product, or the names of their alleged downline distributors.
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After becoming Amway distributors in 2005, petitioners reported income
and expenses from their Amway activity on Schedules C, Profit or Loss from
Business. Petitioners timely filed Forms 1040, U.S. Individual Income Tax
Return, for those years--each of which included a Schedule C--reporting the
following income from wages, gross receipts from Amway sales, net loss from the
Amway activity, and adjusted gross income (AGI):
Income from Gross receipts Net losses Reported
Year wages from Amway sales reported AGI
2005 $96,068 (2) $19,512 $80,956
2006 90,466 (2) 10,605 79,885
2007 97,341 $429 10,958 90,252
2008 103,197 628 16,424 86,126
1
2009 111,078 2,178 22,611 114,884
2010 108,827 1,545 23,934 89,678
2011 190,233 318 25,073 184,651
1
2
This figure includes $6,146 of wage income Mrs. Hess reported.
The record does not contain information for these amounts.
Petitioners purchased Amway products for personal use, but the record does not
reflect whether the gross receipts they reported on Schedules C include those
purchases.
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Despite generating losses from their Amway activity year after year,
petitioners operated the activity in the same manner regardless of the prior year’s
results and did not seek advice from anyone other than their sponsoring
distributors.
Respondent determined that petitioners’ losses from their Amway activity
are limited by section 183 because petitioners did not engage in the activity for
profit. Petitioners timely petitioned the Court for redetermination.
Discussion
Generally, the Commissioner’s determination of a deficiency is presumed
correct, and the taxpayer bears the burden of proving it incorrect. See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Moreover, deductions are
a matter of legislative grace, and the taxpayer bears the burden of proving his
entitlement to any deductions claimed. INDOPCO, Inc. v. Commissioner, 503
U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Under certain circumstances the burden of proof as to factual matters may
shift to the Commissioner pursuant to section 7491(a). Petitioners claim to have
met the requirements to shift the burden of proof to respondent under section
7491(a). The Court need not determine which party bears the burden of proof
because this case will be decided on the preponderance of the evidence. See
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Estate of Black v. Commissioner, 133 T.C. 340, 359 (2009); Knudsen v.
Commissioner, 131 T.C. 185, 189 (2008), supplementing T.C. Memo. 2007-340.
I. Section 183 Generally
Under section 183(a), if an activity is not engaged in for profit, then no
deduction attributable to that activity is allowed except as provided for in section
183(b). In general, section 183(b) allows deductions attributable to an activity not
engaged in for profit only to the extent of the gross income from the activity. The
phrase “activity not engaged in for profit” means any activity other than one with
respect to which deductions are allowed for the taxable year under section 162 or
under paragraph (1) or (2) of section 212. Sec. 183(c). Generally, deductions are
allowable for ordinary and necessary expenses incurred in conducting a trade or
business or for the production of income. Secs. 162(a), 212(1).
To be entitled to business expense deductions without limitation by section
183, the taxpayer must have engaged in or continued the activity with the actual
and honest objective of making a profit. Elliott v. Commissioner, 90 T.C. 960,
969-970 (1988), aff’d without published opinion, 899 F.2d 18 (9th Cir. 1990);
Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), aff’d without published
opinion, 702 F.2d 1205 (D.C. Cir. 1983). The taxpayer’s expectation of profit
need not be a reasonable one, but merely bona fide. See Elliott v. Commissioner,
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90 T.C. at 970; Dreicer v. Commissioner, 78 T.C. at 645; sec. 1.183-2(a), Income
Tax Regs. “Profit” for purposes of section 183 means economic profit,
independent of tax savings. See Antonides v. Commissioner, 91 T.C. 686, 694
(1988), aff’d, 893 F.2d 656 (4th Cir. 1990); Hulter v. Commissioner, 91 T.C. 371,
393 (1988). Whether a taxpayer has an actual and honest objective of making a
profit is a question of fact to be resolved by examining all of the facts and
circumstances of the case. Elliott v. Commissioner, 90 T.C. at 970; Dreicer v.
Commissioner, 78 T.C. at 645; sec. 1.183-2(a), Income Tax Regs.
