T.C. Summary Opinion 2009-165
UNITED STATES TAX COURT
STEVEN LENARD AND JAMIE TEAGUE-LENARD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 27826-07S. Filed November 9, 2009.
Steven Lenard and Jamie Teague-Lenard, pro sese.
Thomas L. Fenner, for respondent.
DEAN, Special Trial Judge: This case was heard pursuant to
the provisions of section 7463 of the Internal Revenue Code in
effect when the petition was filed. Pursuant to section 7463(b),
the decision to be entered is not reviewable by any other court,
and this opinion shall not be treated as precedent for any other
case. Unless otherwise indicated, subsequent section references
are to the Internal Revenue Code in effect for the year in issue,
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and all Rule references are to the Tax Court Rules of Practice
and Procedure.
Respondent determined a deficiency in petitioners’ 2005
Federal income tax of $14,129, an addition to tax for failure to
file timely under section 6651(a)(1) of $707, and an accuracy-
related penalty under section 6662(a) of $2,826.
The parties agree that petitioners are entitled to deduct
expenses for the insurance agency business of Steven Lenard
(petitioner) of $78,952 for 2005. The parties also agree that,
without taking into consideration certain contested payments by
Farmers Insurance Group of Companies (Farmers), petitioner’s
insurance agency business generated gross receipts of $111,632 in
2005. The parties further agree that petitioners are not liable
for the addition to tax under section 6651(a)(1).1 The issues
for decision2 are whether: (1) Unreported “Contract Value”
payments by Farmers to petitioners in 2005 are ordinary income;
(2) the contract value payments by Farmers to petitioners are
subject to self-employment tax; and (3) petitioners are liable
for the accuracy-related penalty under section 6662(a).
1
The stipulation of settled issues states the parties’
agreement that petitioners are not liable for the addition to tax
under sec. 6651(a)(2), but the notice of deficiency does not
determine that addition to tax.
2
Adjustments to petitioners’ child tax credit, earned
income credit, itemized deductions, and self-employment tax
deduction are computational and will be resolved consistent with
the Court’s decision. See secs. 24(b), 32, 67(a), 164(f), 1401.
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Background
Some of the issues and facts have been stipulated and are so
found. The stipulation of facts and the exhibits received in
evidence are incorporated herein by reference. Petitioners
resided in Texas when their petition was filed.
History of the Insurance Agency
During the year at issue petitioner was a property and
casualty insurance agent for Farmers conducting his business as
Steve Lenard Agency (the agency). He was introduced to the
insurance business by his father, who started doing business with
Farmers in 1956. Petitioner began working with his father in
1982, and in 1983 he signed an agency agreement with Farmers
known as the 32-0389 contract (old contract). In 1987 petitioner
signed a revised agreement known as the 32-1106 contract that is
the subject of this litigation.
The 1987 Agreement
Under the 32-1106 contract, the “Agent’s Appointment
Agreement” (AAA), petitioner accepted an appointment as “agent”
for Farmers. Among other items under the agreement, Farmers
agreed to: (1) Pay petitioner as an agent “new business and
service commissions or any other commission” according to
established schedules; and (2) provide approved manuals, forms,
and policyholder records necessary to carry out the provisions of
the agreement.
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The AAA provided that petitioner agreed to several items,
including: (1) To sell insurance for Farmers in accordance with
their rules and manuals; (2) to provide facilities necessary to
furnish insurance services, including collecting and remitting
money, receiving and adjusting claims, notifying the company of
claims, and servicing all policyholders of Farmers; and (3) to
permit the authorized representatives of Farmers to review and
examine agency records. There was a series of other pertinent
provisions in the AAA.
Provision F
Provision F of the AAA allowed for the agent or the agent’s
heirs to “sell all or any part of this Agency” to a member of the
agent’s immediate family if acceptable to Farmers, provided the
“sale price does not exceed the proportionate share of the
‘Contract Value’” of the agency.
Provision G
If the agency is terminated other than by a “sale” under
provision F, provision G stated that Farmers agreed to pay the
“Contract Value” to the agent or heirs. The contract value is an
amount based on: (1) The amount of service commissions paid to
the agent on active policies during either the “six month or
twelve month period immediately preceding termination”; (2) “the
number of policies in the agent’s active code number”; and (3)
“the number of years of continuous service as an Agent” for
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Farmers immediately before termination.3 Provision G stated that
if an agent had fewer than 50 policies in an active code number,
“there is no Contract Value”.
