WILLIAM R. AND MURIEL G. JACKSON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23558-94.
UNITED STATES TAX COURT
Filed March 31, 1997.
108 T.C. No. 10
William R. Jackson, pro se.
John F. Driscoll, for respondent.
DAWSON, Judge: Respondent determined deficiencies in petitioners’ Federal income taxes for the taxable years 1990 and 1991 in the amounts of $2,837 and $2,837.48, respectively.
At issue is whether termination payments received by William R. Jackson, a former independent agent for State Farm Insurance Companies, are subject to self-employment tax pursuant to
This case was submitted fully stipulated under Rule 122. The stipulation of facts and attached exhibits are incorporated herein by this reference. The pertinent facts are summarized below.
Petitioners resided in Lakeshore, Mississippi, at the time they filed their petition in this case.
On April 15, 1954, William R. Jackson (petitioner) was appointed as an exclusive agent of State Farm Insurance Companies (State Farm), which consisted of the following four subcompanies: (1) State Farm Mutual Automobile Insurance Co.; (2) State Farm Life Insurance Co.; (3) State Farm Fire & Casualty Co.; and (4) State Farm General Insurance Co.
From April 15, 1954, to May 31, 1959, and from January 1, 1972, until his retirement on December 31, 1987, petitioner served as an agent of State Farm under a series of three separate State Farm Agent‘s Agreements. During these periods of time both petitioner and State Farm considered their association to be an independent contractor relationship. From June 1, 1959, to December 31, 1971, petitioner served State Farm as District Agency Manager, and he operated under a District Agency Manager Agreement. During that period both he and State Farm considered their relationship to be that of an employer and an employee.
Petitioner was 63 years of age when he retired. Being an independent contractor operating pursuant to the provisions of a previously executed State Farm Agent‘s Agreement, Form AA3 (the Agreement), petitioner closed his office on December 31, 1987, and did not thereafter engage in further insurance business of any kind. At that time his agency relationship with State Farm ended and he became eligible for “Termination Payments” under Section IV of the Agreement. In 1990 and 1991 petitioner received termination payments from State Farm of $21,885 and $21,837, respectively. On his Federal income tax returns for
Because the Agreement was terminated more than 2 years after its effective date, the termination made petitioner eligible to receive 5 years of monthly termination payments from State Farm. Section II of the Agreement entitled “Compensation” did not include or refer to Section IV entitled “Termination Payments“.
For the first post-termination year, Section IV of the Agreement required each of the State Farm companies to compute termination payments based on a percentage of petitioner‘s compensation during the previous 12 months, which was generally 20 percent of the income generated by personally produced policies in that year, less any deductions for commission charge-backs. For the subsequent 4 years of termination payments, each company was required to pay an amount equal to 1/12th the amount payable in the first post-termination year, less commission charge-backs. None of the termination payments depended upon the length of petitioner‘s service for State Farm and overall earnings.
Petitioner had no vested right to receive any termination payments. The Agreement conditioned such payments upon two contractual requirements; i.e., (1) returning all of State Farm‘s property within 10 days of termination entitled petitioner to 2 months of termination payments, and (2) refraining from competing
The Agreement also conditioned the termination payments upon certain adjustments to reflect: (1) The amount of income the State Farm companies received on petitioner‘s book of business during the first post-termination year, and (2) the number of his personally produced policies canceled during that year.
On Forms 1099-Misc sent to petitioner and the Internal Revenue Service for 1990 and 1991, State Farm reported the amounts of termination payments as nonemployee compensation attributable to service rendered by petitioner prior to his retirement.
In the notice of deficiency respondent determined that the amounts petitioner received from State Farm as termination payments constituted income from self-employment within the meaning of
We begin by pointing out that this case is indistinguishable from Milligan v. Commissioner, 38 F.3d 1094 (9th Cir. 1994), revg. T.C. Memo. 1992-655. Both cases involve former State Farm insurance agents who received termination payments under precisely the same provisions of Section IV of the State Farm Agent‘s Agreement. However, our opinion in Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), is not applicable here because an appeal of our decision
Petitioner, of course, urges us to follow the Court of Appeals’ decision in Milligan and hold that the income he received as termination payments is not subject to self-employment tax. To the contrary, respondent asserts that we should adhere to our Milligan opinion and conclude that petitioner is liable for self-employment tax on the termination payments.
