T.C. Memo. 2002-29
UNITED STATES TAX COURT
ORIN F. FARNSWORTH AND MARY L. FARNSWORTH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14460-99. Filed January 28, 2002.
Orin F. Farnsworth and Mary L. Farnsworth, pro sese.
Paul K. Webb, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge: Respondent determined a deficiency of
$111,808 in petitioners’ joint Federal income tax for 1995.
After concessions by the parties, there are two issues for
decision: (1) Whether petitioners are entitled to exclude from
income, as a recovery of basis, any portion of the “contract
value” termination payments received in 1995 by petitioner Orin
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F. Farnsworth under his District Manager’s Appointment Agreement
(DMAA) with Farmers Insurance Group, and (2) whether petitioners
are liable for self-employment tax under section 14011 on the
DMAA “contract value” termination payments.
We hold that petitioners are not entitled to exclude from
income any portion of the DMAA “contract value” termination
payments because petitioners failed to prove that Mr. Farnsworth
had any basis in the DMAA contract. We further hold that the
DMAA “contract value” termination payments included in
petitioners’ income are subject to self-employment tax under
section 1401.
FINDINGS OF FACT
Most of the facts have been stipulated and are so found.
The stipulation of facts and related exhibits are incorporated by
this reference.
Petitioners were residents of Redding, California, when they
filed their petition. Petitioners are married and filed a joint
Federal income tax return, Form 1040, U.S. Individual Income Tax
Return for the taxable year 1995.
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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On April 18, 1954, petitioner Orin F. Farnsworth (Mr.
Farnsworth), formerly known as Jose Farnsworth, married Gloria
Farnsworth, from whom he is now divorced.
From 1956 through part of 1962, Mr. Farnsworth was employed
as an agent of Farmers Insurance Group2 (Farmers) in El Paso,
Texas, selling home, commercial casualty and life insurance.
In 1962, Mr. Farnsworth, Gloria Farnsworth, and their family
moved to Chico, California. From 1962 through part of 1966, Mr.
Farnsworth worked as a division agency manager for Farmers in the
Chico, California, area.
On September 30, 1966, Mr. Farnsworth applied to become a
district manager with Farmers. On November 1, 1966, Farmers and
Mr. Farnsworth entered into the DMAA, under which he was
appointed district manager for district number 98-26, in Redding,
California. The DMAA between Mr. Farnsworth and Farmers was
effective, including addenda, from its execution on November 1,
1966 through Mr. Farnsworth’s retirement on January 31, 1995.
Under the DMAA, Farmers agreed to pay Mr. Farnsworth an
“overwrite” on all business produced by agents of Farmers within
district number 98-26. An “overwrite” is a percentage of the
commissions earned by the sales agents supervised by the district
2
Farmers Insurance Group (Farmers) is a collection of
companies which, during 1966, included Farmers Insurance
Exchange, Truck Insurance Exchange, Fire Insurance Exchange, Mid-
Century Insurance Co., and Farmers New World Life Insurance Co.
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manager. Under the DMAA, Farmers also provided certain benefits
to Mr. Farnsworth, including life and health insurance, in
accordance with Farmers’s rules. Mr. Farnsworth, in return,
agreed to recruit and train as many agents acceptable to Farmers
as might be required to produce sales in accordance with the
goals and objectives established by Farmers; to actively
represent only Farmers; to conform to Farmers’s regulations and
operating principles; to maintain in full force and effect any
required licenses; to provide service to policyholders through
the agents; to maintain and make available for audit by Farmers
adequate records, including profit and loss statements; and to
surrender on cancellation or termination of the DMAA agreement
all records, levy lists, cards, books, manuals, papers, forms, or
other material of whatsoever kind, and all copies thereof, having
to do with the business of Farmers. Farmers had the exclusive
right to decrease or otherwise change overwrite rates, schedules
or classifications.
The DMAA was terminable by either Farmers or Mr. Farnsworth
without cause on 30 days’ notice. The DMAA was also terminable
immediately by Farmers for cause on specified grounds.
The DMAA provided that upon cancellation by either party
without cause or as a result of Mr. Farnsworth’s death, Farmers
would have the right to pay Mr. Farnsworth the “contract value”
and terminate the contract. If Farmers did not exercise its
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right to pay “contract value”, Mr. Farnsworth or his estate could
attempt to sell his district manager position to a successor
nominee acceptable to Farmers for an amount not exceeding
"contract value".
