T.C. Memo. 2002-305
UNITED STATES TAX COURT
EDGAR L. AND JOAN H. PARKER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5732-01. Filed December 16, 2002.
P, self-employed, worked under contract as a
district manager for F, a group of insurance companies.
F canceled P’s contract and paid P an amount designated
“Contract Value”, based on the quantity (length of
service) and quality (final 6 months’ earnings) of the
services rendered by P to F. P failed to pay self-
employment tax with respect to the Contract Value,
claiming that it constituted a capital gain.
Held: The contract value is subject to the tax on
self-employment income and is not capital gain.
Robert B. Alexander, for petitioners.
Donna M. Palmer, for respondent.
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MEMORANDUM OPINION
HALPERN, Judge: By notice of deficiency dated February 22,
2001 (the notice), respondent determined deficiencies in
petitioners’ Federal income taxes of $58,127, $22,433, and
$11,221 for their taxable (calendar) years 1996, 1997, and 1998,
respectively.
The issue for decision is whether certain payments received
by petitioner Edgar L. Parker (petitioner) are ordinary income
subject to self-employment taxation or are capital gains income,
which is not subject to self-employment taxation. We conclude
that the payments are ordinary income subject to self-employment
taxation.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue.
Some facts have been stipulated and are so found. The
stipulation of facts, with accompanying exhibits, is incorporated
herein by this reference. We need find few facts in addition to
those stipulated and shall not, therefore, separately set forth
our findings of fact. We shall make additional findings of fact
as we proceed.
Background
At the time the petition was filed, petitioners resided in
Kingwood, Texas.
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On September 1, 1985, petitioner, previously an insurance
agent, was appointed a district manager by a group of insurance
companies, Farmers Insurance Companies (the companies). To
accomplish the appointment, petitioner and the companies executed
a document entitled “District Manager’s Appointment Agreement”
(the agreement). As a district manager, petitioner could not
personally sell insurance policies but recruited, trained, and
supervised agents within his district to do so. As a district
manager, petitioner was not treated as an employee by the
companies.
Pursuant to the agreement, petitioner received a service
commission overwrite on all business produced by the companies’
agents within his district. A service commission overwrite is a
specified commission paid to a district manager based on each
insurance policy sold and on renewals of policies sold by the
supervised agents. The agreement states that either the
companies or petitioner can cancel it on 30 days’ written notice,
and any service commission overwrites unpaid as of the date of
cancellation are deemed unearned, with petitioner’s rights with
respect to such commissions being deemed waived.
Petitioner had completed 11 years of service as a district
manager when he received written notice that the companies were
canceling the agreement. The agreement was canceled as of
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September 16, 1996. In part, the agreement provides the
following with respect to cancellation:
E. In the event of cancellation * * * of the agency
created hereby for any reason whatsoever, * * *
(1) the Companies may at their option elect to pay
“Contract Value”, as hereinafter defined, to the
District Manager, his/her personal representative
or heirs, or (2) the Companies agree to give
consideration to a written nomination of his/her
successor by the District Manager, or in case of
the District Manager’s death, by his/her heirs or
personal representative, provided such nominee is
in all respects acceptable to the Companies.
If the Companies do not elect to pay “Contract
Value” it is agreed that the District Manager, or
his/her heirs or personal representative, may
negotiate with such nominee for compensation in an
amount not exceeding “Contract Value” for the
nomination and the District Manager’s interest
under his/her Appointment Agreement. * * *
* * * * * * *
CONTRACT VALUE
“Contract Value” will be based upon (1) the service
commission overwrite paid to the District Manager
during the six months immediately preceding
termination, and (2) the number of years of service as
District Manager for the Companies in this district all
in accordance with the following schedule:
SCHEDULE
* * * * * * *
7. 10 or more years as a District Manager-–5 times
the last 6 months’ service commission overwrite.
* * * * * * *
Payment of “Contract Value” by either the Companies or
the nominee will be based on the following schedule:
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* * * * * * *
E (7) Above – Four equal semi-annual installments.
* * * * * * *
The District Manager agrees to transfer and assign all
of his/her interest under the District Manager
Appointment Agreement and his/her agency to the nominee
acceptable to the Companies, or to the Companies
themselves in the event they elect to pay the “Contract
Value” as hereinabove provided, and further agrees that
for a period of three years from date of said
cancellation * * * he/she will neither directly nor
indirectly in any manner solicit, accept or service,
for or on behalf of himself/herself or any insurer or
broker, the insurance business of any policyholder of
any of the Companies within the County or Counties in
which the district is located and all Counties
immediately adjoining.
