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Milligan Case

(CITE AS: 3a P.3D 1094)

Robert B. MILLIGAN, Petitioner-Appellant,

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 93-70273.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted June 15, 1994.

Decided Oct. 25, 1994.

Commissioner of internal Revenue Service (IRS) issued taxpayer notice of deficiency for unpaid self-employment tax. The United States Tax Court upheld determination of deficiency, and taxpayer appealed. The Court of Appeals, Pregerson. Circuit Judge, held that termination payments did not 'derive' from taxpayer's insurance sales business and, therefore, were not subject to self employment tax.

Reversed.

> Ill

> 22Ok4381 k. Self-employment.

C.A.9,1994.

Term 'derive' within meaning of self-employment tax statute stating that income must be derived from trade or business requires nexus between income received and trade or business that was actually carried on. > 26 U.S.C.A.

1401

> [2]

> 22Ok4361 k. Self-employment.

C.A.9,1994.

Payment's 'derived' from cessation of taxpayer's business activity were not

subject to self-employment tax. > 26 U.S.C.A. s 1401.

> [3]

> 22Ok4381 k. Self-employment.

C.A.9,1994.

Self-employment tax did not apply to payments received by independent contractor under non-competition agreement he entered with insurer when he terminated his business relationship with insurer. > 26 U.S.C.A. s 1401.

> [4]

> 22Ok4381 k. Self-employment.

C.A.9,1994.

Termination payments taxpayer received did not derive from his insurance sales business and, therefore, payments were not subject to self-employment tax, where payments were linked only to taxpayer's previous status as two year-plus independent contractor for insurer, where taxpayer had already been compensated for his services, and where termination payments were subject to adjustments unrelated to any business activity on taxpayer's part for insurer. > 26

U.S.C.A. n 1401.

> [5]

> 22Ok4361 k. Self-employment.

C.A.9,1994.

To be taxable as self-employment income, earnings must be tied to quantity or quality of taxpayer's p7r or labor, rather than mere fact that taxpayer worked or works for payor. > 26 U.S.C.A. s 1401.

> [6]

> 22Ok43Bl k. Self-employment.

C.A.9,1994.

In determining whether disputed payments are subject to self-employment tax, it is not enough that, had taxpayer not performed certain services, taxpayer never would have received disputed payments. > 26 U.S.C.A. a 1401.

*1095 David L. Haga, Jr., Robert P. Solliday, Carolyn R. Matthews and Arthur W. Peterson, Mohr, Hackett, Pederson, Blakley, Randolph & Haga, Phoenix, AZ, for petitioner-appellant.

1Alice L. Ronk, Asst. Atty. Gen., Tax Div., Dept. of Justice, Washington, DC, for the respondent-appellee.

Bogdan Rentea and Oren L. Connaway, Rentea & Associates, Austin, TX, amicus curiae, for United Farmer's Agent Ass'n, Nat. Ass'n of American Family Agents. and Nat. Ass'n of State Farm Agents, Inc.

Appeal from the United States Tax Court.

Before GOODWIN, PREGERSON, and RYMER, Circuit Judges.

PREGERSON, Circuit Judge:

Robert E. Milligan (-Milligan') appeals the tax court's order and decision upholding the Commissioner of Internal Revenue's determination of a deficiency in Milligan's federal income tax for the taxable year 1987 in the amount of $3,076.00. We have jurisdiction under > 26 U.S.C. s 7482(a)(1). We reverse.

BACKGROUND

On April 12, 1949, Appellant Milligan began working as an exclusive insurance

agent, on an independent contractor basis, for State Farm Insurance Company

("State Farm"). As a State Farm insurance agent, Milligan sold and serviced

insurance policies for four sub-companies of State Farm--State Farm Mutual

Automobile Insurance Company ('State Farm-Auto'), State Farm Life Insurance

Company ('State Farm-Life'), State Farm Fire and Casualty Company ("State Farm-

Fire'), and State Farm General Insurance Company ('State Farm-General').

