In yesterday’s post Joy Mullane discussed the Danielson rule and set the table for today’s detailed discussion of the 11th Circuit case Peterson v Commissioner, where as Joy explains the 11th Circuit expands the application of the Danielson rule to a situation where the taxpayer never expressly agreed to the characterization the Commissioner sought. Les
In Peterson v Commissioner, the Eleventh Circuit significantly expanded the reach of the Danielson rule based on a distinctive set of facts. Ms. Peterson was an independent contractor for Mary Kay, who rose to the highest level of the Mary Kay sales network and became a very successful National Sales Director (NSD). Mary Kay offers NSDs the opportunity to participate in two different programs that provide certain monetary benefits to the NSD once she is no longer actively associated with Mary Kay: the Family Security Program (established in 1991) and the Great Futures Program (established in 2005). These programs are unique in the direct sales industry, providing benefits of a retirement plan nature to non-employees.read more...
Under the Family Security Program, the payment amounts are based on a formula, calculated by averaging the three highest years of domestic sales commissions from the NSD’s last five years of active association with Mary Kay. Payments pursuant to the Great Futures Program are a percentage of commissions on current sales made by the former NSD’s foreign sales teams. In other words, Family Security Program payments are determined with reference to past sales activity and the Great Futures Program payments are determined with reference to ongoing sales activity after the former NSD is no longer associated with Mary Kay. In exchange for receiving payments under the programs, the NSD agrees to sever her NSD agreement with Mary Kay at either age 65 or 55 and agrees to non-compete covenants. Nothing in the program agreements characterized the nature of the program payments prior to 2008.
Both program agreements were modified in 2008 pursuant to a unilateral amendment clause, allowing Mary Kay to make any change to the agreements at any time. The amendments provided that the programs were intended to be nonqualified deferred compensation arrangements and were also intended to comply with section 409A. In brief, section 409A governs the taxation of nonqualified deferred compensation plans. It provides that participants in such plans that fail to satisfy section 409A’s requirements are immediately subject to current taxation, plus interest, on all compensation deferred under the plan to the extent the compensation is not subject to a substantial risk of forfeiture or has not been previously included in gross income. Section 409A also imposes an additional twenty percent tax on the non-complying compensation that was included in the participant’s income for the taxable year. Mary Kay claimed they always viewed the payments under the plans as deferred compensation (deductible by Mary Kay) and undertook the amendments to protect participating NSDs from the consequences of not complying with section 409A.
Ms. Peterson participated in both of the programs offered by Mary Kay, and thus began receiving payments pursuant to the programs once she ceased her involvement with Mary Kay in 2009. The tax characterization of these payments is the principal issue of the case — whether they are deferred compensation payments subject to self-employment tax or some other type of payment that is not subject to self-employment tax. While the Commissioner argued for the payments to be treated as deferred compensation, Ms. Peterson argued the program payments were consideration for “ending her Mary Kay businesses and her agreement not to compete with Mary Kay.”
The Tax Court agreed with the Commissioner and concluded the program payments were deferred compensation, and thus Ms. Peterson was liable for self-employment tax. On appeal, the majority (Judge Fay with Judge Middlebrooks sitting by designation) similarly concluded by expressly holding as follows:
“On the facts of this case and controlling law, we hold the percentage commissions received by Peterson, a retired NSD, under the Family Program and Futures Program are subject to self-employment tax, because they are classified specifically as deferred compensation, derived from her prior association with Mary Kay.”
What is not entirely clear is whether the language “classified specifically as deferred compensation, derived from her prior association” is referring to a conclusion reached by application of the Danielson rule or substantive legal analysis. The lack of clarity stems from the opinion’s initial focus on and use of the Danielson rule, followed by a consideration of the underlying substantive issues. Essentially, in a less direct fashion, the opinion is saying the payments are deferred compensation pursuant to the Danielson rule, but even if the rule were not applicable the payments would still be considered deferred compensation (this is the opposite of the Tax Court, which first focused on the substantive deferred compensation issue before giving a nod to the Danielson rule). The dissent (Judge Rosenbaum), on the other hand, disagrees with the application of the Danielson rule on the Peterson facts and also disagrees on the merits with the characterization of the payments as deferred compensation.