Section 1401 imposes a tax upon each individual‘s “self-employment income“.2 “Self-employment income” is defined in
In Newberry v. Commissioner, 76 T.C. 441, 444 (1981), this Court held that, for income to be taxable as self-employment income, “there must be a nexus between the income received and a trade or business that is, or was, actually carried on.” Under our interpretation of the “nexus” standard, any income must arise from some actual (whether present, past, or future) income-producing activity of the taxpayer before such income becomes subject to self-employment tax. Id. at 446. And
This Court found in Milligan v. Commissioner, T.C. Memo. 1992-655, that the termination payments were the equivalent of deferred compensation which a State Farm agent, active or retired, would receive from policies sold in prior years. On that basis, we held that the payments were “derived” from self-employment even though they were received in years subsequent to the business activity which generated them. In other words, we found that there was a sufficient nexus between the income received and Mr. Milligan‘s trade or business to render the termination payments self-employment income. We stated that termination payments were analogous to the renewal commission payments in Becker v. Tomlinson, 9 AFTR 2d 1408, 62-1 USTC par. 9446 (S.D. Fla. 1962), because they constituted the payment of
The Court of Appeals for the Ninth Circuit reversed our Milligan decision. In doing so, it acknowledged that in order for Mr. Milligan to receive termination payments, he had to have worked for State Farm as an independent contractor for 2 years or more. Milligan v. Commissioner, 38 F.3d at 1098. But the Court of Appeals stated that this fact by itself did not create a close enough nexus to establish that the termination payments were “derived” from Mr. Milligan‘s prior business activity within the meaning of the self-employment tax. The Court of Appeals concluded that Mr. Milligan had already been fully compensated for his services and that his business activity was not the “source” of the termination payments. Id. at 1099. It stated that the payments did not represent deferred compensation of previously earned commissions because none of Mr. Milligan‘s earnings were deferred; i.e., he had no vested right to payment of an identifiable amount of money. Nor were they renewal commissions or retirement income tied to Mr. Milligan‘s years of service and overall earnings. The Court of Appeals stated that “To be taxable as self-employment income, earnings must be tied to the quantity or quality of the taxpayer‘s prior labor, rather than the mere fact that the taxpayer worked or works for the
Here, the Termination Payments were linked only to Milligan‘s previous status as a two year-plus independent contractor for State Farm. Had Milligan not worked for State Farm, he never would have received the Termination Payments. And, had he worked for State Farm for less than two years, or had he not generated any policies that produced commissions (or service compensation with respect to State Farm Auto, see ER 54-55: section IV.A.1(a)) in the final pre-termination year, he would have received nothing.
Without more, this link between the disputed payments and any business activity carried on by Milligan does not satisfy the “derive” requirement. * * * [Id.]
It was further emphasized by the Court of Appeals that Mr. Milligan had a contingent right to receive as termination payments an uncertain amount of money or nothing depending upon the level of his prior business activity leading to compensation in his final year as an agent. The payment amount depended in part upon the level of his commissions on personally produced policies. However, the termination payments were subject to two adjustments. The State Farm companies adjusted the termination payments to reflect the amount of income received on Mr. Milligan‘s book of business during the first post-termination year, and the number of his personally produced policies canceled during that year. If all of his customers had canceled their policies during the first post-termination year, Mr. Milligan would have received nothing. The Court of Appeals reasoned that in that sense the adjusted payment amount depended not upon Mr. Milligan‘s past business activity, but upon a successor agent‘s
We have set forth at length the reasons stated by the Ninth Circuit for reversing our Milligan opinion because we think they are persuasive. The case now before us is identical to Milligan in all material respects. Milligan cannot be distinguished, as it was in Schelble v. Commissioner, T.C. Memo. 1996-269, on appeal (10th Cir., Sept. 16, 1996), which involved “extended earnings” under a Career Agent‘s Agreement with American Family Insurance Companies, where this Court held that the taxpayer was subject to self-employment tax. But see, Gump v. United States, 86 F.3d 1126 (Fed. Cir. 1996), holding that “extended earnings” paid by Nationwide Mutual Insurance Company to a retired insurance agent were not “derived” from a trade or business carried on by him, and therefore he was not subject to self-employment tax. The Court of Appeals for the Federal Circuit found the Ninth Circuit‘s reasoning in Milligan persuasive, and stated that “we do not see any meaningful differences between Milligan and Gump that would counsel a different result“. Id. at 1129.
We have given further thought to our conclusion in Milligan v. Commissioner, T.C. Memo. 1992-655, that the termination payments were the equivalent of deferred compensation.
