Capital Gain Treatment Denied For Agent’s Termination Pay
A retired agents attempt to treat his termination payment as capital gain was recently rejected by the Tax Court, which held that the payment constituted ordinary income.
Warren Baker worked as a State Farm agent for 34 years. Baker, an independent contractor, developed his own customer base, chose his office location (with State Farms approval), hired and paid employees, paid overhead expenses, and deposited premiums collected on behalf of State Farm to a trust fund.
The agents agreement between Baker and State Farm stated that all property furnished by the company to Baker (e.g., manuals, forms, records, supplies, etc.) remained the property of State Farm. This included all data relating to policyholders. Upon termination of the agreement, Baker was required to return all of State Farms property, including the customer data.
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Baker retired in 1997 and returned all of the property to State Farm. A successor agent assumed Bakers telephone number and hired Bakers former employees.
Bakers compensation was based on a percentage of net premiums. The termination payment was based on a percentage of policies that remained in force after termination of the agreement, or those that had been in force for the 12 months preceding termination.
On his 1997 tax return, Baker reported the termination payment received from State Farm ($38,622) as capital gain. The Service rejected this treatment, and classified the payment as ordinary income.
In Tax Court, Baker argued that “the termination payment was for the sale or buyout of a business resulting in capital gain.” In defense of this position, he contended that he had built his own customer base, and that the termination payment was designed to protect the existing customer base for the successor agent as well as to compensate him for the goodwill and going business concern he had developed.
As further proof that he sold the agency to State Farm, Baker pointed to the fact that the successor agent assumed his telephone number, hired his two employees, and that he had taught the successor agent about the agency and introduced him to the policyholders.