Everyone agrees, however, that for self-employment tax to be due, the taxpayer’s income must be “derived by an individual from any trade or business carried on by such individual.” 26 U.S.C. § 1402(a). The substantive question in Peterson is whether the program payments were “derived” from the taxpayer’s Mary Kay business (e.g., deferred compensation or other income captured by self-employment tax) or were instead paid to acquire Ms. Peterson’s Mary Kay business or to secure a non-competition agreement.
After providing a very lengthy factual background, the majority opinion quickly delves into its summary Danielson analysis. The majority notes that the 2008 amendments to the Mary Kay programs labeled payments under the programs as “deferred compensation.” As such, the majority then concludes that pursuant to the Danielson rule the contract terms control the treatment of the program payments. The majority is unconcerned with the post-hoc unilateral amendments, indicating that Peterson’s initial assent to the agreements at the time of contract formation “permitting Mary Kay to amend [the programs] prospectively,” meant she “had consented to the 2008 Amendments that expressly characterized the Family Program and Futures Program payments as ‘deferred compensation’ under a nonqualified compensation plan pursuant to Section 409A of the Internal Revenue Code, which makes the Danielson rule applicable.’” Thus, “the Danielson rule requires that the Petersons are bound by the characterization of her 2009 Mary Kay, post-retirement Program payments as deferred compensation, subject to self-employment tax.”
The dissent is troubled, however, by the fact that Ms. Peterson never explicitly agreed to the characterization of the payments as deferred compensation. The dissent examines the history and purpose of the Danielson rule, and views the majority’s expansion of the rule as unwarranted and unadvisable. In the words of the dissent:
[T]he agreements Peterson executed to enter Mary Kay’s programs empowered Mary Kay to make unilateral amendments to the Programs. Years after Peterson and Mary Kay entered into the agreements, Mary Kay invoked that power to unilaterally characterize payments made under the Programs as “deferred compensation.” The Danielson rule has never been applied on facts like these. Nor should it be.
Considering the role of the Danielson rule in preventing “a party from unjustly enriching itself by unilaterally altering the intended tax consequences of a transaction after consummation,” the dissent asserts:
Applying the rule here stands the first purpose for which the rule was formulated on its head. Peterson, the taxpayer, made no attempt to alter the express terms of the transaction that she and Mary Kay agreed to at formation; she merely seeks review and enforcement of the terms of the Programs themselves. Only Mary Kay has arguably attempted to alter the tax consequences flowing from the substantive terms of the Programs to which the parties agreed.
In these circumstances, applying the Danielson rule does not prevent a unilateral, post-consummation contract reformation. Instead, the Majority’s application of the rule insulates Mary Kay’s unilateral, ex post facto characterization of the Program payments from meaningful review. As a result, today’s decision encourages parties to risk litigation by attempting unilateral, post-consummation contract reformations to avoid the tax consequences of their transactions. Another result of today’s decision is that parties will be less certain about the tax consequences of a transaction where the agreement contains a unilateral amendment provision-whichever party has the power to amend the agreement will be able to alter those consequences by simply re-characterizing the transaction after consummation.
The dissent then thoroughly explores the Danielson rule’s role in preventing whipsaw litigation as follows:
The Danielson rule was never intended to entirely eliminate the need for the Commissioner to ever pursue litigation against both parties to an agreement, as evidenced by the rule’s own carve-out for cases where a taxpayer “adduc[es] proof which in an action between the parties to the agreement would be admissible to alter [the Commissioner’s] construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.” Danielson, 378 F.2d at 775.
Instead, the rule eliminates the need for the Commissioner to pursue litigation against both parties in a very particular set of cases. Where a taxpayer initially agrees to an express contractual characterization or form and later attempts to re-characterize the term or form, the Danielson rule acts as a prophylactic to prevent the IRS from having to pursue the taxpayer’s counterparty out of a concern that a court will agree with the taxpayer’s ex post facto re-characterization. See Plante, 168 F.3d at 1281-82 (the Danielson rule prevents the IRS from having to pursue whipsaw litigation by preventing a party from “alter[ing] the express terms of his contract by arguing that the terms did not represent economic reality” (emphasis added)); see also Patterson, 810 F.2d at 572 (“The Danielson rule can only be meaningfully applied in those cases where a specific amount has been mutually allocated to the covenant as expressed in the contract.” (emphasis added)).
