By Jeffrey Babener, © 2018
(First Published in World of Direct Selling)
“As Gregor Samsa awoke one morning from uneasy dreams he found himself transformed in his bed into a gigantic insect…”
Metamorphosis, Franz Kafka
A Kafka experience 1996:
Dateline Maine 1996 for one of America’s leading direct selling companies:
One day you have no presence; the next day you are the largest employer in the state…at least until the state amends its unemployment statute, in 1996, to follow the federal tax definition of independent contractor exemption for direct sellers:
Service performed by a direct seller as defined in 26 United States Code, Section 3508(b)(2).
Maine 26 M.R.S.A. 13 sec. 1043(11)(F)(28) (Amendment 1996)
Groundhog Day 2018; Deja Vu all over again
One day, leading direct selling telecom company, ACN, had virtually no employee presence in Oregon. A day after a seminal Oregon Supreme Court ruling, ACN found itself held to be an Oregon employer, with the accompanying challenges. Future: uncertain. A similar case is playing itself out for Kirby of Norwich in Connecticut.
And so, the DSA initiative…
In July, 2018, the Direct Selling Association announced an industry-wide initiative to update state unemployment legislation to be in sync with federal standards, in place since 1982, which call out direct sellers as independent contractors.
Most observers agree that, for the vast majority of 16 million individual U.S. direct sellers, many with incremental average monthly income, often a $100 or less, the compliance costs and taxes of income tax withholding or unemployment taxes, could be devastating to direct selling companies.
With state challenges, already happening in Oregon and Connecticut, which threaten the viability of the direct selling model, the DSA undertaking could not be more timely. The initiative is the legacy of a multiyear effort in which, says the DSA, 38 states have already adopted a similar umbrella exemption that follows the historic achievement of the DSA in the 1982 amendment of the U.S. Internal Revenue Code (TEFRA…Tax Equity Fairness Responsibility Act) recognizing independent contractor status of direct sellers for federal tax purposes. 26 U.S Code § 3508. The most recent DSA accomplishment: North Carolina, effective July 1, 2018.
And the update initiative is reflective of the forward looking wisdom of the 2018 U.S. Supreme Court Wayfair decision (upholding state sales tax collection on interstate online sellers) that, to paraphrase the Court, it is imperative for courts and legislatures to recognize the changing economic realities of how interstate companies do business in the various states. In light of recent state employment direct selling decisions in Oregon and Connecticut, accommodating changing business model paradigms to economic reality is quite important.
Prior to 1982, the direct selling industry suffered a cloud over its head, i.e., the potential that the distributors of direct selling companies might be classified as employees for federal tax purposes, with all the onerous challenges of withholding, record keeping, payment of employee taxes, etc. Such burdens threatened the economics of the direct selling model. The industry needed relief and certainty for its channel of distribution.
Led by former 40 year DSA President, Neil Offen, in 1982, Congress amended the Internal Revenue Code to recognize “direct sellers” as independent contractors for federal tax purposes. In 1995, Congress, recognizing the industry diversification (or as Wayfair might put it: changing economic reality) into sale of telecom and other services, specifically added “sale of services” to its “sale of products” exemption.
TITLE 26-INTERNAL REVENUE CODE
Subtitle C-Employment Taxes
CHAPTER 25-GENERAL PROVISIONS RELATING TO EMPLOYMENT TAXES
For purposes of this title, in the case of services performed as a direct seller—
(1) the individual performing such services shall not be treated as an employee, and
(2) the person for whom such services are performed shall not be treated as an employer.
(2) Direct seller
The term “direct seller” means any person if—
(A) such person—
(i) is engaged in the trade or business of selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis which the Secretary prescribes by regulations, for resale (by the buyer or any other person) in the home or otherwise than ina permanent retail establishment,
(ii) is engaged in the trade or business of selling (or soliciting the sale of) consumer products in the home or otherwise than in a permanent retailestablishment, or
(iii) is engaged in the trade or business of the delivering or distribution of newspapers or shopping news (including any services directly related to such trade or business),
(B) substantially all the remuneration (whether or not paid in cash) for the performance of the services described in subparagraph (A) is directly related to sales or other output
(including the performance of services) rather than to the number of hours worked, and (C) the services performed by the person are performed pursuant to a written contract between such person and the person for whom the services are performed and such contract provides that the person will not be treated as an employee with respect to such services for Federal tax purposes.