In a typical deferred compensation arrangement, an employee wants to postpone receiving a portion of the income to which he or she is entitled with the understanding that the income will be paid at a later time, usually upon retirement or other termination. Arizona Governing Committee v. Norris, 463 U.S. 1073, 1076 (1983); Minor v. United States, 772 F.2d 1472 (9th Cir. 1985). In these cases the employee chose to receive less than his or her agreed compensation when earned with the understanding that it would be paid out at some later time. The employer ordinarily contributes the amount designated by the employee to a fund established for that purpose.
To be sure, deferred compensation arrangements often exist with respect to insurance agents operating as independent contractors. Such a plan was discussed in Petr v. Nationwide Mut. Ins. Co., 712 F.Supp. 504 (D. Md. 1989). In that case, which involved a Nationwide plan, the insurance company “credited to an account maintained over the years for * * * [the agent] a percentage of * * * [the agent‘s] earnings based on his original and renewal fees for insurance policies.” Id. at 505. The same plan was at issue in Darden v. Nationwide Mut. Ins. Co., 922 F.2d 203 (4th Cir. 1991), revd. on other grounds 503 U.S. 318 (1992). In that case the deferred compensation plan was funded by the
Petitioner performed services for State Farm for 33 years. During his service he received commissions, service compensation, and renewal commissions. The record does not show that he was entitled to more compensation than he received once the termination payments were made. The Agreement contains no provisions to accumulate funds for termination payments. The language of Section IV of the Agreement indicates that the parties intended to create a payment scheme separate and distinct from compensation for services rendered.
Other distinctions between the termination payments and the ordinary deferred compensation plan are apparent. Deferred compensation which becomes payable after the recipient‘s retirement takes into account his overall earnings and years of service. The amount ultimately to be paid to the individual is a vested property right when earned which usually cannot be cut off arbitrarily. See Phillips v. Alaska Hotel and Restaurant Employees Pension Fund, 944 F.2d 509, 516 (9th Cir. 1991).
In those respects petitioner‘s termination payments differed from the ordinary deferred compensation plan. Under the Agreement, the amount of termination payments was not dependent upon the amount petitioner earned over his career. As long as he had at least 2 years of service prior to the termination, it made
The termination payments were linked to the amount of commissions paid to petitioner during the 12 months immediately preceding the termination. The amount was unaffected by petitioner‘s income during any prior period, by the total number of policies written over his career with State Farm, or by the total time period he served as a State Farm agent. No matter how long he had been a State Farm agent, petitioner‘s termination payments would be based only on his compensation for the last 12 months. Unlike deferred compensation, petitioner had no vested right to payment of any particular funds or any specific amount until the termination and unless he complied with the conditions of the Agreement to return property to State Farm and to refrain from competition.
Consequently, we conclude that the termination payments received by petitioner were not deferred compensation derived from self-employment and that our prior conclusion in Milligan v. Commissioner, supra, was incorrect. See also Darden v. Nationwide Mutual Insurance Co., supra, where the Court of Appeals for the Fourth Circuit held that an Extended Earnings Plan providing for similar payments was not a pension plan
Respondent also maintains that the Courts of Appeals’ decisions in Milligan and Gump are erroneous, based on the following arguments. First, it is argued that both decisions require that a portion of the taxpayer‘s compensation be set aside as earned, to provide a specific fund for the post-termination payments, else the taxpayer‘s business activity could not be considered the “source” of such payments. Thus, respondent construes both decisions as adding a “salary reduction agreement” or “direct tracing” requirement to the “derived from trade or business” standard that is not supported by other case law or the language of
Second, respondent argues that the existence of post-termination conditions upon the agent‘s right to receive the termination payments should play no role in deciding whether such payments are subject to self-employment tax. Respondent stresses that the relevant statutory language provides no exclusion from self-employment tax liability for income which is received only after the recipient satisfies certain post-termination obligations. Respondent argues: (1) The fact that a post-termination obligation exists does not detract from the fact that an individual‘s right to receive income directly arises from his prior business activities; (2) the introduction of any such “post-termination obligation” exclusion into the statutory
Third, respondent argues the appropriate
Finally, respondent argues that an overview of the employment tax provisions indicates that Congress intended to subject all payments to former workers, whether employees or independent contractors, to the imposition of employment tax on deferred compensation in the absence of a specific exception.