The amount of the "contract value" referred to in the DMAA
was based upon a schedule that took into account (1) the service
commission overwrite paid to the district manager during the 6
months immediately preceding termination, and (2) the number of
years of service completed by the district manager. In the case
of Mr. Farnsworth, who had worked for more than 20 years as a
district manager at the time of termination, the DMAA provided
for a “contract value” of seven times the last 6 months’ service
commission overwrite.
The DMAA specified that all lists and records of any kind
pertaining to policyholders or expirations, and also the
information contained therein, were the secret and confidential
property of Farmers and were never to be used or divulged by Mr.
Farnsworth. All policy rights remained the property of Farmers.
Mr. Farnsworth had no rights or privileges in the continuing
effectiveness of the policies produced for Farmers. Mr.
Farnsworth had no interest, assignable or otherwise, in the
district or in the DMAA, except as to the “contract value”
payments upon termination without cause.
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On November 1, 1966, Mr. Farnsworth and Farmers signed an
addendum to the DMAA, amending his concurrently signed DMAA.
The November 1, 1966, addendum to the DMAA reduced Mr.
Farnsworth’s overwrite commissions to the portion of the
overwrite in excess of $935 per month. The monthly reduction in
the overwrite payable to Mr. Farnsworth is commonly referred to
as the “retention amount”. Under the terms of the addendum, the
retention amount was to be withheld for the first 120 months of
the contract (10 years). Commencing with the 121st month, the
retention would be reduced or eliminated if Farmers, in its
discretion, determined that Mr. Farnsworth’s performance
warranted the reduction.
A second addendum to the DMAA, entered into by Farmers and
Mr. Farnsworth on February 6, 1968, reduced the “retention
amount” from $935 per month to $605 per month, but extended the
term of the retentions to the 178th month of the contract
(approximately 15 years from inception of the contract).
Commencing with the 178th month, the retention would be reduced
or eliminated if Farmers, in its discretion, determined that Mr.
Farnsworth’s performance warranted the reduction.3
3
The stipulation of facts between petitioner and respondent
mischaracterized the retention amounts as commencing, rather than
terminating or being reduced, on the 121st and 178th month of the
DMAA, respectively. The addenda make clear, however, that the
retention amounts were to be withheld commencing immediately, and
were to continue until the 121st and 178th month, respectively,
(continued...)
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In order to reimburse itself for the cost of paying
“contract value” to retiring district managers (rather than
requiring the retiring managers to sell their interests to the
replacement managers), Farmers began in 1965 to impose retention
amounts on its new district managers. The retention amounts
withheld by Farmers from the compensation it paid to a new
district manager were not used to fund deferred compensation to
the new district manager upon retirement. Instead Farmers used
the retention amounts to reimburse itself for the cost of paying
“contract value” retirement benefits to the retiring manager.
Farmers conditioned the new district manager’s right to receive
“contract value” benefits from Farmers at retirement on his
agreement to have retention amounts withheld.
In issuing a Form 1099 reporting income to a district
manager, Farmers would take the commission overwrite earned by
the district manager and then deduct any “retention amount”
withheld from the district manager’s earnings to arrive at the
gross income of the district manager. During the entire time
3
(...continued)
and we so find. See Cal-Maine Foods, Inc. v. Commissioner, 93
T.C. 181, 195 (1989). The total payments under both addenda
would have been approximately equal. The first addendum called
for retentions of $935 per month for 120 months, totaling
approximately $112,200. Assuming the retentions called for under
the first addendum were withheld until the effective date of the
second addendum, there would have been retentions of $935 per
month for 17 months, followed by retentions of $605 per month for
the remaining 160 months, totaling $112,695.
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that Mr. Farnsworth worked as a district manager, Farmers
maintained standard accounting practices nationwide, under which
it did not report any “retention amounts” as income to its
district managers.
During that same time, Mr. Farnsworth did not treat the
retention amounts as income and did not pay income taxes on the
retention amounts.
Mr. Farnsworth and Gloria Farnsworth were divorced on
November 8, 1988, pursuant to a marital settlement agreement
filed in the California Superior Court. Gloria Farnsworth is not
a party to this proceeding. Under the terms of the marital
settlement agreement, Mr. Farnsworth assigned to Gloria
Farnsworth 32.91 percent of his right to contract value under the
DMAA.
