Mary Kay Sales Consultant’s Retirement Payments Subject to Self-Employment Tax

The Eleventh Circuit Court of Appeals held, in a case of first impression, that payments a retired Mary Kay cosmetics sales consultant received under a retirement program set up for the company’s most successful salespeople were earnings subject to self-employment tax because the plan under which the payments had been made was characterized as a Sec. 409A deferred compensation plan (Peterson, No. 14-15773 (11th Cir. 5/24/16)).

Christine Peterson was a successful Mary Kay cosmetics salesperson, who reached the level of national sales director (NSD) before she retired in 2009. Of Mary Kay’s 2.7 million salespeople worldwide, there are only 200 NSDs plus about 155 retired ones. NSDs are eligible to participate in a Mary Kay program called the Family Program, under which participating NSDs receive payments after they retire based on a reduced percentage of the sales commissions they received while they were working for the company, if they agree to retire at age 65. A national sales director who retires after putting in 15 years at that level is entitled to payments equal to 60% of her “final average commissions” for 15 years. Peterson also received payments from another program (the Futures Program) that pays a percentage of foreign sales commissions. In 2009, the year at issue in the case, Peterson did not pay self-employment tax on payments that she received under either plan.

Mary Kay salespeople are independent contractors, and all agreements they enter into emphasize that status. Peterson signed the agreement to participate in the Family Plan before the advent of the Sec. 409A rules, so the agreement did not specify that the plan was a Sec. 409A plan. However, when those rules were enacted, the agreement was modified (as the terms of the original agreement allowed) to clarify that the plan was a Sec. 409A plan because the company felt that the plan clearly fell under the rules and that amending the agreement to state that it did would benefit the participants by lowering the penalties that would apply if a participant did not properly pay self-employment tax on plan payments.

The IRS found that the payments, as nonqualified deferred income from a Sec. 409A plan, were subject to Sec. 409A, and assessed Peterson $33,594 of self-employment tax. Peterson appealed to the Tax Court, which upheld the IRS’s determination. Peterson appealed the Tax Court’s decision to the Eleventh Circuit.

The Eleventh Circuit affirmed the Tax Court’s decision. It found that Peterson, by signing the original agreements for the Family Program and the Futures Program that allowed for amendment of the plans by Mary Kay, had characterized the programs as Sec. 409A plans for tax purposes. Having adopted this characterization, the Eleventh Circuit found that under the Danielson rule (Danielson, 378 F.2d 775 (3d Cir. 1967)), Peterson was bound to it and was required to treat the compensation from the plans as nonqualified deferred compensation that was subject to self-employment tax.

Peterson claimed that the retirement payments she received were either payments for the sale of her Mary Kay business back to the company or payments for the covenant not to compete she had signed, neither of which would be subject to tax as earnings on self-employment. However, the court found that there was no evidence of a sale because there was no agreement to sell the business. And it rejected the argument that the payments were for the covenant not to compete, because Peterson had violated the covenant by seeking other employment within two years of her retirement and Mary Kay had not stopped the payments in response.

—Sally P. Schreiber (sschreiber@aicpa.org) is a Tax Adviser senior editor.