In the interest of promoting uniformity, consistency, and fairness in the disposition of this issue with respect to former insurance agents who receive termination payments under similar contractual agreements, we follow the decision of the Court of Appeals for the Ninth Circuit in Milligan v. Commissioner, supra. Accordingly, upon further reflection and analysis, we hold that the termination payments petitioner received in 1990 and 1991 are not subject to self-employment tax. Because we conclude that the termination payments were not “derived” from the carrying on of petitioner‘s insurance business,4 we need not decide the precise nature of the payments or specifically characterize them as a particular type of income. In other words, we need not decide in this case whether the termination payments are consideration for an agreement not to compete or the purchase of petitioner‘s agency, including its assets and goodwill. Milligan v. Commissioner, 38 F.3d at 1100.
Decision will be entered for petitioners.
Reviewed by the Court.
COHEN, CHABOT, SWIFT, JACOBS, GERBER, WELLS, RUWE, COLVIN, LARO, FOLEY, VASQUEZ, and GALE, JJ., agree with this majority opinion.
CHIECHI, J., did not participate in the consideration of this opinion.
If the termination payments are for goodwill, then they are attributable to the sale of a capital asset. Goodwill has been characterized as the expectation that old customers will resort to the old place of business. Goodwill is acquired by the purchaser of a going concern where the transfer enables the purchaser to step into the shoes of the seller. See Decker v. Commissioner, 864 F.2d 51, 54 (7th Cir. 1988), affg. T.C. Memo. 1987-388; Winn-Dixie Montgomery, Inc. v. United States, 444 F.2d 677, 681 (5th Cir. 1971). Here the terms of the Agreement between petitioner and State Farm allowed petitioner‘s successor agent to step into his shoes. The successor agent continued the same business and sold insurance to the same customers. Petitioner‘s goodwill, built up over a 33-year period, passed to the successor agent. State Farm served as the conduit by making payments to petitioner under the termination arrangement, but
If the termination payments are for a covenant not to compete, they are not self-employment income. Payments attributable to a covenant not to compete are not “earned” income, Furman v. United States, 602 F.Supp. 444, 451 (D.S.C. 1984), affd. without published opinion 767 F.2d 911 (4th Cir. 1985), and they are not subject to self-employment tax. Barrett v. Commissioner, 58 T.C. 284 (1972); see also Ohio Farm Bureau Federation, Inc. v. Commissioner, 106 T.C. 222, 236 n.8 (1996). The purpose of the termination payments under the Agreement was to compel petitioner to refrain from entering into an insurance business as a competitor of State Farm. Clearly, State Farm wanted to protect the customer base for its products that had been developed by petitioner during the course of his active affiliation with the company.
It is significant that other courts in analogous agreements involving extended earnings arrangements have concluded that similar payments were in the nature of a buyout. See Darden v. Nationwide Mut. Ins. Co., 922 F.2d 203, 208 (4th Cir. 1991), revd. on other grounds 503 U.S. 318 (1992) (quoting Fraver v. North Carolina Farm Bureau Mut. Ins. Co., 801 F.2d 675, 678 (4th Cir. 1986)), as follows:
The amount of the payment is tied to only one factor, the amount of business in the last year prior to
termination. Finally, the payments are recouped from the individual‘s successor. In sum, the benefits are in the nature of a buy-out in which the departing agent receives payments based on what he leaves behind in the way of business for his successor. If the departing agent goes into competition with his successor, he is destroying the resource that would be used to pay him.
See also Petr v. Nationwide Mutual Ins. Co., 712 F.Supp. 504, 506 (D. Md. 1989); Wolcott v. Nationwide Mutual Ins. Co., 664 F.Supp. 1533, 1538 (S.D. Ohio 1987), affd. in part, revd. in part 884 F.2d 245 (6th Cir. 1989).
Finally, in Milligan v. Commissioner, 38 F.3d 1094, 1098 n.6 (9th Cir. 1994), which is identical to the instant case in all material respects, the Court of Appeals observed: “Payments derived from the cessation of Milligan‘s business are not subject to self-employment tax. * * * Nor does the self-employment tax apply to payments derived from noncompetition with State Farm.”
BEGHE and DAWSON, JJ., agree with this concurring opinion.
By nexus, we mean that the “trade or business activity by the taxpayer gives rise to the income....” Id. [Newberry v. Commissioner, supra] (emphasis added). The income is sufficiently related to the taxpayer‘s
trade or business activity when the business activity is its source. Id. at 446 (“Any income must arise from some actual ... income-producing activity of the taxpayer before such income becomes subject to ... self-employment taxes....“). [Id.]