On March 1, 1977, Milligan and State Farm entered into the fourth of a

succession of agency contracts entitled State Farm Agent's Agreement (the

'Agent's Agreement'). (ER 52-77). According to the Agent's Agreement,

Milligan's compensation consisted of commissions on all personally-produced

policies, -service compensation, for his services on existing policies, and

renewal *1096 commissions on State Farm-Fire and State Farm-General policies

previously written by him. (ER 53: s II; 58, 60-61, 63-64, 66-67). State

Farm compensated Milligan in full when and as he earned commissions, service

compensation, and renewal commissions. No portion of his compensation was ever

deferred to create 'Termination Payments." (See ER 59, 62, 65, 68, 70) (Any

unpaid compensation payable at the time of termination %hall be paid as soon an

ascertainable and shall constitute the final payment under the schedule of

compensation payments.); (ER 69: 11/16/90 letter to Milligan).

Milligan reti d on August 13, 1983, by providing written notice of

termination of the Agent's Agreement (see ER 54: 9 III.A) (agreement

terminated upon Milligan's death or written notice by either party). Because

the Agent's Agreement was terminated more than two years after its effective

date, the termination made Milligan eligible to receive five years of monthly

Termination Payments from State Farm. (ER 34: s IV.A). The section of the

Agent's Agreement entitled "Compensation" (a 11) did not include or refer to

the section entitled "Termination Payments' (s IV).

For the first post-termination year, the Agent's Agreement required each of

the State Farm companies to compute Termination Payments based on a percentage

of Milligan's compensation during the previous twelve months (generally 200 of

the income generated by personally-produced policies in that year), (ER 54-

55: a IV.A.1-2), 'less any deductions for commission charge-backs CFN1]....'

(Id. a IV.A). [FN2] For the subsequent four 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, (id. a IV.A.1-2), less commission

charge-backs. [FN3] None of these Termination Payments depended upon the

length of Milligan's service for State Farm and overall earnings, or his

commissions from assigned policies and other compensation during the final pre-

termination year.

FNI. Commission charge-backs are commissions paid on cancelled policies,

meaning that Milligan had received commissions in excess of those he

actually earned. In effect, State Farm was entitled to offset monies owed

by Milligan against monies owed to Milligan as Termination Payments.

FN2. In particular, State Farm-Auto would pay Milligan a percentage of his

prior service compensation on person2lly-produoed policies. (Id. a

IV.A.1(2)). And, State Farm-Fire and State Farm-General would pay him the

lesser of a percentage of the commissions he had been paid on personally-

produced policies, or the commissions he would have been paid on

person2lly-produced renewal premiums had the Agent's Agreement not been

terminated. (Id. > s IV. > 2(a)).

FN3. The above discussion describes the payment calculations made by State

Farm-Auto, State Farm-Fire, and State Farm-General. The Agent's Agreement

created a different payment structure for payments from State Farm-Life.

State Farm-Life was required to compute all five years of Termination

Payments based on 100% of the amount Milligan would have received during

the post-termination years on personally-produced and assigned policies had

the Agent's Agreement not been terminated, (ER 56: > a IV.A.3; 71-72),

less commission charge-backs. Milligan conceded that the $345.00 in

Termination Payments he received in 1987 from State Farm-Life were taxable

as self-employment income, meaning that the character of those payments is

not at issue on appeal. But see note 8 infra (significant differences

between the payments from State Farm-Life and the disputed payments might

justify disparate tax treatment).

Milligan had no vested right to receive any Termination Payments. The

Agent's Agreement conditioned the Termination Payments upon two contractual

requirements, (ER 54, > a IV.A): (1) returning State Fm- 's property within

ten days of termination entitled an agent to two months of Termination

Payments, (ER 36, > 9 3:V.B.l), and (2) refraining from competing with all of

the State Farm sub-companies for a period of one-year entitled an agent to

subsequent Termination Payments, (id. a IV.B). After retiring in 1983,

Milligan returned state F2rM'S property and did not engage in any insurance

sales activities or other trade or business, (ER 20, P 31).

