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.

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.

On the other hand, the Service argued that Baker did not sell any property to State Farm because all of the property was owned by State Farm and, under the agreement, reverted to the company when Baker retired in 1997.

The Tax Court decided that Baker had returned all assets used in the daily course of business (e.g., computer, books, records, customer lists) to State Farm, in accordance with the agreement. Thus, Baker did not own these assets and, therefore, could not have sold them to State Farm.

The court further decided there was no evidence showing that the telephone number or the employees were Bakers capital assets. Furthermore, the evidence did not indicate that Baker received any portion of the termination payment as payment for: the successor agents use of the telephone number; the successor agents hiring of Bakers former employees; or Bakers teaching the successor agent about the agency and introducing him to policyholders. Nor was there any evidence of an employment contract between Baker and the agency employees, or that the successor agent was required to hire the employees.

In the courts opinion the fact that the successor agent hired Bakers former employees did not support Bakers argument that he “sold” the agency.

Finally, because Baker did not own or sell any capital assets to State Farm, he could not have sold the goodwill because there were no assets for the goodwill to attach.

The Tax Court concluded by holding that Baker did not own any capital assets that he could have sold to State Farm. Furthermore, Baker did not receive the termination payment as payment for any asset. Consequently, the termination payment did not represent gain from the sale or exchange of a capital asset.

Because the termination payment was not entitled to capital gain treatment, the court held that the payment was taxable as ordinary income.

Sonya E. King, J.D., LL.M, is an assistant editor of Tax Facts, a National Underwriter Company publication.


Reproduced from National Underwriter Life & Health/Financial Services Edition, June 24, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.