A Multidimensional Issue
First, it must be recognized that the perennial question of employee vs. independent contractor is not a one dimensional issue. There are many legitimate competing constituencies with a stake: small businesses, entrepreneurs, taxpayers, workers, channels of distribution such as direct selling, etc. The quest for solutions is not a zero sum game.
Said the California Supreme Court in its recent Dynamex decision (4 Cal. 5th 903, 2018) holding package/document delivery drivers to be “employees” rather than “independent contractors,” and sending a shot across the bow against the entire “gig” economy of Ubers, Lyfts, etc., and maybe even precipitating a future second guessing of the existing California statutory exemption for direct selling:
Under both California and federal law, the question whether an individual worker should properly be classified as an employee or, instead, as an independent contractor has considerable significance for workers, businesses, and the public generally.1 On the one hand, if a worker should properly be classified as an employee, the hiring business bears the responsibility of paying federal Social Security and payroll taxes, unemployment insurance taxes and state employment taxes, providing worker’s compensation insurance, and, most relevant for the present case, complying with numerous state and federal statutes and regulations governing the wages, hours, and working conditions of employees. The worker then obtains the protection of the applicable labor laws and regulations. On the other hand, if a worker should properly be classified as an independent contractor, the business does not bear any of those costs or responsibilities, the worker obtains none of the numerous labor law benefits, and the public may be required under applicable laws to assume additional financial burdens with respect to such workers and their families.
And the Court correctly noted, sometimes the decider is a veritable Solomon who must make difficult and compromising choices that will certainly not please everyone:
The difficulty that courts in all jurisdictions have experienced in devising an acceptable general test or standard that properly distinguishes employees from independent contractors is well documented. As the United States Supreme Court observed in Board v. Hearst Publications (1944) 322 U.S. 111, 121, 64 S. Ct. 851, 88 L. Ed. 1170: “Few problems in the law have given greater variety of application and conflict in results than the cases arising in the borderland between what is clearly an employer-employee relationship and what is clearly one of independent, entrepreneurial dealing.
Dark Clouds for Direct Selling
For better or worse, over the last few decades, various leading direct selling companies have become ensnared in state unemployment cases, finding themselves judicially transformed to leading employers in a state, with all the attendant regulatory and financial burdens. The thrust of the uncertainty is played out in:
- States that earlier adopted exemptions, but unfortunately with evolving business models, the statutory exemption might no longer deliver the intended protection.
Example Oregon: A hostile work environment for direct selling.
Oregon is a good example where confusion reigns for direct selling companies in the aftermath of ACN Opportunity, LLC v. Employment Department, 362 Or. 824 (2018).
Actually, many years before Congress sought to protect direct sellers, in 1982, the state of Oregon had already done so in 1977. ORS 657.087(2)provides:
“Employment” does not include service performed:
(2) By individuals to the extent that the compensation consists of commissions, overrides or a share of the profit realized on orders solicited or sales resulting from the in-person solicitation of orders for and making sales of consumer goods in the home.
However, in ACN Opportunity, LLC vs. Employment Department, the state of Oregon asserted that independent distributors of telecom direct seller, ACN, were in fact employees because, in general, their solicitation was not in the home. The Oregon Supreme Court agreed.
If the court really wanted to effectuate the 1977 intent to protect direct sellers, it could have done so. It could have interpreted that either:
- The products/services marketed by ACN distributors were for use “in the home;”
- Or, that distributors used a business based in their home to market products/services.
- In fact, the Court was thrown a softball that it completely “whiffed” when it was pointed out that, in 1983, the Oregon legislature updated, for tax purposes, the exemption of a “direct seller” to be consistent with the federal statute 3508. It could have interpreted the definition in the 1977 legislation to be consistent with 1983 tax definitional updates.