To determine whether a taxpayer engaged in an activity for profit the Court
examines the facts and circumstances of the case using the relevant factors set
forth in section 1.183-2(b), Income Tax Regs. Dreicer v. Commissioner, 78 T.C.
at 645; see Elliott v. Commissioner, 90 T.C. at 970. Those factors include: (1) the
manner in which the taxpayer carries on the activity, (2) the expertise of the
taxpayer or his advisors, (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) whether elements of personal pleasure or
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recreation are involved. Sec. 1.183-2(b), Income Tax Regs. These factors are not
exhaustive, see id.; see also, e.g., Campbell v. Commissioner, T.C. Memo. 2011-
42, 2011 WL 667973, at *5, and no one factor is determinative, Elliott v.
Commissioner, 90 T.C. at 970; sec. 1.183-2(b), Income Tax Regs. Simple
numerical majority will not indicate a lack of profit objective or vice versa, and the
Court may accord certain factors greater weight than others. Sec. 1.183-2(b),
Income Tax Regs.; see also Golanty v. Commissioner, 72 T.C. 411, 426 (1979),
aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981); Allen v.
Commissioner 72 T.C. 28, 34 (1979). In this analysis the Court accords greater
weight to proven objective facts than to mere statements of intent. Elliott v.
Commissioner, 90 T.C. at 971.
Appreciation of assets has no meaningful application as a factor with
respect to determining petitioners’ profit motive in pursuing their Amway activity.
See, e.g., Campbell v. Commissioner, 2011 WL 667973, at *5.
II. Applicability of Section 183 to Petitioners’ Amway Activity
A. Manner in Which Petitioners Carried On the Amway Activity
A taxpayer’s carrying on an activity in a businesslike manner and
maintaining complete and accurate books and records may indicate a profit
objective. Sec. 1.183-2(b)(1), Income Tax Regs. If, however, there is a lack of
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evidence that the taxpayer’s records were used to improve the performance of a
losing operation, such records generally do not indicate a profit objective.
Golanty v. Commissioner, 72 T.C. at 430; Campbell v. Commissioner, 2011 WL
667973, at *5. In particular, keeping records that are used only for purposes of
preparing tax returns is not indicative of a profit objective. See Campbell v.
Commissioner, 2011 WL 667973, at *5.
Petitioners did not create a business plan, budget, or estimate of revenues
and expenses; nor did they introduce records demonstrating the amount of product
they sold, who their customers were or how many customers they had, or who
their downline distributors were or how many downline distributors they had.
Although petitioners carefully maintained receipts, they did not use those receipts
to maintain a general ledger, create profit and loss statements, or improve the
performance of their Amway activity. To the contrary, petitioners used a
document that merely explained Amway’s payment structure as their business plan
and operated their Amway activity in the same manner each year despite
consistently generating losses. On these facts, it appears that petitioners
maintained receipts for substantiation purposes only rather than to monitor the
income and expenses of, and ultimately improve, their Amway activity.
Accordingly, the Court concludes that petitioners did not operate their Amway
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activity in a businesslike manner. See Elliott v. Commissioner, 90 T.C. at 971-972
(taxpayers did not conduct their Amway activity in a businesslike manner where
they did not maintain records indicating who the taxpayers’ customers were, where
and when they met with them, what products had been sold, and which methods
had been successful); Campbell v. Commissioner, 2011 WL 667973, at *6
(taxpayers did not conduct their Amway activity in a businesslike manner in part
because they maintained records primarily to substantiate tax deductions as
opposed to an analytical tool for improving profitability); Theisen v.
Commissioner, T.C. Memo. 1997-539 (taxpayers did not conduct their Amway
activity in a businesslike manner where they did not have a business plan, conduct
a break-even analysis, or create a budget).
B. Expertise of Petitioners or Their Advisers
Preparation for the activity by extensive study of its accepted business
practices, or consultation with those who are experts therein, may indicate a profit
objective where the taxpayer carries on the activity in accordance with such
practices. Sec. 1.183-2(b)(2), Income Tax Regs.
Amway was petitioners’ first independent business venture, and they had no
experience operating a direct marketing distributorship before becoming Amway
distributors. Petitioners obtained advice only from their sponsoring distributors,
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people who had a direct financial interest in recruiting petitioners as members of
their downline. See Campbell v. Commissioner, 2011 WL 667973, at *8 (the
taxpayers’ Amway upline distributors had a direct financial interest in the
maximization of the taxpayers’ sales volume without regard to the taxpayers’
profitability); Ogden v. Commissioner, T.C. Memo. 1999-397 (the taxpayers’
Amway upline distributors’ advice may be biased in view of their financial interest
in downline distributors’ sales volume), aff’d, 244 F.3d 970 (5th Cir. 2001).