In July 1989, the Farmers Insurance Group Federal Credit
Union approved a loan to Mr. Farnsworth of $25,001 secured by an
assignment of Mr. Farnsworth’s “contract value” in the DMAA. In
May 1991, Mr. Farnsworth agreed to guarantee a loan by Farmers to
Fred Fourby, an agent of the company, secured by Mr. Farnsworth’s
right to “contract value” upon termination of the DMAA. Mr.
Farnsworth retired from Farmers on January 31, 1995. At Mr.
Farnsworth’s retirement, his “contract value” under the DMAA was
$761,740. Farmers deducted from the full “contract value” of
$761,740 (1) the outstanding Credit Union loan balance of
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$20,513.68, and (2) the remaining balance of $5,196.53 on the
Fredy Fourby loan guaranty, resulting in a net "contract value"
of $736,029.79.
Pursuant to the DMAA and the divorce decree,
Farmers made the following “contract value” payments during
taxable years 1995 and 1996:
Orin Gloria
Farnsworth Farnsworth Total
Mar. 2, 1995 $161,780.38 $83,562.88 $245,343.26
July 31, 1995 161,780.38 83,562.88 245,343.26
Jan. 31, 1996 161,780.39 83,562.88 245,343.27
Total 485,341.15 250,688.64 736,029.79
Petitioners reported a taxable gain of $263,156 on Form
4797, Sales of Business Property, and Form 6252, Installment Sale
Income, attached to their Form 1040 for taxable year 1995.
Petitioners reported the total gross “contract value”, amounting
to $761,740, which amount included: (1) All payments made to Mr.
Farnsworth in taxable years 1995 and 1996; (2) all payments made
to Orin Farnsworth's former wife, Gloria Farnsworth; (3) the
canceled credit union loan valued at $20,513.68, which was offset
by Farmers; and (4) the Fred Fourby loan guaranty of $5,196.53,
which was also offset by Farmers.
Petitioners reduced the gross “contract value” of $761,740
by $373,560 for “cost or other basis of property sold”. The
“cost or other basis” claimed by petitioners consisted of the
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entire $250,689 (rounded) which Farmers paid from the “contract
value” directly to Gloria Farnsworth during 1995 and 1996, and an
additional $122,871 in alleged basis, leaving a reported gross
profit of $388,180.
Petitioners reported on Form 6252 receiving $516,397 in
“contract value” payments in 1995, consisting of: (1) $323,560
of “contract value” received by Mr. Farnsworth; (2) $167,126 of
“contract value” received by Gloria Farnsworth; (3) the canceled
credit union loan of $20,514 (which was apparently repaid by
Farmers out of the contract value); and (4) the $5,197 Fred
Fourby loan guaranty (which was apparently also repaid or
withheld by Farmers).
Using Mr. Farnsworth’s and Gloria Farnsworth’s relative
shares of total contract receipts, petitioners reported a gross
profit percentage of 50.96 on Form 6252. For 1995, on the basis
of total payments reportedly received by Mr. Farnsworth and
Gloria Farnsworth of $516,397, petitioners reported taxable
installment sale income for the year of $263,156 (50.96 percent x
$516,397 = $263,156).
Respondent's notice of deficiency disallowed the reduction
from “contract value” for the payments made by Farmers directly
to Gloria Farnsworth, disallowed the reduction of Mr.
Farnsworth’s claimed recovery of basis in the DMAA, and
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determined that the “contract value” payments are subject to
self-employment tax under section 1401.
Respondent’s answer concedes that the $167,126 in “contract
value” paid by Farmers directly to Gloria Farnsworth during 1995
should be taxable to Gloria Farnsworth and not to petitioners.
OPINION
Issue 1. Are Petitioners Entitled To Exclude From Income, As a
Recovery of Basis, Any Portion of the DMAA Payments They Received
in 1995?
Petitioners have the burden of proof to establish the amount
of Mr. Farnsworth’s basis, if any, in the DMAA contract. See
Rule 142 (burden of proof generally on petitioner); Martin Ice
Cream Co. v. Commissioner, 110 T.C. 189, 220 (1998) (Court
accepted Commissioner’s determination that taxpayer had no basis
in stock where taxpayer failed to introduce evidence to establish
basis in stock); Reinberg v. Commissioner, 90 T.C. 116, 142
(1988) (petitioners not entitled to depreciation deductions
because they failed to meet burden of proof by establishing
basis).
Petitioners argue that Mr. Farnsworth has basis in the DMAA
contract because he treated the retention amounts as income on
his Federal income tax returns. Petitioners failed to introduce
any documentary evidence to support their contention.
