Post-Retirement Distributions under Deferred Comp Plan Subject to Self-Employment Taxes.

(Parker Tax Publishing June 2016)

The Eleventh Circuit held that post-retirement distributions by Mary Kay, Inc. to a former Mary Kay consultant were taxable as self-employment income because the payments were deferred compensation derived from her former Mary Kay business. In reaching it conclusion, the court drew distinctions between the post-retirement payments received by the Mary Kay consultant and those received by insurance salespeople. Peterson v. Comm'r, 2016 PTC 181.

Background

Christine Peterson was an independent beauty consultant for Mary Kay, Inc., a wholesale distributor of cosmetics and related products. She sold Mary Kay brand products and recruited other individuals to join the company. In 1991, Christine entered into a national sales director (NSD) agreement with Mary Kay. She earned commissions from the wholesale purchases of Mary Kay products from her network of independent beauty consultants, sales directors, and national sales directors. Christine entered into a Family Security Program (FSP) and Great Futures Program (GFP) with Mary Kay. Both agreements provided that Mary Kay would make monthly distributions to Christine after completion of five years of NSD service and upon retirement from the company. The distributions would be calculated using a percentage of her average commissions before her retirement, the post-retirement wholesale purchases of her network, and her age at retirement. The agreements stated that each program was intended to be a nonqualified deferred compensation arrangement that was intended to meet the requirements of Code Sec. 409A. The agreements also included a non-compete clause.

Christine retired from Mary Kay in 2009 and received nonemployee compensation of almost $489,707 under the FSP and GFP agreements. Christine and her husband filed a joint return for 2009. Their financial advisor, Craig Foster, determined that the post-retirement payments were not subject to self-employment taxes.

The IRS issued a notice of deficiency, claiming that the post-retirement distributions received by Christine were subject to self-employment tax. The Tax Court upheld that finding, concluding that Christine's 2009 retirement distributions from the Mary Kay programs were derived from her former Mary Kay business, and the agreements for both programs provided they were deferred compensation, which made the distributions subject to self-employment tax. The Petersons appealed to the Eleventh Circuit.

Self-Employment Tax and Deferred Compensation

For individuals who are self-employed, self-employment tax is the counterpart of the taxes imposed on wages of employees by the Federal Insurance Contributions Act (FICA). Under Code Sec. 1402(b), the term "self-employment income" means the net earnings from self-employment derived by an individual during any tax year. Net earnings are defined as the gross income derived by an individual from any trade or business carried on by such individual less deductions. In Newberry v. Comm'r, 76 T.C. 441 (1981), the Tax Court concluded that 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. In addition, the Tax Court said, 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.

In enacting Code Sec. 409A, Congress titled it "Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans." Code Sec. 409A(d)(1) defines a nonqualified deferred compensation plan as any plan that provides for the deferral of compensation, with certain exceptions not applicable to the instant case. Reg. Sec. 1.409A-1(b)(1) states that a plan provides for a deferral of compensation where, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a tax year to compensation that is or may be payable to the service provider in a later tax year. Code Sec. 409A(d)(3) provides that the term "plan" includes any agreement or arrangement, including an agreement or arrangement that includes one person.

The Petersons' Arguments

The Petersons argued that the 2009 payments from the two Mary Kay programs were not "deferred compensation" but instead constituted consideration for Christine ending her Mary Kay businesses and her agreement not to compete with Mary Kay post-retirement. In essence, the couple said it was a sale of Christine's domestic and foreign businesses to Mary Kay. Based on this premise, the Petersons contended that the retirement program payments did not derive from Christine's previous Mary Kay business and were not deferred compensation subject to self-employment tax.

The Petersons also relied on two circuit court cases - Gump v. U.S., 86 F.3d 1126 (Fed. Cir. 1996) and Milligan v. Comm'r, 38 F.3d 1094 (9th Cir. 1994) - involving insurance salesmen, whose payments after terminating their relationships with their insurance companies were found not to be subject to self-employment.

Eleventh Circuit's Decision

The Eleventh Circuit held that the percentage commissions received by Christine under the FSP and GFP agreements were subject to self-employment tax because the payments were classified specifically as deferred compensation, derived from her prior association with Mary Kay.

With respect to the argument that the post-retirement program payments represented consideration for Christine ending her Mary Kay businesses and entering into a non-compete agreement, the court said such arguments were belied by the various agreements entered into by Christine as well as the record in the case. There were no sales agreements, the court noted, to evidence a sale of Christine's domestic and foreign businesses to Mary Kay.

The court held that the payments to Christine were deferred compensation under the Danielson rule, which is based on the decision in Comm'r v. Danielson, 378 F.2d 771 (3d Cir. 1967). The Danielson rule permits the IRS to bind a taxpayer to the tax consequences of an agreement unless the taxpayer "adduc[es] 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, etc." The FSP and GFP agreements, the court noted, expressly characterize the payments as deferred compensation related to Christine's prior labor.

With respect to the Petersons' reliance on the two circuit court cases involving insurance salespeople, the court noted that those cases were nonbinding and were distinguishable on at least four bases. First, the products were different, the court said. Insurance policies, whether they are for life, automobiles, fire and casualty, or general coverage involve contracts with a customer for a specific time period, the court observed, noting such policies have to be renewed when that term expires. That is not the case with fungible cosmetic sales, the court stated, which do not involve contracts with customers or renewals. Second, the court observed, the calculation of after-termination-of-business payments for insurance salespeople is based on methods and concepts, such as renewals, adjustments, and deductions, which are germane to the insurance business. Third, while insurance salespeople and Mary Kay NSDs are independent contractors, the court found their means of operation are entirely different. Insurance salespeople, the court said, work singularly; the commissions they garner are the result of each salesperson's individual work. In contrast, Mary Kay NSDs no longer are selling cosmetics but instead are leading and training their ever increasing networks, whose sales generate the NSDs' commissions before and after their retirement. The court found this meets the requirement under a nonqualified plan for deferred compensation because the compensation is derived from previous work as an independent contractor. Fourth and most distinctive, the court explained, the Mary Kay FSP and GFP programs, which are based on percentages of commissions from NSDs' domestic and foreign networks, are one of a kind.

For a discussion of self-employment taxes, see Parker Tax ¶13,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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