Petitioners did not seek advice from a disinterested third party at any time during
which they conducted their Amway activity. This factor weighs against
petitioners.
C. Time and Effort Expended by Petitioners in Carrying On the
Activity
The fact that a taxpayer devotes much of his personal time and effort to
carrying on an activity may indicate an intention to derive a profit. Sec. 1.183-
2(b)(3), Income Tax Regs.
Mr. Hess testified that petitioners spent a significant amount of their free
time on nights and weekends carrying on their Amway activity, attending Amway
training functions, and recruiting downline distributors. While petitioners’ records
corroborate Mr. Hess’ testimony that petitioners attended Amway training
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functions and recruited some downline distributors, their records conflict with his
testimony that petitioners met with prospective downline distributors five to seven
times per month in 2010. Instead, their records indicate that they met with
prospective downline distributors 10 times total during 2010. This factor is
neutral.
D. Petitioners’ Success in Carrying Out Other Similar or Dissimilar
Activities
The fact that the taxpayer has engaged in similar activities in the past and
converted them from unprofitable to profitable enterprises may indicate that he is
engaged in the present activity for profit, even though the activity is presently
unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs.
Amway was petitioners’ first independent business venture. Petitioners had
five years of Amway experience before the year in issue but were unable to
translate their experience into improvement, generating only $1,545 of gross
receipts and reporting another net loss in 2010. Further, petitioners did not
provide the Court with names or records of the distributors they allegedly enlisted
as members of their downline. This factor weighs against petitioners. See Elliott
v. Commissioner, 90 T.C. at 972 (in holding that the taxpayers’ Amway activity
was not engaged in for profit, the Court noted that they had two years of Amway
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experience before the year in issue but “learned little from their two years of
experience” because they generated income of only $562 and had enlisted only
one downline distributor).
E. Petitioners’ History of Income or Loss
Although no one factor is determinative of the taxpayer’s intention to make
a profit, a record of substantial losses over many years and the unlikelihood of
achieving a profitable operation are important factors bearing on the taxpayer’s
true intention. Golanty v. Commissioner, 72 T.C. at 426. A series of losses during
the initial or startup stage of an activity may not necessarily be an indication that
the activity is not engaged in for profit. Sec. 1.183-2(b)(6), Income Tax Regs.; see
Golanty v. Commissioner, 72 T.C. at 427; Campbell v. Commissioner, 2011 WL
667973, at *9. Where a taxpayer continues to sustain losses beyond the period
which customarily is necessary to bring the operation to profitable status,
however, such continued losses, if not explainable, may indicate that the activity is
not engaged in for profit. Sec. 1.183-2(b)(6), Income Tax Regs.; see Campbell v.
Commissioner, 2011 WL 667973, at *9. The “goal must be to realize a profit on
the entire operation, which presupposes not only future net earnings but also
sufficient net earnings to recoup the losses which have meanwhile been sustained
in the intervening years.” Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965),
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aff’d, 379 F.2d 252 (2d Cir. 1967); see Golanty v. Commissioner, 72 T.C. at 427;
Campbell v. Commissioner, 2011 WL 667973, at *9.
Petitioners’ gross income from the sale of Amway products never exceeded
their expenses. Petitioners reported a net loss in each year from 2005 to 2011.
Further, after the first two years of experience petitioners generated gross receipts
of only $5,098 from 2007 to 2011 and reported a total net loss of $99,000 during
the same period. During the year at issue, petitioners generated only $1,545 of
gross receipts and reported a $23,934 net loss, despite having five years of
experience. Petitioners’ lack of gross receipts, while reporting increasingly larger
losses for each year from 2006 to 2011, indicates a lack of profit objective,
especially when considering that petitioners did not change the way in which they
conducted their Amway activity. See Elliott v. Commissioner, 90 T.C. at 972 (the
taxpayers did not engage in their Amway activity for profit where they generated
income of only $562 despite having two years of prior experience); Campbell v.
