The Wrong Side of the Law
If you want to know about the legality of cash gifting programs, you should check both Federal Trade Commission regulations and your state’s laws. Your state’s Attorney General and district attorney have the power to determine if a cash gifting program is legal, and unfortunately, many cash gifting clubs have ended up on the wrong side of the law.
There are two model for cash gifting programs - pyramids and one-up structures. All 50 states have laws against pyramid schemes, although they are sometimes referred to as “endless chains” (California), or Ponzi schemes. These laws apply to investments as well as cash gifting programs, and
avoiding the use of investment terms when soliciting new members in cash gifting clubs is not enough to avoid prosecution.
Several states have addressed and even prosecuted cash gifting organizations.
California
California groups pyramid schemes (called “endless chain schemes”) in its statutes against the operation of lotteries. In the landmark cash gifting case
People vs. Sanchez, the court found that not only those who start cash gifting clubs, but also those who promote them, are lottery operators under the law. This case was a result of an investigation into the gifting group
Friends Helping Friends.
In 2002 and 2003, more than twenty women belonging to the Sacramento-based cash gifting club
Women Helping Women were arrested and charged under the endless chain statute. Rather than face imprisonment, all pled guilty and were sentenced to a significant amount of community service and fines, in some instances up to $150,000.
These women pled guilty
despite the fact that many of the individual cash gifting groups within the organization insisted that all their members sign both “non-solicitation” and “gifting statements” saying that they recognized
Women Helping Women as a private, voluntary gifting activity and would be relinquishing all legal rights to their gifts (presumably so they couldn’t later sue to have them returned).
The gifting statements were their declarations that they had been told not to expect any kind of return in exchange for their gifts, and that they were fully informed adults who had not been misled about anything.
Idaho
In 2000
Idaho Attorney General Michel Butts stated:
Idaho law prohibits pyramid schemes, classifying them as felonies. Neither providing money to needy recipients, nor disclosing the potential risk of losing one’s money, nor ‘gifting’ the money to avoid tax consequences absolves citizens of their obligation to comply with Idaho’s Pyramid Statute. Participants and promoters should be aware that Idaho law provides for both civil and criminal penalties for conducting an illegal pyramid.
Iowa
Here’s what Steve St. Clair of the Iowa Attorney General’s Consumer Protection Division had to say about cash gifting programs in 2000:
… promoters may claim that this [gifting] scheme is legal because all payments are designated “gifts,” and participants may even be asked to sign a paper stating that they are making gifts. Promoters often claim that this “gift” angle makes the scheme legal, and that the pay-outs don’t have to be reported as income at tax time. These claims are false.
Many other false representations may be made in promoting such schemes, including the claim that pay-outs are easy and quick, and that a refund will be readily available if requested. These pyramids ultimately collapse, leaving a lot of disappointed participants scrambling to get refunds from the person who got them to participate and/or the person who received their money.
According to St. Clair, cash gifting participants can be prosecuted in Iowa under the following states:
1. Theft by deception (Iowa Code sections 714.1(3) & 702.9). This law makes it a crime to obtain money or property through the use of deception. The written materials used to promote gifting pyramids may make deceptive claims regarding: (a) the fact that the initial payment is a gift rather than an investment; (b) the tax status of these “gifts”; (c) the speed with which a large pay-out will be generated; and (d) the legality of the scheme itself.
2. Securities violations (Iowa Code section 502.102 (19). Securities laws control the promotion of various types of investments. Gifting pyramids have been determined by courts in other jurisdictions to constitute “investment contracts,” a form of security under Iowa law. (See the Nebraska Supreme Court ruling in State v. Irons, below). The sale of securities in Iowa is subject to a variety of registration and licensing requirements, as well as prohibitions regarding misrepresentations under Iowa’s Blue Sky Law, Iowa Code Chapter 502. See e.g., State v. Kraklio, 560 N.W.2d 16 (Iowa 1997).
3. Lottery (Iowa Code section 725.12). Iowa’s lottery law prohibits prize schemes where a person pays to participate and the winners are determined by a process involving a substantial element of chance. With gifting pyramids, one makes a “gift” in order to participate; one participates in order to receive the pay-out (the prize element); and whether a pay-out comes about involves a great deal of chance, since it depends on matters outside the participant’s control (the activities of strangers, and whether the pyramid has already saturated the region).
4. Tax Evasion (Iowa Code sections 422.25(8) & 703.1). Persons who do not report any pay-outs they receive through this scheme as income on their tax returns risk being prosecuted for tax evasion, and persons who inform others that pay-outs are not counted as income risk being prosecuted for aiding and abetting tax evasion.
Finally, in
Hall v. Montgomery Ward, the Iowa Supreme Court ruled that crime victims can sue the person who committed the crime. Participants in cash gifting pyramid schemes in Iowa may be able to use this legal precedent to recover money damages from promoters.
Kentucky
In December 2004, Kentucky Attorney General George Stumbo announced that an ongoing investigation of a gifting program called
Elite Activity revealed that it met all the elements necessary to prove an illegal pyramid, although the program’s promoters claimed that it was a legitimate gifting club under IRS tax laws.
Elite Activity was also shut down in Mississippi, Tennessee, Arkansas, South Dakota, and in Texas, where Elite Activity’s founder, Harry Dockstader, was sentenced to two years in prison and fined $10,000.
Nebraska
In State v. Irons, 574 N.W.2d 144 (1998), the Nebraska Supreme Court held that promoting a cash gifting program qualified as selling investment contracts under the state’s securities laws and upheld the conviction and imprisonment of Jack G. Irons, who ran a cash gifting club called the
Friends Network.