The agreement also obligates petitioner to surrender to the
companies on cancellation of the agreement all records and other
materials having to do in any manner with the business of the
companies. It states petitioner’s agreement that all lists and
records pertaining to policyholders are the property of the
companies and that petitioner has no interest, assignable or
otherwise, in the “Agency” created by the agreement, except as
provided in paragraph E of the agreement (quoted in part above).
It further states that, in the event of cancellation, petitioner
will not interfere with the agency contracts of the agents or
district managers of the companies.
No provision of the agreement provides for any change in
“Contract Value”, once determined, on account of any subsequent
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event, such as policy cancellations or failures to collect
premiums.
Following cancellation of the agreement, petitioner received
payments from the companies of $439,656, $212,466, and $106,233,
in 1996, 1997, and 1998, respectively (collectively, the
payments). Petitioners reported the payments as income from an
installment sale, from the sale of “Insurance Agency”, subject to
the favorable long-term capital gains rates.
Discussion
The principal adjustments giving rise to the deficiencies in
question are respondent’s reclassifications of the payments,
reported by petitioners as installment sale gains (subject to the
favorable long-term capital gains rates), as ordinary income
subject to self-employment taxation.1 Other adjustments made by
respondent are derivative of those adjustments and are not a
matter of dispute between the parties. We have addressed
adjustments similar to the principal adjustments on other
occasions, e.g., Farnsworth v. Commissioner, T.C. Memo. 2002-29;
Schelble v. Commissioner, T.C. Memo. 1996-269, affd. 130 F.3d
1388 (10th Cir. 1997), and the rules are relatively clear. We
1
Notwithstanding that the agreement appears to contemplate
that contract value would be paid in four equal semi annual
installments, the parties appear to agree that the payments (in
their varying amounts) constitute the installment payments of
contract value. We shall proceed based on that assumption.
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need not engage in an extended discussion to dispose of this
case.
Section 1401 imposes a tax on “the self-employment income of
every individual”. Section 1402(b) defines self-employment
income as “the net earnings from self-employment”. Section
1402(a) defines self-employment earnings as “gross income derived
by an individual from any trade or business carried on by such
individual, less the deductions * * * which are attributable to
such trade or business”. Gain or loss from the sale or exchange
of capital assets or from the disposition of other property
(except for stock in trade, inventory, or property held primarily
for sale to customers in the ordinary course of business) is
excluded from the computation of net earnings from self-
employment. Sec. 1402(a)(3)(A), (C).
In Newberry v. Commissioner, 76 T.C. 441, 444 (1981), we
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.” In order to
satisfy the nexus standard, the “income must arise from some
actual (whether present, past, or future) income-producing
activity”. Id. at 446.
During the 11-plus years that petitioner was a district
manager for the companies, his business consisted principally of
recruiting, training, and supervising insurance agents, and he
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was compensated exclusively by commissions based on the business
produced by those agents. Petitioner’s relationship with the
companies was governed by the agreement, and once the agreement
was canceled, petitioner had no right to any further commissions.
He was, however, paid an amount denominated “Contract Value”
(contract value), which was based on the commissions paid him
during the 6 months immediately preceding the cancellation of the
agreement and the number of years of his service as district
manager. That amount was not subject to any change once
determined. Petitioners do not dispute that, during petitioner’s
tenure as a district manager, he was a self-employed individual
engaged in the business of managing a district for the companies.
They do argue that the contract value paid to petitioner
following cancellation of the agreement is excluded from the
computation of net earnings from self-employment since it is a
capital gain or other gain described in section 1402(a)(3)(A) or
(C).