It did not.
ACN also observes that the Oregon legislature adopted that same language in 1983 in ORS 316.209, which defines “direct seller” for tax purposes. See ORS 316.209(3)(a)(B) (defining a direct seller as a person who is “[e]ngaged in the trade or business of selling, or soliciting the sale of, consumer products in the home or otherwise than in a permanent retail establishment”).
ACN argues that it makes no sense for direct sellers like its IBOs to be treated as employees in some contexts (unemployment taxes) but as exempt from the definition of employment in other contexts (income taxes).
The problem, although the State of Oregon in 1977 intended to protect direct sellers, times change and in 2018 it is rare for a direct seller to solicit/sell in the home. And the long story short message from the Court was, effectively “we don’t care…if the direct selling industry thinks it should still be protected, the legislature is the place to go.”
ACN argues that that result will create an “impractical burden for workers and a regulatory nightmare for the state officials tasked with administering Oregon’s employment laws,” jeopardizing the future viability of the direct selling industry in Oregon. If that is true, then it is a policy issue that ACN can present to the legislature to address. (Footnote 6 to Decision)
Having ruled that time had passed by direct selling for its 1977 “home free” ticket, the Oregon court searched for other traditional bases for exemption, but ruled that ACN came up short. Apart from the policy issue, the Court’s legal analysis was subject to legitimate criticism by legal observers that the Court’s analysis was somewhat myopic and tunnel visioned.
- Said the Court, the company failed to demonstrate that owners maintained business location separate from the company, as grounds for classifying owners as independent contractors, citing that direct sellers were not paying for rent or repairs on separate business facilities. This misses modern economic reality.
Try telling 400,000 U.S. Uber drivers that they “really” don’t have their own business because they don’t pay for rent or repairs on a building separate from Uber.
- The company failed to demonstrate that owners had a right to hire and fire, as ground for classifying owners as independent contractors rather than employees. Its analysis was totally off-base, citing a non-circumvention/non-solicitation paragraph in ACN policies, common to all direct selling companies that has nothing to do with hiring and firing. Again, try telling 400,000 Uber drivers that they are not really operating their own business because Uber insists that the contracted Uber driver is the only one authorized to drive Uber passengers on his/her account in his/her car.
The Chief Justice penned a concurring opinion, agreeing with the decision, but imploring the legislature to bring the tracking of direct seller employee/independent contractor status current with “economic reality.” But, in a closer look might suggest that the concurring opinion might easily be construed as opining that the decision was not “bold” enough in addressing and protecting the modern practices and “economic reality” of direct selling and other businesses:
Of course, 1977 was before cell phones, internet (no Facebook, Craigslist, or eBay), and ubiquitous coffee shops (with wifi) holding themselves out as remote offices where a seller of goods or services might conduct business online or meet with a customer or client. The requirements the legislature used to identify exempt direct sales in 1977—in-person solicitation and sales “in the home”—may no longer be appropriate to delineate some of the kinds of direct sales that the legislature intended to reach when it enacted that exemption. In any event, different models of direct sales have emerged because of technological, social, and economic changes, while the direct sales statute remains unchanged.
…Again, given new technology, a person’s “business” may exist entirely on his or her laptop, tablet, or smart phone. And individuals may view their “business location” as wherever they and their device are located—the aforementioned coffee shop, the city library, or a shared workspace such as WeWork—or, if working at their residence, entirely from a deck chair on the porch. The existing statutes often can be useful in determining when a person is an employee or an independent contractor; however, because of the substantial changes in many sectors of the economy—in how work is done, where, by whom and under what compensation arrangements—the results courts reach in those cases may not be those that the legislature intended.
…Whatever direction such legislative or administrative changes might take, it is apparent that existing statutes and regulations do not address the realities of important parts of today’s work environment. If that legal framework can be updated to align contemporary workplace realities with the state’s policy objectives, individual workers and employers—as well as the regulators and courts who apply the laws—will benefit.