Petitioners do not have copies of Mr. Farnsworth’s Federal income
tax returns from the relevant years to show that he reported as
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taxable income any of the “retention amounts” withheld by
Farmers.
Mr. Farnsworth’s testimony regarding the retention amounts
was vague and inconsistent with the provisions of the DMAA and
the addenda. Mr. Farnsworth claims to have a basis in the DMAA
of $86,000. He testified that Farmers withheld retention amounts
for 6 years. Yet the documentary evidence shows originally
required retentions of $935, which were thereafter reduced to
$605 per month. Retentions of $935 per month for 6 years would
total only $67,320, substantially less than the $86,000 basis
petitioners claimed. The reduced retention of $605 per month
beginning in March 1968 for the remainder of the 6-year period
would have resulted in total retentions of only $49,170.4 Mr.
Farnsworth was unable to explain the discrepancies between his
recollection of the facts, the basis he claimed, and the terms of
the addenda. Mr. Farnsworth admitted that he had no
documentation to show the amount that Farmers actually retained.
The only evidence offered to support Mr. Farnsworth’s claim that
he has basis in the DMAA was his self-serving testimony,
testimony that was based on his recollection of events 25 to 30
years before the trial.
4
Payments of $935 per month for 17 months from November 1966
to March 1968, plus the remaining 55 months of payments at $605
per month, for a total of 72 months of payments (6 years).
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Mr. Farnsworth also claimed that the retention amounts
included interest (at a rate he does not recall), which he
deducted. Presumably, Mr. Farnsworth’s basis would be less than
the $67,320 or $49,170 if some portion of the monthly retention
amounts included interest that he deducted. Mr. Farnsworth’s
testimony showed that he did not clearly recollect the facts, and
that the amount claimed as “basis” was, at best, a very rough
estimate.
Petitioners offered no reliable evidence upon which the
Court could determine the actual retention amounts withheld by
Farmers. Mr. Farnsworth has asserted that the terms of the
addenda were not followed, but he has failed to provide any
credible evidence of the amounts actually retained by Farmers.
Petitioners have thus failed to meet their burden of establishing
the retention amounts with credible evidence.
While we should not disallow entirely all amounts because
only some amounts have been proven, see Cohan v. Commissioner, 39
F.2d 540, 543 (2d Cir. 1930), “the basic requirement is that
there be sufficient evidence to satisfy the trier that at least
the amount allowed in the estimate was in fact spent or incurred
for the stated purpose. Until the trier has that assurance from
the record, relief to the taxpayer would be unguided largesse.”
See Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).
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In the case at hand, petitioners have failed to convince us
of a specific amount that was withheld as retentions. We know
that the contractual terms were not followed, that no reliable
documentary evidence is available to establish the true retention
amounts, and that Mr. Farnsworth’s testimony concerning the
retention amounts satisfies neither the rules of arithmetic nor
the laws of probability.
More importantly, even if petitioners had established the
retention amounts, petitioners have failed to establish by a
preponderance of the evidence that the retention amounts were
included in Mr. Farnsworth’s taxable income. In order for the
retention amounts to give Mr. Farnsworth a basis in the DMAA,
petitioners would have to establish that Mr. Farnsworth reported
the retention amounts as income for the years in which they were
withheld; otherwise the retention amounts would not constitute a
cost of his interest in the DMAA that would be taken into account
for income tax purposes. See sec. 1012 (basis of property is
cost); Gertz v. Commissioner, 64 T.C. 598 (1975) (disallowing bad
debt deduction for unpaid wages that were never included in
income).
Petitioners offered no evidence, other than Mr. Farnsworth’s
self-serving testimony, to show that Mr. Farnsworth previously
included the retention amounts in income.
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Respondent called Carl Earl Diltz, Jr., to explain Farmers’s
policy regarding the tax treatment of retention amounts. Mr.
Diltz was employed by Farmers in its accounting department for 36
years and is now retired. Mr. Diltz began his career at Farmers
as an accounting clerk in 1959 and ended his career in 1995 as
director of accounting for the entire company. Mr. Diltz was
thoroughly familiar with Farmers’s DMAA contracts, including the
terms, dates that the terms were changed, and the reasons why the
terms were changed. Mr. Diltz’s testimony was highly credible.
Mr. Diltz testified that Farmers always reduced the amount
of income to the district managers reported on the Forms 1099 by
the retention amounts, and that Farmers did not treat the
retention amounts as taxable income to the managers under the
DMAAs:
Q. [D]uring your tenure from * * * 1959 to 1995 when
you retired, was it ever Farmers procedure to report
those retention amounts as income to district managers?