The Agent's Agreement also conditioned the Termination Payments upon certain

adjustments to reflect: (1) the amount of income the State Farm companies

received on Milligan's book of business during the first post-termination year,

and (2) the number of his personally-produced policies cancelled

*1097 during that year. See ER 54-55: > ss IV.A.l(o), IV.A-2(c) (Payment

amounts were 'subject to appropriate adjustments following a determination of

the net premium collections [received and recorded on State Farm-Auto policies,

and the level of commissions State Farm-Fire and State Farm-General received on

Milligan's personally-produced renewal premiums, in the twelve months following

the date of termination] ... and the number of policies in force (during the

same twelve month post-termination period].').

During taxable years 1985 and 1986, Milligan reported the Termination Payments

he received for both income tax and self-employment tax. However, for taxable

year 1987, when Milligan received $25,121.00 in Termination Payments, he

reported the payments only for income tax. The Commissioner of internal

Revenue (the 'Commissioner") issued Milligan a Notice of Deficiency in the

amount of $3,076.00 for unpaid self-employment tax for 1987.

On February 11, 1991, Milligan filed a petition in the tax court seeking a

redetermination of the tax deficiency asserted against him. He contested the

deficiency based on $24,776.00 in payments from State Fm--Auto, State Farm-

Fire, and State Farm-General. [FN4]

FN4. In 1987. Milligan received $15,354.00 from State Farm-Auto. $8,450.00

from State Farm-Fire, and $972.00 from State Farm-General.

On November 12, 1992, the tax court entered a decision that determined a

deficiency in the amount of $3,076.00. The tax court found that the entire

amount of 1987 Termination Payments was deferred compensation that State Farm

offered to induce agents to enter into the Agent's Agreement. The court

reasoned that, as deferred compensation, the Termination Payments derived' or

emanated' from 14illigan's insurance sales business' and were therefore subject

to self-employment tax. Milligan appeals.

ANALYSIS

The tax court concluded that Milligan's 1987 Termination Payments were taxable

an individual self-employment income. We review the tax court's findings of

law de navo, > Paci First Fed. Sav. Bank v. Commissioner, 961 P.2d 800,

803 (9th Cir.), cert. denied, > 506 U.S. 873, 113 S.Ct. 209, 121 L.Ed.2d 150

(1992), and findings of fact for clear error, > Vukanovich v. Commissioner,

790 F.2d 1409, 1411 (9th Cir.1986). None of the underlying facts in this case

are in dispute. Rather. the parties' dispute relates to the conclusion that

should be drawn from the underlying facts--'whether the facts satisfy the

statutory standard' for self-employment tax. > Pullman-Standard v. Swint, 456

U.S- 273, 290 n. 19, 102 S.Ct. 1781, 1791 n. 19, 72 L.Ed.2d 66 (1982). This is

a mixed question of law and fact, reviewable de novo. > id.

The Self-Employment Contributions Act ('SECA'), > as 1401- > 1403 of

the Internal Revenue Code, imposes a separate tax on the annual self-employment

income of every individual. > 26 U.S.C. s 1401. To be taxable as self-

employment income, an individual's income must be (1) derived, (2) from a trade

or business, (3) carried on by that individual. See > 26 U.S.C. a

1402(b) (defining "self-employment income" as -the net earnings from self-

employment derived by an individual ... during any taxable year'); > 26

U-S.C. s 1402(a) (defining "net earnings from self-employment' as "the gross

income (minus exclusions from gross income[ CFN311] derived by an individual

from any trade or business carried on by such individual').

FN5. "[T]here shall be excluded any gain or loss--(A) which is considered

as gain or loss from the sale or exchange of a capital asset E i.e. , capital

gain or lose] ... or (C) from the sale, exchange ... or other disposition

of property if such property is neither (includible in inventory nor

property held for sale to customers in the ordinary course of business].'