The Ninth Circuit found it unnecessary to characterize the precise relationship between the termination payments and the taxpayer’s prior business activity because it was obvious to the court that the termination payments did not “‘derive’ from Milligan’s prior business activity within the meaning of the self-employment tax.” Id. The Ninth Circuit laid down the following general rule: “To be taxable as self-employment income, earnings must be tied to the quantity or quality of the taxpayer’s prior labor, rather than the mere fact that the taxpayer worked or works for the payor.” Id.
Because Milligan already had been fully compensated for his services, the Ninth Circuit concluded that the termination payments were linked only to Milligan’s previous status as a 2-year plus independent contractor for State Farm, and, thus, “none of his business activity was the ‘source’ of the Termination Payments.” Id. at 1098-1099. The Ninth Circuit supported its holding that previous independent contractor status alone was not a sufficient nexus by analogizing to a wage tax situation in which employer-provided supplemental unemployment benefits were held not to be wages because the benefits, although the result of employment status at some previous time, were “‘[I]n no way * * * a function of the employee’s providing
I dissent because I am not persuaded by the reasoning of the Ninth Circuit in Milligan v. Commissioner, supra. I do not agree with the quantity-or-quality-of-labor test adopted by the Ninth Circuit. I believe that the Ninth Circuit has overemphasized parallels between the wage tax acts (the
The statutory phrase in question is “net earnings from self-employment”, which is defined in
The trade or business must be “carried on” by the individual either personally or through agents or employees, in order for the income to be included in his “net earnings from self-employment.” Accordingly, gross income derived by an individual from a trade or business carried on by him does not include income derived by a beneficiary from an estate or trust even though such income is derived from a trade or business carried on by the estate or trust. [S. Rept. 1669, supra, 1950-2 C.B. at 354.]
See also H. Rept. 1300, 81st Cong., 1st Sess. (1949), 1950-2 C.B. 255, 294.
Clearly, the trade or business need not currently be carried on by the individual; a past carrying on will do. See Schumaker v. Commissioner, 648 F.2d 1198, 1200 (9th Cir. 1981) (affirming self-employment tax on sale proceeds from wheat that the taxpayer grew in the past: “[S]elf-employment income is determined by the source of the income, not the taxpayer’s status at the time the income is realized.” (emphasis added)), affg. in part and revg. in part T.C. Memo. 1979-71;
Thus, the only relevant question is whether the item of gross income in question is derived from the taxpayer’s trade or business or from some other source. It seems safe to conclude that petitioner was in the business of selling insurance as an independent agent of State Farm Insurance Co. (State Farm). His relationship with State Farm, including the terms under which he would earn gross income from State Farm, were governed by his written agency agreements with State Farm. The termination payments were made pursuant to the State Farm Agent’s Agreement, Form AA3 (the Agreement). The Agreement appoints petitioner an agent of State Farm for an indefinite period. The Agreement contains a preamble and six numbered sections:
- Mutual Conditions and Duties
- Compensation
- Termination of Agreement
- Termination Payments
- Extended Termination Payments
- General Provisions
The section entitled “Termination of Agreement” provides, in pertinent part, that the Agreement terminates upon the agent’s death or upon written notice by either party. That section also contains a prohibition against competition by the terminated
The termination payments were conditioned on petitioner’s returning to State Farm all of its property and not competing with State Farm for 1 year, and those payments were a product of both petitioner’s performance during his last year with State Farm and the staying power of petitioner’s performance for State Farm. The payments were not otherwise identified as being in consideration for any particular contractual obligation of petitioner’s under the Agreement. Some portion of the termination payments may have been in consideration for petitioner’s promise not to compete for 1 year. The majority’s report does not contain sufficient information from which to make an allocation. Moreover, I am not convinced that, even if such information were available, an allocation would be required. In Barrett v. Commissioner, 58 T.C. 284, 289 (1972) (rejected sub silentio with respect to its focus on the “goods-and-services test” in Groetzinger v. Commissioner, 82 T.C. 793 (1984), affd. 771 F.2d 269 (7th Cir. 1985), affd. 480 U.S. 23 (1987)), we accepted the parties’ agreement “that noncompetition does not constitute the carrying on of a trade or business.” In addition,
Lastly, the termination payments in this case are fundamentally unlike the insurance proceeds in Newberry v. Commissioner, supra. The payments in Newberry were derived from an insurance policy that was purchased by the taxpayer in order to provide him with a substitute for his trade or business income in the event of a business interruption, such as the catastrophic fire in that case. The payments took the place of income from the trade or business and were not themselves income from that business. In this case, the termination payments were derived from a trade or business carried on by petitioner.