A. No.
Mr. Diltz also testified that Farmers’s procedures were
consistently followed on a nationwide basis, and that it was his
“primary responsibility as a director to develop those procedures
and to see that all 16 offices were doing exactly the same
thing”. We therefore have found that Farmers did not report the
retention amounts as income to Mr. Farnsworth.
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We sustain respondent’s determination denying petitioners
any reduction in income attributable to Mr. Farnsworth’s claimed
basis in the DMAA. Petitioners have established neither the
amount of the retentions nor that any such retentions would
bestow on Mr. Farnsworth a basis in the DMAA.
Issue 2. Are the DMAA Payments Subject to Self-Employment Tax?
The self-employment tax was enacted in 1950 to finance the
extension of Social Security benefits to self-employed
individuals. Social Security Act Amendments of 1950, ch. 809, 64
Stat. 477; S. Rept. 1669, 81st Cong., 2d Sess. (1950), 1950-2
C.B. 302, 307-308, 352-353.
Section 1402(a) defines self-employment earnings as “gross
income derived by an individual from any trade or business
carried on by such individual”.
The seminal case considering the meaning of the “carried on”
requirement is Newberry v. Commissioner, 76 T.C. 441 (1981), in
which this Court held that business interruption insurance
proceeds paid to the owner of a grocery store destroyed by fire
were not subject to self-employment tax. The Commissioner argued
in Newberry that business interruption insurance proceeds were a
substitute for the business income that would have been earned
but for the fire that destroyed the grocery store. The income
that would have been earned but for the fire would have been
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subject to self-employment tax. Therefore, the Commissioner
argued, so should the insurance proceeds.
This Court rejected the Commissioner’s argument, holding
“that there must be a nexus between the income received and a
trade or business that is, or was, actually carried on”. Id. at
444. Since the insurance proceeds were received not from the
operation of the business, but rather because of the nonoperation
of the business, we held that the proceeds were not subject to
self-employment tax.
The comparable statutory terms--carrying on a trade or
business and rendering services--suggests to us that
any income must arise from some actual (whether
present, past or future) income-producing activity of
the taxpayer before such income becomes subject to
either FUTA, FICA, or self-employment taxes, as the
case may be. * * * [Id. at 446.]
From this small seed has grown a great tree of self-
employment tax jurisprudence, a tree with many branches. One
large branch of the tree is made up of cases concerning insurance
company agent and manager termination payments.
One of the principal cases addressing whether insurance
company agent termination payments are subject to self-employment
tax is Milligan v. Commissioner, 38 F.3d 1094 (9th Cir. 1994),
revg. T.C. Memo. 1992-655, in which the Court of Appeals for the
Ninth Circuit, to which the case at hand would be appealable,
reversed a decision of this Court. The taxpayer in Milligan, a
former State Farm insurance agent, received termination payments
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upon retirement. Under the State Farm agreement, the taxpayer
was entitled to 5 years of termination payments based on a fixed
percentage of his final year’s commissions. The taxpayer was
eligible for termination payments only if the termination
occurred more than 2 years after the contract was entered into.
The termination payments were also subject to reduction for
refundable commissions that had already been earned by the
taxpayer on policies that were canceled during the year following
termination. The reductions were called “chargebacks”.
This Court held, in a Memorandum Opinion, that the
termination payments were subject to self-employment tax because
the payments were “derived”, in the dictionary meaning of the
word, from petitioner’s prior employment. The termination
payments were found to be analogous to the payment of future
commissions on policies written during the term of the contract,
which had been held subject to self-employment tax in Becker v.
Tomlinson, 9 AFTR 2d 1408, 62-1 USTC par. 9446 (S.D. Fla. 1962):
We find that Termination Payments are the
equivalent of the deferred compensation which a State
Farm agent, active or retired, would receive from
policies sold in prior years. On this basis, we hold
that Termination Payments are derived from self-
employment, even though they are received in years
subsequent to the activity which generated them.
[Milligan v. Commissioner, T.C. Memo. 1992-655.]
In reversing the Tax Court’s decision in Milligan, the Court
of Appeals for the Ninth Circuit held that “to be taxable as
self-employment income, earnings must be tied to the quantity or
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quality of the taxpayer’s prior labor, rather than the mere fact
that the taxpayer worked or works for the payor.” Milligan v.
