Beware tax, licensing implications of multi-level marketing schemes.

As some companies emerge from the recession, they must revisit the way in which they market and distribute their products in order to reduce their operating expenses and increase their bottom lines. By the same token, many new "emerging" companies consider marketing and distribution strategies that simply challenge the status quo. Whatever the case might be, the potentially high costs of marketing and distribution have given rise to so-called multi-level marketing schemes.

In the typical MLM scheme, traditional methods of marketing, such as media advertising, and traditional distribution methods, such as retail sales, are cast aside in favor of a person-to-person network. Companies that use these networks to market and distribute their products make their concept very appealing to would-be "distributors."

However, the promotional materials given to such participants fall short of candidly advising them about potential "tax traps" that could arise through participation.

One tax trap addresses the question of liability for sales and use tax. The liability for sales tax arises from non-exempt sale of tangible personal property within the boundaries of the state. The Revenue and Taxation Code requires that retail sellers pay the state the appropriate amount of sales tax for the transaction. The code also permits the seller to pass the sales tax directly on to, and to collect it from, the consumer.

The relevant code sections apply to sales that arise from MLM schemes that promote, market and sell non-exempt tangible personal property, like "dietary aids and nutritional supplements," within the state. Therefore, in the MLM context, the issue is "who is liable" for payment of sales tax?

Promotional materials of MLM-type companies, particularly those located out-of-state, often disclaim the liability for local sales tax. If the disclaimer is both valid and correct, then the liability falls directly on the distributor (i.e., a member of the MLM network) who sells the product.

In such a case, a distributor would be required to obtain a retail seller's license and make periodic payments of sales tax to the state. If, however, the disclaimer is valid, but incorrect, then the sales tax liability falls directly on the company under an agency theory, and the distributor has no personal liability. Depending on the facts, the company might well be disclaiming a duty that cannot be delegated.

If the disclaimer is incorrect, and the company is thus liable for the sales tax, then the company cannot escape its obligation by attempting to delegate it to the distributor by using a disclaimer. The statutory obligation to pay over sales tax is a so-called non-delegable duty. Thus, the company must undertake its obligation or be subject to the various statutory measures for failing to do so.

If the disclaimer is correct, and the distributor is therefore liable for sales tax, then the distributor must seriously consider passing the tax directly onto the consumer by identifying it in the sales invoice. Not doing so shall make the distributor "personally liable" for payment of the tax. Just as companies must be sensitive to potential application of California's sales tax laws, so must their distributors. Consequently, MLM distributors should be wary of the potential tax trap resulting from the failure to pay over sales tax to the state.

Another tax trap addresses the issues of income tax liability and social security taxes that could arise from the activity of selling the products as an independent contractor. Assuming the classification as independent contractor is proper, the income tax laws require independent contractors, as a type of "self-employed" person, to make quarterly payments of income taxes (and, possibly, self-employment taxes) to the state and the IRS.

As with the sales tax, income tax laws impose stiff penalties for failure to make appropriate income tax and self-employment tax payments during the calendar year.

The companies using MLM schemes usually disclose the fact that they have classified the distributor as an independent contractor, and generally record the contractor's social security number. When the calendar year closes, the company will likely issue Form 1099-M to the distributor and transmit a copy to the IRS. This alerts the IRS that the distributor has received the non-employee compensation shown on Form 1099-M.

The IRS will therefore expect to see this item reported on the distributor's tax return. Failure to report shall certainly result in an audit of the return.

Besides potential tax problems inherent in these MLM schemes, they may also give rise to the operation of a business, if the distributor sells the product. Local municipalities and cities generally require that businesses operating within their boundaries be licensed and pay annual business taxes determined by the amount of gross receipts. Consequently, besides a possibility of having to obtain a retail seller's permit, distributors must almost always obtain a business license from the local government agency.

An individual considering becoming a distributor for a company that relies upon the MLM scheme as its main method of marketing and distribution has many factors to consider. The distributor may be a seller. If so, then the distributor must obtain a retail seller's license, and would be required to pay the state the proper sales tax from each transaction. Moreover, distributors properly classified as independent contractors must make quarterly estimated tax payments. Finally, it may be necessary to obtain a business license from the distributor's city of origin, or location of business. Consequently, anyone considering becoming a participant in an MLM scheme should consult his or her tax adviser and/or business adviser before moving forward.

Jacobson is a tax attorney and practices tax law in the South Bay.