Provision G also provided for an “Underwriting Contract
Value Bonus” (bonus). The bonus was to be a percentage based on
the contract value at the time of termination, in accordance with
the bonus program as modified by Farmers from time to time.
Provision H
Provision H provided that the agent, upon tender of the
payment described in provision G, agreed to assign all of his
“interest under this Agreement and Agency” including any interest
in the telephone numbers and leased or rented office space to
Farmers, at their request. The agent also agreed to accept
tender of contract value and for 1 year to not “directly or
indirectly solicit, accept, or service the insurance business” of
a policyholder of record as of the date of payment.
Provision I
Provision I stated that the agent acknowledges that all
manuals, lists, and records of any kind (including policyholder
and expiration information) are the confidential property of
Farmers. This provision of the AAA further states that the
3
Percentage increases were activated at the fifth, tenth,
and fifteenth year of service.
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manuals, lists, and records “shall be returned” to Farmers upon
termination of the agency.
Termination of the Agency by Petitioner
In May 2005 petitioner faxed a letter to the Texas State
executive of Farmers in which he offered his official resignation
as an agent. By the end of June 2005 petitioner had returned to
Farmers all manuals, lists, and records as required by his
contract, including information pertaining to policyholders and
all other property of Farmers. Farmers did not request or
receive petitioner’s business phone number or leasehold. On June
30, 2005, petitioner and Farmers terminated the AAA. The
contract value of the AAA was $60,596 as of the termination date.
The contract value calculation for petitioner included the three
required items of provision G.
Petitioner’s AAA contract value of $60,596 included a bonus
of $3,430. Of the $60,596 due to petitioner, he received
$51,009.56 in 2005.
Petitioners’ Tax Return for 2005
Petitioners, pursuant to an extension of time to file,
timely mailed their Federal income tax return for 2005 on October
16, 2006. Included with the return was a Schedule C, Profit or
Loss From Business, for the agency, reporting gross receipts of
$98,848. The contract value payments petitioners received in
2005 were not reported on the return.
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Discussion
Generally, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and the taxpayer has the burden
of proving that those determinations are erroneous. See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). In some
cases the burden of proof with respect to relevant factual issues
may shift to the Commissioner under section 7491(a). As there is
no dispute as to a factual issue, section 7491(a) is inapplicable
to this case.
Capital Gain or Ordinary Income
Petitioners do not dispute that the termination payments
constitute gross income. Petitioners, however, believe that they
“sold” the agency, including goodwill of the business, to
Farmers. According to petitioners, Farmers’ payment of the
contract value was in exchange for the agency, “including the
files, data, phone lines, etc” and the “contractual non-compete
clause.” Their belief is based in part on provision F of the AAA
that allows for the agent or the agent’s heirs to “sell all or
any part of this Agency” to a member of the agent’s immediate
family for a price not in excess of the contract value of the
agency. Because of their belief that the agency was sold to
Farmers, petitioners assert that the proceeds qualify for capital
gain treatment.
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Respondent takes a different view. Respondent argues that
petitioners did not sell any property to Farmers; there was no
transfer of title, so there could be no sale of a capital asset.
Because petitioners sold no assets to Farmers, they could not
have sold Farmers any goodwill.
Respondent cites as support for his position the Court’s
Opinion in Baker v. Commissioner, 118 T.C. 452 (2002), affd. 338
F.3d 789 (7th Cir. 2003). The facts of that case are
surprisingly similar to those of the case at hand. The taxpayer
was an insurance agent for State Farm Insurance Co. (State Farm)
whose compensation consisted of commissions on new policies and
renewals of existing policies. The taxpayer was an independent
contractor who was responsible for his own office expenses and
hiring and paying his own employees. His relationship with State
Farm was governed by an agent’s agreement that could not be sold,
assigned, or pledged without the consent of State Farm. State
Farm supplied the taxpayer with manuals, records, forms, and
supplies, but the agreement provided that those items as well as
information regarding policyholders constituted the “sole and
exclusive property” of State Farm.
The agent agreement in Baker also provided for termination
payments to agents who had: (1) Worked for 2 or more continuous
years, (2) returned all property belonging to State Farm upon
termination, and (3) agreed not to compete for business from
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State Farm policyholders for a year following termination. The
issue for decision in Baker was whether the termination payments
were for the sale of a capital asset, the same issue being
contested here.
