                         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. at 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.