> 26 U.S.C. a 1402(a)(3)(A), (C). Gain or loss from 'sale, exchange, or

other disposition of property' includes a disposition that creates ordinary

gain or loss, as opposed to capital gain or loss. Treas.Reg.

a 1.1402(a)-6(a) (as amended in 1965).

Milligan agrees with the tax court that the trade or business, and carried

on' requirements have been satisfied. In other words, he agrees that the

Termination Payments are subject to self-employment tax if they were derived'

from the carrying on of his previous work as an insurance agent.

> *1096 Simpson v. Commissioner, 64 T.C. 974, 989, 1975 WL 3150

(1975) (self-employment tax on insurance agent's trade or business earnings,

e.g., commissions, an an independent contractor); > Erickson v. Commissioner,

64 T.C.M. (CCH) 963, 966, 1992 WL 245517 (1992), aff'd without op.. > 1 P.3d

1231 (lst Cir.1993) (self-employment tax on deferred payments of unpaid

commissions and renewal commissions to former insurance agent). It in

immaterial that Milligan was no longer self-employed in 1987 when he received

the Termination Payments. Treas.Reg. s 1.402(a)- > l(c) (as amended in

1974) (Gross income derived from a trade or business includes gross income

received ... in the taxable year even though such income may be attributable in

whole or in part to services rendered or other acts performed in a prior

taxable year....'); > Shumaker v. Commissioner, 648 P.2d 1196, 1200 (9th

Cir.1981) (affirming self-employment tax on sale proceeds from wheat taxpayer

grew in the past: "[Self-employment income is determined by the source of the

income, not the taxpayer's status at the time the income is realized.')

(Emphasis added.) -

> [1] Milligan disputes only whether the 1987 Termination Payments were

'derived' from the trade or business carried on by him within the meaning of

the tax code and regulations. The term 'derive" requires '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 WL 11375 (1981). BY

nexus, we mean that the 'trade or business activity by the taxpayer gives rise

to the income.... 0 > Id. (emphasis added). The income in sufficiently

related to the taxp2yer'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.... 1). See, e.g., > Shumaker, 648 P.2d at 1200

(income derived from selling wheat from prior farming activity).

> [2][3][4][5] We are not prepared to characterize the precise

relationship between the Termination Payments and Milligan's prior business

activity. Ambiguities in the Agent's Agreement prevent us from doing so.

CFN6] But, despite the ambiguities, we can see that the Termination Payments

did not 'derive, from 14illigan's prior business activity within the meaning of

the self-employment tax. 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.

FN6. It would appear that Milligan received the Termination Payments

because he stopped working for State Farm and did not compete with State

Farm. The payments derived from termination of the Agent's Agreement

(termination of Milligan's business activity for State Farm), and

Milligan's compliance with the contractual covenant not to compete (and

return of State Farm property). Payments derived from the cessation of

Milligan's business activity are not subject to self-employment tax. See

> Newberry, 76 T.C. at 446 (holding that-insurance proceeds were not

taxable self-employment income where taxpayer's inability to operate a

destroyed grocery store, rather than the carrying on of a business, gave

rise to the proceeds). Nor does the self-employment tax apply to payments

derived from non-competition with State Farm. > Barrett v. Commissioner,

58 T.C. 284, 289, 1972 WL 2450 (1972) ('Noncompetition does not constitute

the carrying on of a trade or business.').

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: > a IV.A.I(a)) in the final pre-

termination year, he would have received nothing.

> [6] Without more, this link between the disputed payments and any business

activity carried on by Milligan does not satisfy the derive' requirement. It

is not enough that, had the taxpayer not performed certain services (that were

fully compensated for)--not been an independent contractor, for example--the

taxpayer never would have received the disputed payments. See > Newberry, 76

T.C. at 445 (harmonizing self-employment *1099 tax-with the Federal

Unemployment Tax Act and the Federal Insurance Contributions Act: CFN7] An

Individual who becomes eligible for benefits as a -result of the individual's

employment status at some previous time' has not received wages subject to

social security tax. I[I]n no way are the benefits a function of the

employee's providing services for his employer. Those benefits are not derived

from any employment carried on.').

