William R. and Muriel G. Jackson v. Commissioner

108 T.C. No. 10

UNITED STATES TAX COURT

WILLIAM R. AND MURIEL G. JACKSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 23558-94. Filed March 31, 1997.

P, a former insurance agent for State Farm
Insurance Companies, received termination payments
after his retirement on December 31, 1987, pursuant to
the terms of an independent contractor Agent's
Agreement. Held, the termination payments P received
were not "derived" from a trade or business carried on
by him as an insurance agent during 1990 and 1991.
Therefore, such payments are not subject to self-
employment tax under sections 1401 and 1402, I.R.C.,
and P is not liable for such tax. Milligan v.
Commissioner, 38 F.3d 1094 (9th Cir. 1994), revg. T.C.
Memo. 1992-655, followed.

William R. Jackson, pro se.

John F. Driscoll, for respondent.
 - 2 -

OPINION

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

sections 1401 and 1402.1

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.

1
Unless otherwise indicated, all section references are
to the Internal Revenue Code in effect for the years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
 - 3 -

While serving as an agent for State Farm, petitioner's

duties included soliciting applications for insurance, collecting

payments, and generally assisting State Farm policyholders. His

compensation for his State Farm duties consisted of commissions

on new policies and renewals on existing policies.

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
 - 4 -

1990 and 1991, he reported the amounts received as termination

payments as income, but not for purposes of self-employment tax.

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
 - 5 -

with all of the State Farm companies for a period of 1 year

entitled petitioner to subsequent termination payments.

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 section 1401, and, therefore, were subject to self-

employment tax.

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
 - 6 -

in this case would be to the United States Court of Appeals for

the Fifth Circuit. Consequently, we must decide whether to

follow the rationale of our Milligan opinion or the decision of

the Court of Appeals for the Ninth Circuit that reversed us.

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

section 1402(b) as "net earnings from self-employment" with

certain exceptions not relevant to this case. "Net earnings from

self-employment" is defined in section 1402(a) as "gross income

2
A self-employed individual pays both the employer's and
employee's share of the Social Security tax. The self-employment
tax ("SECA") has two components, the Old Age, Survivors, and
Disability Insurance portion (OASDI) and the rate for this
portion of the SECA tax for 1990 and later years is 12.4 percent.
The second component of the SECA tax is Hospital Insurance
(Medicare) and the rate for this portion of the tax for 1990 and
later years is 2.9 percent. The combined rate of the self-
employment tax was 15.3 percent for both 1990 and 1991. In 1990
this tax was imposed on self-employment income of up to $51,300
and in 1991 on self-employment income of up to $53,400. In
addition, in 1990 the Medicare tax of 2.9 percent was imposed on
self-employment income of more than $51,300 but less than
$125,000, and in 1991 on income of more than $53,400 but less
than $130,200.
 - 7 -

derived by an individual from any trade or business carried on by

such individual, less the deductions allowed by this subtitle

which are attributable to such trade or business". It is well

established that the earnings of an insurance agent who is an

independent contractor are "self-employment income" subject to

self-employment tax. Simpson v. Commissioner, 64 T.C. 974

(1975); Erickson v. Commissioner, T.C. Memo. 1992-585, affd.

without published opinion 1 F.3d 1231 (1st Cir. 1993).

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 section

1.1402(a)-1(c), Income Tax Regs., provides that gross income

derived from an individual's trade or business may be subject to

self-employment tax even when it is attributable in whole or in

part to services rendered in a prior taxable year. This Court

and others have repeatedly applied the "nexus" test.3

3
In her reply brief in this case, respondent has
requested that we apply a less restrictive test, the one
reflected in Rev. Rul. 91-19, 1991-1 C.B. 186, 187, under which
"the required nexus exists if it is clear that a payment would
not have been made but for an individual's conduct of a trade or
(continued...)
 - 8 -

In applying the statutory definition of self-employment

income, we must decide whether the income from the termination

payments satisfies three requirements: that it was (1) derived,

(2) from a trade or business, (3) carried on by petitioner.

Here, as in Milligan v. Commissioner, supra, petitioner agrees

that he formerly carried on a trade or business as a State Farm

insurance agent. Thus, the narrow question presented is whether

the termination payments were "derived", pursuant to the terms

and conditions of the Agreement, from the carrying on of

petitioner's previous work as a State Farm insurance agent.

