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Tax Court Rules That Loan Offsets Were Income To Former Agent

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An insurance agents renewal commissions, which were used by his former employer to repay outstanding advances and loans, constituted unreported income according to the Tax Court in Diers. v. Comm., TC Memo 2003-229.

Everett Diers worked as an insurance agent for American Income Life Insurance Company for approximately six years. American paid Diers the years commissions in advance for each insurance policy he sold during the year. In addition, Diers received a renewal commission so long as the insured renewed the policy.

American also lent Diers funds to cover expenses related to his business for American. Because of the advance payment of commissions and loans made to him, American regularly carried a debt on its books for Diers. When Diers left American in 1994, he had an obligation to repay the company for the commission advances and loans.

After Diers resigned from the company, American sued Diers for advances and loans made to him during his employment. In 1995, Diers and American entered into a settlement agreement providing that American would look exclusively to renewal commissions due (or to become due) to Diers to satisfy the outstanding loan balance. In exchange, Diers released all claims and rights to renewal commissions attributable to past services rendered for American that were due to him (or that would become due in the future).

When insurance agents receive advances based on future commission income, whether those advances constitute income depends on whether at the time of the making of the payment: (1) the agent had unfettered use of the funds, and (2) there was a bona fide obligation on the part of the agent to make repayment.

In many instances, repayment is made simply out of future earned commissions. Where the repayments will be taken only from future commissions earned and the agent will not become personally liable in the event the future income does not cover the repayment schedule, the payments will constitute income to the agent for each year to the extent he received them. Such payments are nothing more than disguised salary.

However, where the advances are actually loans, when the repayments are offset directly by the future earned commissions, then the agent will have either commission income or cancellation of indebtedness income at the time of the offsets.

The Tax Court agreed with the IRS that Diers received income from the renewal commissions when American credited those commissions against the outstanding advances and loans in 1996. Although Diers employment with American terminated in 1994, he continued to earn renewal commissions on policies he had sold before his departure.

Under the settlement agreement, instead of paying these commissions to Diers, American credited his account showing outstanding advances. When American made the advances to Diers, he was not taxable on them because they were in effect loans. However, when the commissions Diers earned after his departure from American were credited to his account, his obligation to repay the loans was reduced by those amounts, and the reduction of that obligation constituted the receipt of taxable income. The court concluded by holding that Diers had failed to report commission income in the amount of $26,738 and upheld the Services deficiency notice.

Retired Agents Capital Gain Disallowed. In another case, the Seventh Circuit Court of Appeals recently held that a retired insurance agents termination payments were income, and not capital gain, affirming last years Tax Court ruling in Baker v. Comm., 2003 U.S. App. LEXIS 15509 (7th Cir. 2003), affg, Baker v. Comm., 118 TC 452 (2002).

The appeals court held that Baker did not own any property related to the policies and, thus, could not sell anything related to those policies, including goodwill; accordingly the termination payments were not consideration for the sale of a capital asset.

The appeals court also held that a portion of State Farms payments to Baker was for a covenant not to compete, which is taxable as ordinary income.

Note that legislation (H.R. 2509) has been introduced by Rep. Sam Johnson, 3rd District-Texas, that would provide capital gains treatment for certain termination payments received by former insurance salespeople. The bill (“Fair Tax Treatment for Insurance Agents Termination Payments Act of 2003″) was referred to the House Ways and Means Committee on June 18, 2003, where it is currently pending.

Sonya E. King, J.D., LL.M., is an Assistant Editor of Tax Facts.

Reproduced from National Underwriter Life & Health/Financial Services Edition, September 8, 2003. Copyright 2003 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.


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