The Court stated that:
“the factors that define an investment contract are whether there is (1) an investment (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others.”
The
Friends Network was typical of hundreds of other cash gifting clubs, with each member participant having to recruit others to join the pyramid so that he or she could progress toward the point of “reward,” at which time the pyramid would be split in two and the participant could either leave or start over at the bottom. Each member was required to bring in at least one recruit, and was pressured to bring in more.
While the
Friends Network was closed because it violated Nebraska’s securities laws, it was also violating Nebraska’s statute against pyramid schemes:
“A chain distributor scheme also known as pyramid sales shall mean a sales device whereby a person, upon a condition that he or she make an investment, is granted a license or right to recruit for profit one or more additional persons who also are granted such license or right upon condition of making an investment and may further perpetuate the chain of persons who are granted such license or right upon such condition… “
New York
In
Pacurib v. Villacruz, the Civil Court of New York City ruled that not only were the founders of a cash gifting pyramid program guilty of fraud; the victims and participants of such programs had the right to sue those most responsible for promoting the programs.
Maine
In 2002, four women participating in a cash gifting club called
A Woman’s Project filed suit in federal court against the State Attorney General, Steven Rowe, to prevent him from prosecuting them. They claimed that their First and Fourteenth Amendment rights to free assertion had been violated because the Maine State Attorneys’ office had called
A Woman’s Project illegal, and wanted to be given an injunction protecting them from prosecution, as well as a judgment stating that their cash gifting activities were not in violation of state laws.
They lost on both fronts - the Federal Court ruled that the state attorneys had every right to publicly warn people against possible scams. In April of 2002, Rowe filed suit against 31 members of
A Woman’s Project for operating an illegal pyramid scheme. The group fell apart as soon as the suit was announced, but the State has managed to settle with its organizers and get some of the money returned to its victims.
Virginia
From a letter written by William Fuller, the Danville, Virginia, City Attorney:
The Honorable William H. Fuller III
Commonwealth’s Attorney for the City of Danville
August 29, 2000
You ask for guidance regarding the meaning of the term “operates” as it is used in § 18.2-239 of the Code of Virginia, pertaining to pyramid promotional schemes. You enclose documents describing a “gifting program…”
A “promotional scheme” is defined as “any program utilizing a pyramid or chain process by which a participant gives a valuable consideration for the opportunity to receive compensation or things of value in return for inducing other persons to become participants in the program.”
Participants in the described “gifting program” give valuable consideration for the opportunity to receive compensation in return for inducing others to become participants in the scheme. The action of a participant in making the payment or “gift” sustains the program and induces others to make that contribution.
Accordingly, it is my opinion that every person who participates in the “gifting program” by paying $2,000, with the expectation of advancing and ultimately receiving $16,000, is guilty of a Class 1 misdemeanor for operating a pyramid promotional scheme, in violation of § 18.2-239.
Punishment for conviction of a Class 1 misdemeanor is “confinement in jail for not more than twelve months and a fine of not more than $2,500, either or both.”
But what about one-up cash gifting programs?
The operators of one-up cash gifting programs claim that they are immune to prosecution as pyramid schemes because of their structures - “receiving lines” - which never have more than one “receiver” and one” giver” in them at any given time.
But does that that really matter, since they still require recruitment of new participants if old participants are to recoup their “gifts?” One promoter of these cash gifting programs claims that they must meet several standards:
- They must provide statements between the giver and the receiver that the gifts are given with no expectation of any returns;
- They must provide statements between the giver and the receiver that gifts were unsolicited and that the giver approached the receiver inquiring about the opportunity to give;
- There should be a statement between the giver and the receiver acknowledging that the giver accepts he or she is not making an investment;
- And there must be a clear understanding between the giver and receiver that the giver is not guaranteed any benefits for making a gift.
But California successfully prosecuted
Women Helping Women, even though many of its members had met all of these standards.
States like Iowa have made it clear that cash gifting clubs can be prosecuted not only as pyramids, but under their tax evasion, lottery, securities, and theft by deception laws. One-up cash gifting schemes can still qualify under any of those categories.
Federal Actions Against Cash Gifting Programs
Further doubt was cast on the legality one one-up systems by the 2006 SEC prosecution of Prosperity Automated Systems. Although it wasn’t a cash gifting system, PAS ran afoul the SEC because its founder, William Osterhout, was found to be selling unregistered securities. But the key finding in this instance was the SEC description of the PAS marketing system:
“The Complaint further alleges that in order to purchase a PAS membership, prospective investors submit their personal information into an existing PAS website and agree to be contacted by a PAS team leader, who then directly solicits the investor.
Investors who choose to purchase PAS memberships receive the following: (1) their own unique replicated PAS website that automatically offers PAS memberships to additional prospective investors; and (2) the services of PAS team leaders to solicit new prospective investors. The proceeds from an investor’s first sale of a PAS membership must be paid to an earlier investor; thereafter, PAS investors retain commissions for each subsequent sale of PAS memberships to new investors…”
This is a perfect illustration of how one-up cash gifting systems work.
When dealing with the SEC, the bottom line is that it can label whatever it wants as an “unregistered security” and leave it up to the other party to prove otherwise. How many cash gifting operators have the money to either challenge the SEC, or protect their programs from prosecution under any number of state statutes?
Anyone considering a cash gifting program should not listen to any advice about its legality except that of a qualified attorney, including his or her state’s attorney general, and the SEC.
So will the IRS pursue you for cash gifting? No. Again, the IRS does not define the legality of any income source - after all, they just want to tax your income, no matter where it comes from. But be advised before joining any cash gifting program that the law is not quite as friendly as gifting promoters may like to think.