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.

3
(...continued)
business." We decline to do so. We will continue to apply the
"nexus" test of Newberry v. Commissioner, 76 T.C. 441 (1981).
 - 9 -

9446 (S.D. Fla. 1962), because they constituted the payment of

previously earned commissions, similar to the deferred

commissions that an active insurance agent would receive.

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
 - 10 -

payor". Milligan v. Commissioner, supra at 1098. The Court of

Appeals then commented as follows:

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
 - 11 -

future business efforts to retain Mr. Milligan's customers and to

generate service compensation for State Farm. The Court

concluded that the disputed termination payments did not "derive"

from Mr. Milligan's prior service.

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.
 - 12 -

Respondent, of course, urges us to adhere to that conclusion.

But we are no longer inclined to do so because we now think such

payments are not 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
 - 13 -

insurance company's "annual contributions based on an agent's

earnings from original and renewal fees for insurance policies."

Id. at 204.

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
 - 14 -

no difference whether he had 2 or 33 years of service with State

Farm for purposes of computing his termination payments. If he

had received no commissions during the last 12 months, then he

would not have been entitled to any termination payments.

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
 - 15 -

subject to regulation under ERISA, but that the payments were in

the nature of a buyout.

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 section 1402.

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
 - 16 -

framework of sections 1401 and 1402 would serve to encourage tax

avoidance through the use of tax-motivated or other "condition

subsequent" language, thereby interfering with the administrative

enforcement of these provisions; and (3) the presence of a

condition subsequent would have no impact upon the "source of

income" requirement imposed by the section 1402 "derived from

trade or business" standard because it would relate only to the

amount or existence of income and not its source.

Third, respondent argues the appropriate section 1402

"derived from trade or business" test should be based on an

"ordinary sense" or "common parlance" all-inclusive definition of

the term "derived from". Here again, it is contended that

petitioner would not have received the termination payments "but

for" his prior pursuit of his business as a State Farm insurance

agent. Thus, respondent argues, the "causal nexus" between

petitioner's prior business activity and his receipt of a benefit

from such activity is established notwithstanding the conditions

subsequent that could have eliminated or substantially altered

his right to receive any such benefit.

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.
 - 17 -

We have considered all of respondent's arguments, but we

have not found them convincing.

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.

4
See, e.g., Ohio Farm Bureau Federation, Inc. v.
Commissioner, 106 T.C. 222, 236 (1996), an analogous case, in
which we pointed out that the statutory language defining
"unrelated business income" in sec. 512(a) is similar to that
contained in sec. 1402(a). There it was held that a lump-sum
payment made by Landmark, Inc., to the taxpayer, pursuant to the
terms of a nonsponsorship and noncompetition clause contained in
their termination agreement, did not constitute unrelated
business taxable income under sec. 511(a). We applied the
rationale of Newberry v. Commissioner, 76 T.C. at 444. The
Government did not appeal our decision, and the IRS has since
revoked GCM 39865, TR-45-1437-90 (Dec. 12, 1991), which reached a
contrary conclusion.
 - 18 -

To reflect the foregoing,

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.
 - 19 -

PARR, J., concurring: I concur in the result reached by the

majority. I would conclude that the termination payments

received by petitioner are not subject to self-employment tax,

because in my judgment the payments are in the nature of a buyout

of petitioner's business by State Farm. Thus, they should be

treated as a sale of a capital asset and are excluded from the

definition of self-employment income under section 1402(a)(3)(A).

The payments are in reality either for the goodwill of

petitioner's former insurance business (his books of customer

accounts) or for a covenant not to compete.

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
 - 20 -

deducted the payments from the commissions payable to the

successor agent, and, if there was any shortfall, the balance was

paid from State Farm's general operating funds.

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
 - 21 -

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.
 - 22 -

HALPERN, J., dissenting: The majority holds that certain

termination payments received by petitioner after his retirement

as an independent insurance agent are not subject to self-

employment tax pursuant to sections 1401 and 1402 because such

payments were not “‘derived’ from the carrying on of petitioner’s

insurance business”. Majority op. p. 17. The majority is

persuaded by the reasoning of the Court of Appeals for the Ninth

Circuit (the Ninth Circuit) set forth in Milligan v.