Commissioner, 38 F.3d at 1098.
The Court of Appeals found that the taxpayer’s earnings were
not tied to the quantity of his prior labor. The Court of
Appeals ruled that the 2-year qualification requirement related
only to the taxpayer’s eligibility for termination payments; the
payment amounts did not depend on the taxpayer’s length of
service beyond the period of eligibility. The Court of Appeals
pointed out that it did not matter whether the taxpayer had
worked for State Farm for 2 years or 20--the payments would in
either case be the same. Because the payment amounts did not
depend on the length of service or overall earnings, the payments
were not tied to the quantity of the taxpayer’s services.
In the same vein, the Court of Appeals held that the
termination payments did not depend on the quality of the
taxpayer’s prior service. The Court of Appeals recognized that
the payments were based on the taxpayer’s final year’s
commissions. According to the Court of Appeals, “At most, the
amount of the Termination Payments, not the payments themselves,
actually arose from Milligan’s business activity.” Id. at 1099.
The Court of Appeals went on to note that even the amount was not
entirely related to Milligan’s prior earnings, because of the
potential for chargebacks based on future policy cancellations
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over which Milligan had no control. Because these chargebacks
were entirely unrelated to Milligan’s business activity, the
Court of Appeals held that the payments were not tied to the
quality of the taxpayer’s prior services. The Court of Appeals
in Milligan therefore concluded that the termination payments did
not derive from the “carrying on” of the taxpayer’s trade or
business and so were not subject to self-employment tax.
In Gump v. United States, 86 F.3d 1126 (Fed. Cir. 1996), the
Court of Appeals for the Federal Circuit followed Milligan in a
virtually identical factual situation involving the “extended
earnings” of a Nationwide Insurance Co. agent. As in Milligan,
the taxpayer in Gump was entitled to receive upon termination of
his agency contract a percentage of his final year’s earnings if
he had performed services under the contract for more than 5
years. The earnings were subject to reduction for policy
cancellations occurring in the 2 years after termination.
Following Milligan, the Court of Appeals for the Federal Circuit
held that the payments were not based on the “quantity or
quality” of the taxpayer’s prior services and therefore were not
subject to self-employment tax. The Court of Appeals for the
Federal Circuit explained in Gump the reason for the rule as
follows:
Thus, the extended earnings are not unpaid renewal
commissions, they are computed by reference to renewal
commissions--a reasonable indicator of the value of
Gump’s insurance business at the time he relinquished
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control of it. The amount is unaffected by his income
during any prior period, by the total number of
policies written over his career, by the total time
period he served as an agent, or even by the length of
his service to Nationwide. In other words, the amount
is not “tied to the quantity or quality” of his labor
in any meaningful way. [Id. at 1130.]
An offshoot of the tree sprouted in Schelble v.
Commissioner, 130 F.3d 1388 (10th Cir. 1997), affg. T.C. Memo.
1996-269. There, the “extended earnings” of an American Family
Life Insurance Co. independent agent were held to be subject to
self-employment tax. Both the Tax Court and the Court of Appeals
for the Tenth Circuit distinguished Milligan on its facts, on the
ground that the payments to the taxpayer in Schelble depended on
the quantity and quality of his prior self-employment services.
In general, the extended earnings payments were
calculated based on a percentage of the renewal service
fees paid to the agent during the six- or twelve-month
period preceding the month the Agreement terminated.
The percentage was based upon the agent’s length of
consecutive service for the Companies immediately
preceding termination of the Agreement. * * * [Id. at
1390.]
Unlike Milligan, the amount of termination payments to be
received by the taxpayer in Schelble depended on the length of
his service to the insurance company and were tied entirely to
his earnings during the 12-month period prior to termination
without being subject to any posttermination adjustments for
events outside of his control (such as, in Milligan, chargebacks
for policy cancellations after termination of the agreement).
The Court of Appeals in Schelble distinguished Milligan and held
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that “Mr. Schelble’s payments are tied to the quantity and
quality of his prior services performed for the Companies.” Id.
at 1393.
The Court of Appeals in Schelble also distinguished Gump v.
Commissioner, supra. Id. The “extended earnings” payments in
Gump were calculated in the same way as the termination payments
in Milligan and differently from the “extended earnings” in
Schelble. The Court of Appeals for the Tenth Circuit rejected
the taxpayer’s suggestion that the label attached to the payments
has any tax significance.
However, the payment scheme in Gump is nearly identical
to that in Milligan and distinguishable from Mr.
