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Jackson Case
108 T.C. No. 10, Tax Ct.
Rep. (CCH) 51,965, Tax Ct. Rep. Dec. (RIA) 108.10
William R. and Muriel G.
JACKSON, Petitioners,
v.
COMMISSIONER OF INTERNAL
REVENUE, Respondent.
No. 23558-94.
United States Tax Court.
March 31, 1997.
William R. Jackson, pro se.
John F. Driscoll, for
respondent.
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. [FN1]
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.
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 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 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 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". [FN2]
"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 derived by an individual from any trade or
business carried on by such individual, less the
deductions allowed by this subtitle which
areattributable 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. [FN3]
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. 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 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 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. [FN3]
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. 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 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'sattributable 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. [FN3]
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. 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 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'sattributable 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. [FN3]
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. 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 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 Milligan's past
business activity, but upon a successor agent's 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. 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 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 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 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 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.
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, [FN4] 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.
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.
PARR, Judge, 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
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 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.
HALPERN, Judge, 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. 16. 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 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 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
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
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 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 |