Commissioner, 38 F.3d 1094 (9th Cir. 1994), revg. T.C. Memo.

1992-655. In Milligan, the Ninth Circuit recognized that, to be

taxable as self-employment income under the Self-Employment

Contributions Act of 1954 (SECA), sections 1401-1403, an

individual’s income must be (1) derived (2) from a trade or

business (3) carried on by that individual. Id. at 1097. In

Milligan, the taxpayer disputed only whether the termination

payments there in question (which the majority implies were

“indistinguishable” from the payments here in question) were

“derived” from the trade or business carried on by him. Relying

on our opinion in Newberry v. Commissioner, 76 T.C. 441, 444

(1981), the Ninth Circuit stated: “The term ‘derive’ requires ‘a

nexus between the income received and a trade or business that

is, or was, actually carried on.’” Milligan v. Commissioner,

supra at 1098. The Ninth Circuit continued:

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
 - 23 -

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
 - 24 -

services for his employer. Those benefits are not derived from

any employment carried on.’” Id. at 1099 (quoting Newberry v.

Commissioner, 76 T.C. at 445).

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 Federal Insurance

Contributions Act (FICA) and the Federal Unemployment Tax Act

(FUTA)) and SECA, forgetting that SECA, unlike FICA and FUTA,

does not impose a levy solely against labor, but, rather, imposes

a levy against certain trade or business income of an individual.

Compare sections 3121(a) and 3306(b) with section 1402(a).

Properly, the Ninth Circuit looks for a connection (nexus)

between the gross income in question and the taxpayer’s business

“activity”. Improperly, however, the Ninth Circuit uses the word

“activity” in a limited sense, a sense that encompasses only

physical or mental exertions: e.g., “Because Milligan already

had been fully compensated for his services, none of his business

activity was the ‘source’ of the Termination Payments.” Milligan

v. Commissioner, supra at 1099 (emphasis added). Such a

restrictive interpretation may be appropriate for a wage tax

analysis, in which the question is whether the payment is

remuneration for employment (labor), see sections 3121(a),

3306(b), but it is too narrow a frame of reference to determine
 - 25 -

whether the taxpayer’s trade or business is the source of an item

of gross income.

The statutory phrase in question is “net earnings from self-

employment”, which is defined in section 1402(a) as “gross income

derived by an individual from any trade or business carried on by

such individual [less certain deductions]”. The only term that

suggests that less than all of the trade or business income of an

individual is subject to tax is the term “carried on”. S. Rept.

1669, 81st Cong., 2d Sess. (1950), 1950-2 C.B. 302, is the report

of the Committee on Finance that accompanied H.R. 6000, which was

enacted as the Social Security Act Amendments of 1950,

ch. 809, 64 Stat. 477, which included the Self-Employment

Contributions Act. That report indicates that Congress used the

verbal phrase “carried on” in a relational sense, to describe a

business conducted or operated by the individual subject to the

tax (as opposed to someone else):

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
 - 26 -

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; sec. 1.1402(a)-1(c), Income Tax Regs.

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:

(1) Mutual Conditions and Duties
(2) Compensation
(3) Termination of Agreement
(4) Termination Payments
(5) Extended Termination Payments
(6) 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
 - 27 -

agent. Termination payments are provided for in the section

entitled "Termination Payments" and are as described by the

majority. The Agreement provides that it is the sole and entire

agreement between the parties. No part of the agreement has to

do with anything other than the beginning, middle, and end of

petitioner’s business relationship with State Farm.

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,
 - 28 -

in Ohio Farm Bureau Fedn., Inc. v. Commissioner, 106 T.C. 222,

236 (1996), we suggested that the rationale in Newberry v.

Commissioner, 76 T.C. 441 (1981), supported the holding that

income from a nonsponsorship and noncompetition agreement does

not constitute "unrelated business income" under the definition

of that term in section 512(a). Those cases, however, do not

mandate the conclusion that income received from a covenant not

to compete is per se excluded from the reach of SECA. I think

that the law on that point still may be uncertain. Since that

point is not crucial to my disagreement with the Ninth Circuit, I

shall not pursue it any further. It is sufficient to me that, on

the facts as I understand them, the payments were made pursuant

to a business contract that served no purpose other than to

define both the consideration for and other aspects of the

business relationship between petitioner and State Farm.

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.