The Court held in Baker that the taxpayer’s State Farm
insurance agency was not a capital asset. Since he did not own a
capital asset that he could sell, the termination payment could
not represent gain from the sale of a capital asset. And because
he did not own and sell his agency as a capital asset, he did not
sell any “goodwill” to the insurance company he represented.
Having determined that the termination payment was not gain from
the sale of a capital asset, the Court found that it was taxable
as ordinary income.
Petitioners admit that they have searched for a tax case
with an opinion contrary to that of Baker but “we could find
none.” Petitioners have attempted to distinguish their case from
Baker, relying on the wording of provision F of the AAA. That
provision provides that the agent may “sell” the agency to a
member of the agent’s immediate family “if acceptable to
Farmers”, provided the price does not exceed the contract value
of the agency. Despite petitioners’ argument, it is not apparent
to the Court how the language of provision F allowing a sale to a
family member if acceptable to Farmers is different in substance
from the provision in the agreement in Baker allowing a sale,
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assignment, or pledge of the agency (apparently to anyone) only
with the consent of State Farm. In fact, it appears that the
AAA’s provision on “sale” was more restrictive than was the
taxpayer’s agreement in Baker.
Petitioners’ pretrial memorandum referenced the case of
Heston v. Farmers Ins. Group, 206 Cal. Rptr. 585 (Ct. App. 1984).
In Heston, an insurance agent sought declaratory and injunctive
relief to prevent Farmers from removing policyholder files and
information from his agency. That court held that the agent
involved could terminate the agency, refuse to accept contract
value, retain possession of policyholder files and records, and
compete against Farmers for policyholder business. The court’s
holding resulted from its interpretation of Farmers’ old contract
using, in part, parol evidence.
Petitioner, however, admits in his pretrial memorandum that
on account of the decision in Heston, Farmers began exerting
“tremendous pressure” and threatened termination of petitioner’s
agency. As a result petitioner “relented and signed the new, 32-
1106 AAA.” The new AAA, among other items, revised provision H
in part by adding language that says: “The Agent agrees to
accept tender of Contract Value”. Because of the new contract
provision in the AAA, an agent could not refuse to accept
contract value, as the agent did in Heston, without breaching the
agreement.
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The Court finds that the case of Heston v. Farmers Ins.
Group, supra, does not affect the application of the reasoning
and the holding of the Court’s Opinion in Baker v. Commissioner,
supra. See also Trantina v. United States, 512 F.3d 567, 572
(2008) (payment to terminate service contract is not capital gain
unless contract is for more than right to perform service or
receive payment for services). Petitioners’ termination payment
received in 2005 constitutes ordinary income, not capital gain.
Self-Employment Tax
Generally, the tax on self-employment income applies to the
“net earnings from self-employment” of an individual. Secs.
1401, 1402(b). In simplified terms, net earnings from self-
employment means the “gross income derived by an individual from
any trade or business carried on by such individual,” less the
deductions attributable to the trade or business. Sec. 1402(a).
In order 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.” Newberry v.
Commissioner, 76 T.C. 441, 444 (1981). The Court’s
interpretation of the “nexus” standard requires 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” self-employment tax. Id. at 446. Gross
income derived from an individual’s trade or business may be
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subject to self-employment tax even when it is attributable in
whole or in part to services rendered in a prior taxable year.
Sec. 1.1402(a)-1(c), Income Tax Regs.
In applying the definition of self-employment income, the
Court must decide whether the termination payments were:
(1) Derived (2) from a trade or business (3) carried on by
petitioner. See sec. 1402(a).
Petitioners rely primarily on Milligan v. Commissioner, 38
F.3d 1094 (9th Cir. 1994), revg. T.C. Memo. 1992-655, to support
their position that the termination payments are not self-
employment income. The agent’s agreement in Milligan conditioned
termination payments to the agent upon terminating the agreement
no sooner than 2 years after its effective date, returning State
Farms’ property, and refraining from competition with State Farm
for 1 year. The agent’s agreement also conditioned the
termination payments upon adjustments to reflect the amount of
income received by State Farm on the taxpayer’s “book of
business” during the first year after termination and the number
of the policies produced by the taxpayer that were canceled
during the first year after termination.
The court found that to be “derived” from a taxpayer’s trade
or business, income must arise from some actual income-producing
activity, past or present, of the taxpayer. Id. at 1098. “To be
taxable as self-employment income, earnings must be tied to the
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quantity or quality of the taxpayer’s prior labor”. Id. The
court found that the payments were subject to adjustments related
not to the taxpayer’s business activity but to that of his
successor.