Schelble’s payment scheme. For the same reasons we
reject Milligan, we also find Gump does not apply [to]
Mr. Schelble’s case. [Schelble v. Commissioner, supra
at 1393-1394.]
In Jackson v. Commissioner, 108 T.C. 130 (1997), the Tax
Court, in a reviewed opinion, followed Milligan in a case that
would not have been appealable to the Court of Appeals for the
Ninth Circuit. Like Milligan, Jackson involved termination
payments to a State Farm agent under a contract providing for a
2-year qualification period, payments based on a fixed percentage
of the final-year’s compensation without regard to the length of
service, and a reduction for commission chargebacks on policies
canceled after termination. Following Milligan, this Court held
that the termination payments were not subject to self-employment
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tax because the payments were not tied to the “quantity or
quality” of the employee’s services.
This Court in Jackson also recognized the factual
distinction identified in Schelble: where the termination
payments are tied to the quantity or quality of the taxpayer’s
prior services, the payments will be subject to self-employment
tax. Jackson v. Commissioner, supra at 136.
In Lencke v. Commissioner, T.C. Memo. 1997-284, after
distinguishing the facts from those in Milligan and Jackson, this
Court held that payments in lieu of renewal commissions to which
an insurance agent would otherwise be contractually entitled are
subject to self-employment tax because the payments retain the
character of the renewal commissions they replaced.
Congress, in section 1402(k), codified the standard
established in Milligan with respect to termination payments made
after December 31, 1997, to an “insurance salesman”. Taxpayer
Relief Act of 1997, Pub. L. 105-34, sec. 922(a), 111 Stat. 879-
880. Section 1402(k) exempts insurance salesman termination
payments from self-employment tax if, among other things, the
amount of the payments “does not depend to any extent on length
of service or overall earnings from services performed for such
company (without regard to whether eligibility for payment
depends on length of service).” Sec. 1402(k)(4)(B). The parties
agree that section 1402(k) does not apply to the case at hand,
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because Mr. Farnsworth was not an “insurance salesman”, and
because the payments were made in 1995, before the effective date
of the statute. However, the legislative history of section
1402(k) makes it clear that the provision was intended to codify
existing law.5
Factually, the case at hand is like Schelble, and unlike
Jackson, Gump, and Milligan, because the amount of Mr.
Farnsworth’s termination payments depended on the length of his
relationship with Farmers. Mr. Farnsworth’s “contract value”
referred to in the DMAA was based upon a schedule that took into
account the number of years of service completed by the district
manager. This was more than a one-step eligibility requirement.
The longer the taxpayer’s tenure as district manager, the higher
the percentage of the taxpayer’s final 6 months’ earnings that
was used to compute “contract value”. The amount varied between
three times the last 6 months’ service commission overwrite for a
district manager with 5 years of service to seven times the last
6 months’ service commission overwrite for a manager who had, as
5
After citing Jackson v. Commissioner, 108 T.C. 130 (1997),
Gump v. United States, 86 F.3d 1126 (Fed. Cir. 1996), and
Milligan v. Commissioner, 38 F.3d 1094 (9th Cir. 1994), revg.
T.C. Memo. 1992-655, the Conference Committee report states:
“The House bill codifies case law by providing that net earnings
from self-employment do not include any amount received during
the taxable year from an insurance company on account of services
performed by such individual as an insurance salesman for such
company”. H. Conf. Rept. 105-220 at 458 (1997), 1997-4 C.B.
(Vol. 2) 1457, 1927-1929.
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Mr. Farnsworth did, 20 or more years of service as a district
manager.
Moreover, unlike the taxpayers in Jackson, Gump, and
Milligan, the payments to which Mr. Farnsworth was entitled were
not subject to reduction for events unrelated to his services and
occurring after termination.
There is also evidence in the record to suggest a
significant relationship between Mr. Farnsworth’s rights under
the DMAA to recover “contract value” at termination and his
agreement at inception of the DMAA to have the retention amounts
withheld. Mr. Diltz testified that the retention amounts were
imposed in order to enable Farmers to recover from a successor
manager the cost of paying “contract value” to the retiring
manager replaced by the successor. Prior to the requirement for
the successor manager to have retention amounts withheld, there
was no provision for the payment of contract value upon
termination. While there is no relationship between the new
manager’s retention amount and the “contract value” amount
(because the retention amount is based on the former manager’s
contract value), the successor manager’s right to contract value
upon his retirement was conditioned upon his agreement to have
the retention amounts withheld. There was thus a causal
relationship between the right to contract value and the
retention requirement. The causal relationship between Mr.