The Danielson rule, however, has no application in cases where, as here, the taxpayer does not seek to avoid an express contractual term or form. See Plante, 168 F.3d at 1282; Patterson , 810 F.2d at 572. In these cases, the Commissioner must resort to litigating the tax deficiency on the merits and, if need be, “assert[ing] inconsistent positions and … assess[ing] deficiencies against more than one person for the same tax liability if there is an accepted legal basis for each assertion.” Gerardo v. Comm’r , 552F.2d 549, 555 [39 AFTR 2d 77-1176] (3d Cir. 1977). In other words, the Commissioner must go ahead and pursue whipsaw litigation. Indeed, the reason courts permit the Commissioner to pursue whipsaw litigation is to protect the public fisc from any whipsaw effect in cases where “there is an accepted legal basis” for asserting a single tax deficiency against multiple parties.
Here, Peterson never expressly agreed to a characterization of the Program payments as “deferred compensation” in the Danielson sense. Instead, as the Commissioner implicitly acknowledges, there is a reasonable legal basis to conclude that Program payments are either (1) deferred compensation, in which case Peterson is liable for the tax deficiency; or (2) payments for a covenant not to compete, in which case Mary Kay would be responsible for incorrectly deducting the payments on its tax returns. In these circumstances, I would hold that the Commissioner may not rely on the Danielson rule in lieu of pursuing actual whipsaw litigation to resolve a genuine dispute about whether Peterson or Mary Kay is responsible for the tax deficiency at issue. The Majority’s contrary conclusion, in my opinion, does not vindicate the rule’s prophylactic purpose of preventing unnecessary whipsaw litigation; it prevents necessary whipsaw litigation.
After their Danielson rule discussions, both opinions considered the tax characterization issue on its merits. This aspect of the case is also interesting, as once again there is some disagreement among the panel as to whether the payments are of a nature that would subject them to self-employment tax. The narrow substantive issue is whether the post-retirement payments are “derived” from Ms. Peterson’s Mary Kay business. Consideration of this issue in the context of the direct sales industry is also unique and worthwhile, but beyond the scope of this writing. Nevertheless, the upshot is that the majority concluded the program payments are deferred compensation, while the dissent disagreed. The dissent concluded the Family Security Program payments are subject to self-employment tax, even though the payments are not deferred compensation, because the payment amount is directly tied to – derived from — the quality of Ms. Peterson’s prior Mary Kay labor. However, the dissent held that the Great Futures Program payments are not subject to self-employment tax because payment amounts are “entirely dependent on the quality of other, non-retired Mary Kay laborers.”
- This case is a particularly good candidate for going en banc, as the application of the Danielson rule (as well as the deferred compensation discussion) is an issue of first impression, would be precedent setting, and is of exceptional importance in the conduct of tax disputes. In addition, the dissenting opinion is thorough and persuasive.
- Peterson significantly expands the scope of the Danielson rule, with the long-term ramifications not entirely clear yet. Certainly parties should exercise caution in dealing with contracts that contain a unilateral amendment clause. Savings clauses should be considered even though they are sometimes considered illusory. Although it was not discussed in the opinions, an implicit assumption is that there was no savings clause that would have allowed Ms. Peterson to object or otherwise terminate the agreement in the face of an unsatisfactory unilateral amendment.
- The majority insinuated that if Mary Kay had not labeled the program payments as deferred compensation, the government would have been able to consider the substance of the payments in determining whether section 409A applied. Of course, because Mary Kay did indeed exercise its unilateral amendment power to label the payments as deferred compensation, the government asserted Ms. Peterson was essentially estopped from challenging that label based on a substantive examination of the payments. This highlights the combined lopsided nature of the Danielson rule and substance over form doctrine that is a one-way street favoring the government.
- In the early years after the Danielson rule was judicially created, it was the subject of controversy and academic interest, as it is the antithesis of the substance over form doctrine and allows the government to have the best of both worlds. However, the Danielson rule has received little attention in the last 20 years. Peterson may bring renewed interest in the Danielson rule and this may be a good time to revisit the justifications for the rule.