Network marketing compliance mistakes that experienced operators still make

What to take away

Mistake one: calling distributors 1099 when the company controls the day

The most common failure is a distributor agreement labeled independent while the company sets call times, scripts, lead sources and pricing. Federal status for direct sellers starts with IRC section 3508. It treats a direct seller as a nonemployee only if the work is selling consumer products for resale in the home or outside a fixed store, substantially all pay is tied to sales rather than hours, and a written contract says the worker is not an employee for federal tax.

Workers outside those conditions fall under the common-law control test, which the IRS publishes in Publication 15-A and Form SS-8. The fix is to check each 3508 condition in writing, then test the control factors for anyone who fails one. California and Massachusetts apply stricter state ABC tests that the federal rule does not override. Where the company controls the method, the exposure is back taxes and penalties.

Mistake two: income claims with no substantiation file

An operator posts a distributor's earnings screenshot as proof the plan works. That is an objective claim about typical results. The FTC advertising substantiation policy requires evidence before the claim runs, not after a complaint arrives.

The fix is a claim file per asset: the exact words, the audience, the evidence, and the qualification. A sample entry reads: claim, "earn $5,000 your first month"; audience, new recruits; evidence, none; qualification, not typical. Remove the claim or add an income disclosure statement to the recruiting flow.

The FTC's 2018 Business Guidance Concerning Multi-Level Marketing says income claims need a reasonable basis and a typical-results disclosure. The 2016 Herbalife settlement required a $200 million payment and changes to its earnings claims. The 2019 AdvoCare settlement required a $150 million payment.

Mistake three: treating the compliance register as a document nobody tests

A register that lists policies but no evidence is decoration. Each line needs the control, the owner, the test performed, the date and the result. When an auditor or a state AG asks how you know the control works, the register is the answer or the gap.

For a network marketing company, add two lines to this register: a pay plan test that shows the share of commissions paid on retail sales, and a buyback log that records every repurchase and refund.

Mistake four: a pay plan that pays for recruiting, not retail sales

Pyramid risk comes from how money moves, not from the word in a deck. In Koscot Interplanetary (1975), the FTC looked at whether participants paid to join and earned mainly by recruiting others, with commissions not tied to sales to end users.

Amway's case (1979) went the other way. The FTC found Amway was not a pyramid scheme, relying on its retail sales requirement, its buyback rule for excess inventory and the absence of an entry fee. Test your plan against those three features, then have counsel review the result. A plan that pays heavy recruiting bonuses with no retail requirement is the one to fix first.

Mistake five: skipping the business opportunity rule and state buyback terms

The FTC Business Opportunity Rule (16 CFR Part 437) requires a disclosure document and an earnings claim statement for most business opportunity sellers. The current rule has no small-payment exemption, so any required payment counts. Payments for reasonable inventory at bona fide wholesale prices are excluded. Check whether your required payments trigger the rule before you assume a direct selling offer sits outside it.

Buyback terms are set by state law, and states differ. Check the current statute for each state where you sell rather than relying on a general standard. The FTC Cooling-Off Rule (16 CFR Part 429) gives buyers three business days to cancel certain sales of $25 or more made away from the seller's store, and state rules add more. Compare your terms with the state cooling-off laws for each state where you sell.

Mistake six: treating the DSA Code as the law

The Direct Selling Association Code of Ethics sets a benchmark for member companies. Under the Code as published, a member repurchases marketable inventory within 12 months at no less than 90 percent of the distributor's original net cost. Check the current Code text before you quote it.

The Code binds members, not regulators, and it does not replace federal or state law. A company can meet the Code and still fail a state buyback or income disclosure rule. Use the Code as a floor for your own policy, not as proof of compliance.

A worked example: tracing one overstated claim

Suppose a distributor posts "earn $5,000 your first month." Trace it backward: who wrote it, who approved it, what evidence existed, and where else it ran. Then trace it forward to every asset, training slide and recruiting page carrying the same number.

Close the incident only after each asset is corrected and a second reviewer confirms the correction. Keep the old version, the correction date and the reviewer's name.

The correction steps in order:

If the same claim can reappear through a template nobody edited, the defect is still open.

For the recurring questions operators ask about claim review and register upkeep, see our common network marketing compliance questions.

Common questions

Who decides whether a distributor is an employee or a contractor?

For federal tax, IRC section 3508 applies first when a direct seller meets its conditions. Otherwise the IRS common-law control test applies. California and Massachusetts use stricter ABC tests. A licensed CPA or employment attorney applies these rules to your facts. No article, including this one, can classify your workers for you.

Can I publish distributor earnings as proof the plan works?

Only with evidence in place before publication, per FTC substantiation policy. The California Attorney General enforces the False Advertising Law (Business and Professions Code section 17500) against misleading income claims, and some state business opportunity laws add their own disclosure duties. Have counsel review the specific asset.

Is a plan with recruiting bonuses automatically a pyramid scheme?

No. Regulators look at whether money comes mainly from recruiting rather than from product sold to people outside the organization, and at entry fees and buyback terms. Apply the Koscot and Amway questions to your plan, then have counsel confirm the result.

How often should the compliance register be tested?

Set the interval by the control's risk, then keep the test reproducible. For example, review income claims quarterly and worker status annually. A register line with no test date is an open finding, not a completed one. The network marketing compliance section covers register structure in more detail.