Bottomline: right or wrong, the high court has spoken; the only remedy is legislative.
- States that have not adopted Section 3508 type exemptions, applying a common law test and/or statutory test referred to as the three prong ABC test, to which direct selling companies typically struggle to fulfill prong C:
The ABC Test:
- The worker is free from the employer’s control or direction in performing the work.
- The work takes place outside the usual course of the business of the company and off the site of the business.
- Customarily, the worker is engaged in an independent trade, occupation, profession, or business.
Connecticut is a second prime example of the need for legislative update.
In 2018, the Connecticut Supreme Court, noting that the legislature had abandoned use of a favorable common law employment/independent contractor analysis with a statutory ABC Test, held that there was a challenge with Kirby of Norwich and prong C of the ABC test, and therefor its sales representatives, in that case, were now reclassified as employees rather than independent contractors, with all the attendant obligations. Kirby of Norwich v. Administrator, Unemployment Compensation Act, 328 Conn. 38 (2018)
And again, the message to the direct selling industry is a polite “too bad.” Times may be changing and you should look for relief in the legislature and not the courts:
Although we recognize the appeal of the plaintiff’s arguments, we are not persuaded that we should overrule JSF Promotions, Inc. We acknowledge that a narrow interpretation of part C of the ABC test imposes significant burdens on businesses, like the plaintiff…
We will not interpret the ABC test in such a manner.14 Although we are sympathetic to the plaintiff’s claim that part C creates certain, undesirable practical consequences as applied to the specific facts and circumstances of this case, any decision to alter or modify part C on the basis of a determination that, under such facts and circumstances, its costs outweigh its benefits must be made by the legislature, not this court.15
Even after acknowledging the DSA’s amicus brief that identify 31 states that have gone so far as to statutorily exempt direct sellers as independent contractors rather than employees, the Connecticut Supreme Court punted to its statutory ABC test. In essence said the Connecticut Court, “good luck…you are on your own.”
The amicus curiae contends that, in states without such statutes, direct sellers have been recognized as independent contractors under the common law “for decades.” The only case addressing that question in Connecticut, however, is Electrolux Corp. v. Danaher, supra, 128 Conn. at 342, 23 A.2d 135, which, as we have explained, was decided before the legislature amended the act to include the ABC test. Other jurisdictions are split on the issue of whether a putative employee must actually be engaged in an independently established occupation to satisfy part C of the ABC test. It may well be that exempting direct sellers from the act, regardless of whether they are actually engaged in an independently established occupation, is the better public policy. As we have indicated, however, that policy judgment is one to be made by the legislature, not us.
The DSA Initiative is Timely
Over the decades, the DSA has done a stellar job in protecting the direct selling industry from the challenges of “employer designation.” Its success approaches 40 states. However, the recent adverse cases in Oregon and Connecticut, suggest that its new initiative is timely. In addition the DynamexCalifornia case is a shot across the bow of the “gig” economy, and the direct selling industry should be vigilant that it is not caught in a new legislative Dynamex tsunami. The DSA has indicated that its upcoming initiative will focus on Connecticut, Oregon, and Indiana.
If the industry is looking for simple clarity and guidance, citation to the federal independent contractor tax standard, it is suggested that the model exists in the most recent DSA sponsored legislation from North Carolina.
H 931/S 717
Effective July, 2018
Exclusions. – The term excludes all of the following:
…Service performed by a direct seller, as defined in section 24 3508(b)(2) of the Code.
This approach is clean, direct and sends a clear message to protect the viability of the direct selling model.
Jeffrey A. Babener, of Portland, Oregon, is the principal attorney in the law firm of Babener & Associates. For more than 30 years, he has advised leading U.S. and foreign companies in the direct selling industry, including many members of the Direct Selling Association. He has served as legal advisor to various major direct selling companies, including Avon, Amway, Herbalife, USANA, and NuSkin. He has lectured and published extensively on direct selling.
Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.