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Farnsworth’s agreement to allow his overwrite commissions to be
reduced by retentions and his right to recover “contract value”
upon termination creates an additional nexus between the
termination payments and his prior employment.
Because, as in Schelble v. Commissioner, 130 F.3d 1388 (10th
Cir. 1997), the contract value payments to Mr. Farnsworth were
based on the quantity (length of service) and quality (final 6
months’ earnings without reduction for post termination events)
of the services rendered by Mr. Farnsworth, and because of the
causal relationship between retentions and the right to “contract
value” payments at termination, Farmers’s contract value payments
to Mr. Farnsworth are subject to self-employment tax.
Petitioners attempt to distinguish Schelble on three
grounds. First, petitioners argue, without citation of
authority, that the holding of Schelble should not apply to the
case at hand because the taxpayer was an insurance agent, while
Mr. Farnsworth was a district manager. Petitioners fail to
explain how a difference in Mr. Farnsworth’s title or duties
would make any difference in the result. The fact remains that
there is a sufficient nexus between the payments and Mr.
Farnsworth’s self-employment services to cause the payments to be
subject to the self-employment tax.
Second, petitioners argue that the payments in Schelble were
“based on the future commissions the Agent would have earned if
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the Agent had stayed with the insurance company”. The
termination payments in Schelble were based on a percentage of
the renewal commissions paid during the final months of the
contract. One of Schelble’s companies paid between 50 percent
and 150 percent of the commissions for the final 12 months of
service, while the other company paid between 50 percent and 100
percent of the commissions for the final 6 months of service. In
both cases, the percentage depended on the length of the agent’s
term of service. Petitioners argue that the holding in Schelble
should not apply to the case at hand, where the termination
payments are based on prior earnings rather than future
commissions. Again, we reject petitioners’ argument. In
Newberry v. Commissioner, 76 T.C. 441, 444 (1981), we held that
it does not matter whether the income arises from a “past,
present, or future income-producing activity”. See also
Schumaker v. Commissioner, 648 F.2d 1198, 1200 (9th Cir. 1981)
(self-employment income determined from source of income, not
taxpayer’s status when income realized); sec. 1.1402(a)-1(c),
Income Tax Regs. (self-employment income may include payments
received from services provided in a prior taxable year).
Finally, petitioners argue that the termination payments
should be treated as gain or loss from the sale of property under
section 1402(a)(3)(C), rather than as ordinary self-employment
income. Following a long line of authority, we held in Clark v.
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Commissioner, T.C. Memo. 1994-278 and Lowers v. Commissioner,
T.C. Memo. 1991-75, that the “contract value” payments upon
termination of a Farmers DMAA constitute ordinary income and not
capital gains from the sale of property. In Clark we stated:
Under the 1967 Agreement, all * * * rights or
privileges for the continuing effectiveness of policies
produced on behalf of any of the Companies, including
all records pertaining thereto, were and should at all
times remain the property of Farmers. The short answer
is that petitioner transferred nothing to Farmers. The
contract with Farmers was not sold or exchanged, but
was terminated. On December 31, 1986, petitioner’s
services as a Farmers district manager came to an end.
The local agents that petitioner had obtained for
Farmers remained, as before, local agents of Farmers.
* * *
See also Deal v. Commissioner, T.C. Memo. 1973-49 (ordinary
income treatment for termination payment by Farmers under earlier
form of Farmers DMAA).
Like the taxpayers in Clark, Lowers, and Deal, Mr.
Farnsworth did not sell any property to Farmers. Farmers owned
all the business property used by Mr. Farnsworth. The DMAA
between Mr. Farnsworth and Farmers provides:
The District Manager understands and agrees that all
lists and records of any kind pertaining to
policyholders or expirations, and also the information
contained therein, are the secret and confidential
property of the Companies and shall never be used or
divulged, except as specifically authorized by, and for
the benefit of, the Companies.
The payments Mr. Farnsworth received were expressly in
consideration for the termination of the DMAA contract; the
payments were not made in return for the transfer of specific
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property owned by him. Neither in form nor substance was the
transaction at issue a sale of property by Mr. Farnsworth.
The “contract value” termination payments to Mr. Farnsworth
under the DMAA are subject to self-employment tax.
To reflect concessions of the parties,
Decision will be entered
under Rule 155.