In any business activity, the end result is to make a profit.

The IRS expects all businesses to make a profit in at least three of five years, or be subject to the business being classified as a hobby.

A recent tax court ruling of a multilevel marketing business showed that the taxpayers did not engage in the business to make a profit. The court case of James E. Hess and Robyn J. Hess v. Commissioner of Internal Revenue, 2016, ruled that the taxpayers did not have a business plan, products were used for personal use and this use was not reflected on the tax return, records of the amount of time spent in this business endeavor were not documented and the losses reported over a period of six years were reflective of the business being more of a hobby. The taxpayers were involved in Amway.

Even though the taxpayers had receipts for travel expenses for monthly, quarterly and yearly meetings, the lack of a profit characterized the “hobby” classification.

When a business endeavor does not generate a profit and the taxpayer works the business only on the side of his normal employment, the IRS looks to see how the taxpayer is planning on making the business profitable. When a business is classified as a hobby, the losses can only offset the earnings. A Schedule C is not used, but rather the income is reported on line 21 of the 1040, with the losses up to the income taken on the Schedule A.

In this court case, the IRS asked the taxpayers to produce a business plan that would show that a profit was the goal of the business. In addition to the business plan, the IRS wanted records of the taxpayer’s downline (people under the taxpayer) and the amount of time the taxpayer spent on managing the downline in order for a profit to be generated.

Business activities are governed by section 183(a) of the Internal Revenue Code. 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.

Before becoming involved in a MLM, it is important to investigate the company. MLMs that encourage downline recruitment and not the actual sale of a product are actually pyramid schemes that may not satisfy the IRS standards to be classified as a business.

Many companies have come and gone over the years in the MLM world. As with any business, the time and money involved to make a profit has to have some type of return on the investment to make sense.

Be wary of get-rich schemes that may end up costing you a lot of money and no deduction for the expenses.

Tracy Bunner is an enrolled agent and tax preparer in Harrisville. She can be reached at 801-686-1995 or at tracy.bunner@hrblock.com.

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