Commissioner, 2011 WL 667973, at *9 (the taxpayers did not engage in their
Amway activity for profit despite seeing an $80,000 increase in gross receipts over
a three-year period where their Amway activity always generated annual losses
exceeding $20,000). This factor weighs against petitioners.
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F. The Amount of Occasional Profits, If Any, Which Are Earned
This factor concerns the amount of profits in relation to the losses incurred,
investments made in the activity, and the value of the assets used in the activity.
Sec. 1.183-2(b)(7), Income Tax Regs.
As discussed supra, petitioners generated total gross receipts of only $5,098
from 2007 to 2011 and reported a total net loss of $99,000 during the same period.
“The magnitude of the activity’s losses in comparison with its revenues is an
indication that * * * [the taxpayer] did not have a profit motive with respect to the
activity.” Miller v. Commissioner, T.C. Memo. 1998-463, 1998 WL 906689, at *6
(citing Smith v. Commissioner, T.C. Memo. 1997-503, aff’d, 182 F.3d 927 (9th
Cir. 1999), and Burger v. Commissioner, T.C. Memo. 1985-523, aff’d, 809 F.2d
355 (7th Cir. 1987)). This factor weighs against petitioners.
G. Petitioners’ Financial Status
Substantial income from sources other than the activity (particularly if the
losses from the activity generate substantial tax benefits) may indicate that the
activity was not engaged in for profit. Sec. 1.183-2(b)(8), Income Tax Regs.
Mr. Hess was employed full time by MCI, Inc., and Verizon between 2005
and 2010. Petitioners also conducted their Amway activity during that period.
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Mr. Hess offset the wages that he reported during those years by reporting Amway
net losses as follows:
Year Wages Amway net loss Reported AGI
2005 $96,068 $19,512 $80,956
2006 90,466 10,605 79,885
2007 97,341 10,958 90,252
2008 103,197 16,424 86,126
1 2
2009 111,078 22,611 114,884
2010 108,827 23,934 89,678
1
This figure includes $6,146 of wage income Mrs. Hess reported.
2
For 2009 petitioners reported “other income” of $22,964.
By deducting the net losses associated with their Amway activity, petitioners
substantially reduced the tax liability they would otherwise have owed. This
indicates a lack of profit objective. See Ransom v. Commissioner, T.C. Memo.
1990-381. This factor weighs against petitioners.
H. Elements of Personal Pleasure or Recreation
The presence of personal motives in carrying on an activity may indicate
that the activity is not engaged in for profit, especially where recreational or
personal elements are involved. Sec. 1.183-2(b)(9), Income Tax Regs.
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The Court has previously observed that “there are significant elements of
personal pleasure attached to the activities of an Amway distributorship” and that
“an Amway distributorship presents taxpayers with opportunities to generate
business deductions for essentially personal expenditures.” Brennan v.
Commissioner, T.C. Memo. 1997-60, 1997 WL 39496, at *3; see also Campbell v.
Commissioner, 2011 WL 667973, at *10. In many of the Amway cases in which
the Court has found elements of personal pleasure attached to Amway activities,
taxpayers have deducted personal expenditures as Amway-related expenses, see,
e.g., Campbell v. Commissioner, 2011 WL 667973, at *10-*11, or deducted costs
associated with maintaining an active social life as Amway-related expenses, see,
e.g., Elliott v. Commissioner, 90 T.C. at 973. The Court cannot definitively say
that petitioners deducted personal expenditures as Amway-related expenses or
used Amway to maintain an active social life while generating tax deductions.
The record does not tip the scale in favor of either respondent or petitioners with
respect to this factor. Accordingly, this factor is neutral.
I. Conclusion
Although petitioners maintain that they engaged in and continued their
Amway activity with the actual and honest objective of making a profit, the
objective facts indicate otherwise. Petitioners did not conduct their Amway
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activity in a businesslike manner, did not seek advice from disinterested third
parties, did not maintain records for the purpose of monitoring and improving
business performance, and have consistently produced losses while generating
nominal gross receipts. On this record, the Court concludes that petitioners did
not engage in their Amway activity with the requisite objective of making a profit.
Consequently, their deductions arising from the Amway activity are limited by
section 183.
The Court has considered all of the arguments made by the parties, and to
the extent they are not addressed herein, they are considered unnecessary, moot,
irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
for respondent.