Congress has codified the standard established in Milligan
for termination payments made to an insurance salesman after
December 31, 1997, in section 1402(k). Taxpayer Relief Act of
1997, Pub. L. 105-34, sec. 922(a), (c), 111 Stat. 879, 880.
Section 1402(k) exempts the termination payments of insurance
salesmen from self-employment tax as long as the payments do not
depend “to any extent” on length of service (except for a length
of service requirement for eligibility) or overall earnings from
service.
Petitioner’s termination payments fall outside the
protection of section 1402(k) and the court’s holding in
Milligan.
Provision G of petitioner’s contract specifically provides
that his termination payments are determined by three items: (1)
The amount of service commissions paid to him on active policies
during either the “six or twelve month period immediately
preceding termination”; (2) “the number of policies in the
agent’s active code number”; and (3) “the number of years of
continuous service as an Agent” for Farmers immediately before
termination. The termination payments depended on petitioner’s
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length of service and his overall earnings from service and
therefore fall outside the protection of section 1402(k).
Petitioners’ case is analogous to that of the taxpayer in
Schelble v. Commissioner, T.C. Memo. 1996-269, affd. 130 F.3d
1388 (10th Cir. 1997). The taxpayer’s payments in that case
depended in part on how long he had been an agent for the
insurance company. Like petitioner, to qualify for the lowest
level of payments the taxpayer had to have represented the
company for at least 5 years. The taxpayer, like petitioner,
earned a higher payment than if he had been an agent for only 5
or 10 years. The taxpayer had to have 400 or more policies in
force at the time his agency was terminated while petitioner was
required to have 50. And like petitioner’s, the taxpayer’s
termination payments were based on the commissions received
during the last 6 or 12 months preceding the termination of the
agreement.4
The Court found in Schelble that the payments received by
the taxpayer were tied to the quantity and quality of his prior
services and were subject to self-employment tax. The Court
finds that petitioner’s termination payments were tied to the
quantity and quality of his prior service and are subject to
4
Respondent points out that while provision E of the AAA
subjects petitioner’s right to receive commissions payable in the
year after termination to a “chargeback”,it would not affect
contract value and would not reduce petitioner’s termination
payments.
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self-employment tax. See also Parker v. Commissioner, T.C. Memo.
2002-305; Farnsworth v. Commissioner, T.C. Memo. 2002-29.
The Accuracy-Related Penalty
Section 7491(c) imposes on the Commissioner the burden of
production in any court proceeding with respect to the liability
of any individual for penalties and additions to tax. Higbee v.
Commissioner, 116 T.C. 438, 446 (2001); Trowbridge v.
Commissioner, T.C. Memo. 2003-164, affd. 378 F.3d 432 (5th Cir.
2004). In order to meet the burden of production under section
7491(c), the Commissioner need only make a prima facie case that
imposition of the penalty or addition to tax is appropriate.
Higbee v. Commissioner, supra.
Respondent determined that petitioners are liable for an
accuracy-related penalty under section 6662(a). Section 6662(a)
imposes a 20-percent penalty on the portion of an underpayment
attributable to any one of various factors, including a
substantial understatement of income tax. See sec. 6662(b)(2).
A “substantial understatement” includes an understatement of tax
that exceeds the greater of 10 percent of the tax required to be
shown on the return or $5,000. See sec. 6662(d); sec.
1.6662-4(b), Income Tax Regs.
Section 6664(c)(1) provides that the penalty under section
6662(a) shall not apply to any portion of an underpayment if it
is shown that there was reasonable cause for the taxpayer’s
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position and that the taxpayer acted in good faith with respect
to that portion. The determination of whether a taxpayer acted
with reasonable cause and in good faith is made on a case-by-case
basis, taking into account all the pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The most
important factor is the extent of the taxpayer’s effort to assess
his proper tax liability for the year. Id.
Petitioners had a substantial understatement of income tax
for 2005 since the understatement amount exceeded the greater of
10 percent of the tax required to be shown on the return or
$5,000. Petitioners also failed to report $51,009.56 of income.
The Court concludes that respondent has produced sufficient
evidence to show that the accuracy-related penalty under section
6662 is appropriate.
Petitioners have not shown that their failure to report such
a large amount of income was an action taken with reasonable
cause and in good faith. Respondent’s determination of the
accuracy-related penalty under section 6662(a) for 2005 is
sustained.
To reflect the foregoing,
Decision will be entered
under Rule 155.