In Schelble v. Commissioner, supra, the taxpayer was an
insurance agent (not a manager), and, on termination of his
agency agreement, he was paid “extended earnings”, which amount
was determined based on renewal commissions paid to him during
the last 6 or 12 months of his service and the number of his
years of service. Because the record showed that there was no
express agreement for the sale of any assets or any evidence of
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vendible business assets, we concluded that the taxpayer had
failed to prove that the extended earnings constituted gain from
the sale of any capital asset. We found that, because the
extended earnings “were tied to the quantity, quality, and
duration” of the taxpayer’s prior labor as an insurance agent,
there was a nexus between the payments and that business, and the
payments constituted net earnings from self-employment, subject
to the tax on self-employment income provided for in section
1401. The Court of Appeals for the Tenth Circuit affirmed,
recognizing that the extended payments were in consideration of
the taxpayer’s return of records and a covenant not to compete,
but emphasizing that the extended payments were “tied to the
quantity and quality of his prior services performed for [the
insurance companies in question]” and were not subject to
adjustment on account of any factor unrelated to his prior
service. Schelble v. Commissioner, 130 F.3d 1388, 1393 (10th
Cir. 1997). The Court of Appeals concluded: “Based on these
distinguishing factors, we conclude that Mr. Schelble’s payments
are sufficiently derived from his prior insurance business to
constitute self-employment income subject to self-employment tax
under 26 U.S.C. § 1401.” Id. The Court of Appeals dismissed the
taxpayer’s argument that he had sold a capital asset for the same
reason as the Tax Court; i.e., no evidence of vendible assets nor
any language referencing a contract of sale. Id. at 1394.
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Recently, in Farnsworth v. Commissioner, T.C. Memo. 2002-29,
we addressed cancellation payments made to a former district
manager of Farmers Insurance Group (a group of insurance
companies consisting of many of the same insurance companies that
constitute the companies). The district manager’s agreement in
that case provided for the payment of “contract value” similar to
the payment of contract value at issue here, except that, during
the taxpayer’s tenure as a district manager, “retention amounts”
were retained from commissions to reimburse Farmers Insurance
Group for payments of “Contract Value” to the district manager’s
predecessor. In Farnsworth, as in Schelble, we determined that
the payment in question was subject to self-employment tax
because it was based on the quantity (length of service) and
quality (final 6 months’ earnings without reduction for post-
termination events) of the services rendered by the taxpayer. We
found that the retention amount device provided an “additional
nexus” between the cancellation payments and the taxpayer’s prior
position as a district manager. We analyzed the provision of the
agreement in question that dealt with business property used by
the taxpayer (identical to a provision in the agreement), and
found: “The payments Mr. Farnsworth received were expressly in
consideration for the termination of the * * * contract, the
payments were not made in return for the transfer of specific
property owned by him. Neither in form nor substance was the
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transaction at issue a sale of property by Mr. Farnsworth.”
Farnsworth v. Commissioner, supra; see also Baker v.
Commissioner, 118 T.C. 452, 461-465 (2002) (termination payment
made to insurance agent not received for sale of capital assets).
The payments by the companies of contract value are subject
to the tax on self-employment income since they constitute net
earnings from self-employment. We reach that conclusion because
contract value was determined based on the quantity (length of
service) and quality (final 6 months’ earnings without reduction
for posttermination events) of the services rendered by
petitioner to the companies. That establishes a nexus between
the contract value and petitioner’s business of being a district
manager. Petitioners argue that the agreement created a
franchise, which petitioner transferred back to the companies.
The agreement contains no language establishing a franchise, nor
do we believe that the agreement, which gives petitioner the
right to render personal services as a district manager,
establishes a franchise within the meaning of section
1253(b)(1).2 See Clark v. Commissioner, T.C. Memo. 1994-278
(implicitly rejecting the argument that a district manager with
Farmers Insurance Companies relinquished a franchise in
2
Sec. 1253(b)(1) provides: “The term ‘franchise’ includes
an agreement which gives one of the parties to the agreement the
right to distribute, sell, or provide goods, services, or
facilities, within a specified area.”
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consideration of the payment of a contract value amount).
Petitioners have failed to introduce evidence of vendible assets
or show language referencing a contract of sale. That is
sufficient for us to conclude that petitioner received no payment
for any property. See Schelble v. Commissioner, T.C. Memo. 1996-
269, affd. 130 F.3d 1388 (10th Cir. 1997). We reach the same
conclusion that we reached in Farnsworth v. Commissioner, supra,
also involving a district manager’s agreement, that neither in
form nor in substance did the cancellation of the agreement give
rise to the sale of property by petitioner. See also Clark v.
Commissioner, supra.
We sustain in full the deficiencies in tax determined by
respondent.
Decision will be entered
for respondent.