FN7. The self-employment tax on self-employed individuals is the

counterpart to the tax on employees, wages under the Federal Unemployment

Tax Act (IFUTAII) and the Federal Insurance Contributions Act ("FICA').

> Steffens v. Commissioner, 707 F.2d 478, 481 (llth Cir.1983) (citing

> Newberry v. Commissioner, 76 T.C. 441, 443, 1981 WL 11375 (1981)). The

wage tax under both PUTA and FICA attaches to 'all remuneration for

employment.' See > 26 U.S.C. s 3121(a) (FICA wage definition), id.

> s 3306(b) (PUTA wage definition). . 'Employment' [under FICA] means any

service, of whatever nature, performed ... by an employee for the person

employing him....' > 26 U.S.C. s 3121(b) (emphasis -added); id.

> 9 3306(c) (same under FUTA).

Because Milligan already had been fully compensated for his services, none of

his business activity was the 'source" of the Termination Payments. The

payments did not represent deferred compensation of previously-earned

commissions, cf. > Erickson, supra, because none of Milligan's earnings were

deferred, i-e., he had no vested right to payment of an identifiable money

amount. Nor were they renewal commissions on previously-generated policies,

cf. > id.; Becker v. Tomlinson, > 9 A.F.T.R.2d 1407, 1409-10 (S.D.Fla.1962),

or retirement income tied to Milligan's years of service and overall earnings.

At most, the amount of the Termination Payments, not the payments themselves,

actually arose from Milligan's business activity. Milligan had a contingent

right to receive 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 upon the level of his commissions

(and service compensation from State Farm-Auto) on personally-produced

policies, i.e., his previous value as a State Farm insurance agent.

However, in part, even the payment amount did not depend upon the level

of Milligan's prior business activity because the Termination Payments were

subject to two adjustments unrelated to any business activity on Milligan's

part for State Farm. The State Farm companies adjusted the Termination

Payments to reflect the amount of income received on Milligan's book of

business during the first post-termination year, and the number of his

personally-produced policies cancelled during that year. If all of Milligan's

customers had cancelled their State Farm non-life policies during the first

post-termination year, then Milligan would have received nothing. The adjusted

payment amount depended not upon Milligan's past business activity, but upon

the successor agent's future business efforts to retain Milligan's customers

and to generate service compensation for State Farm. In this way too, the

disputed Termination Payments did not "derive" from Milligan's prior services.

Therefore, the tax court erred by characterizing the Termination Payments as

earnings derived from the carrying on of Milligan's trade or business. As

stated in supra note 3, we express no opinion on whether the Termination

Payments from State Farm-Life are subject to self-employment tax. We therefore

reject the Commissioner's suggestion that the tax status of the State Farm-Life

payments affects that of the disputed Termination Payments provided for in the

same Agent's Agreement.

Nonetheless, we note two significant differences, which might justify

disparate tax treatment, between the payments from State Farm-Life and the

disputed payments. First, payments from State Farm-Life represent unpaid

earned income from Milligan's prior life insurance sales. He received the same compensation from those insurance policies that he would have received had the agent's Agreement not been terminated. In contrast, Termination Payments e other three State Farm companies were monies that Milligan would not have received had the Agent's Agreement not been terminated. He received these

payments precisely because he was no longer working for State Farm. These

payments were calculated *1100 based on Milligan's past earnings, which had

been fully paid, and were not made to compensate him for prior labor. Second,

Termination Payments from State Farm-Life were not subject to adjustments

unrelated to Milligan?s business activity. The Termination Payments are not

subject to self-employment income tax. Because we conclude that the

Termination Payments are not derived from the carrying on of Milligan's trade

or business, we need not decide whether the payments are within the exclusion,

> 26 U.S.C. 3 1402(a)(2)(A): (C), supra note 5, for capital gain and

ordinary gain from the sale exchange or other disposition of property.

REVERSED.

END OF DOCUMENT