Warren L. Baker, Jr. and Dorris J. Baker v. Commissioner , 118 T.C. No. 28 ( 2002 )

118 T.C. No. 28UNITED STATES TAX COURT
WARREN L. BAKER, JR. AND DORRIS J. BAKER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 599-00. Filed May 29, 2002.
P (husband) entered into “agents agreements”
(agreement) with State Farm Insurance Cos. (State Farm)
wherein P agreed to write insurance policies
exclusively for State Farm. The agreement provided
that all property including information about policy
holders belonged to State Farm. P’s compensation was
based on a percentage of net premiums. The agreement
also contained detailed provisions for termination.
P was entitled to a termination payment based on the
percentage of policies that either (1) remained in
force after termination or (2) were in force for the 12
months preceding termination. P and State Farm did not
negotiate the terms of the agreement.
P retired after approximately 34 years of
operating as an independent agent for State Farm.
Pursuant to the termination agreement P returned
account information, computers and the like to State
Farm and the successor agent. P received a payment of
$38,622 in 1997 from State Farm pursuant to the
termination agreement.
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Ps reported the payment on their 1997 Federal
income tax return as a long-term capital gain. In a
notice of deficiency issued to Ps, R disallowed capital
gain treatment and determined that the payment was
ordinary income. R did not impose self-employment tax
on the income.
Held: P did not own a capital asset or sell a
capital asset to State Farm, nor did the termination
payment P received from State Farm represent payment
for transfer of a capital asset to State Farm or the
successor agent. Held, further, that Ps are not
entitled to capital gain treatment for the termination
payment received from State Farm in 1997. Held,
further, Ps must treat the payment received in 1997 as
ordinary income.
Thomas J. O’Rourke, for petitioners.
Roger W. Bracken, for respondent.
OPINION
DAWSON, Judge1: This case was assigned to Chief Special
Trial Judge Peter J. Panuthos pursuant to the provisions of
section 7443A(b)(5) and Rules 180, 181, and 183.2 The Court
1
I wrote the Court’s majority opinion in Jackson v.
Commissioner, 108 T.C. 130 (1997), holding that termination
payments received by the insurance agent from State Farm were not
subject to self-employment tax under secs. 1401 and 1402, I.R.C.
I also joined Judge Parr’s concurring opinion indicating that
such payments could be treated as being in the nature of a buyout
of the agent’s business. After further consideration, I am now
persuaded by the opinion of Chief Special Trial Judge Panuthos
that this petitioner (agent) is not entitled to capital gain
treatment for the termination payment he received.
2
Section references are to the Internal Revenue Code in
effect for the year in issue. All Rule references are to the Tax
(continued...)
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agrees with and adopts the opinion of the Special Trial Judge,
which is set forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
PANUTHOS, Chief Special Trial Judge: Respondent determined
a deficiency in petitioners’ Federal income tax of $2,519 for
1997. All references to petitioner are to Warren L. Baker, Jr.
After a concession by petitioners,3 the issue for decision
is whether the termination payment received by petitioner upon
retirement as an insurance agent of State Farm Insurance Cos. is
taxable as capital gain or ordinary income.
Background
Some of the facts have been stipulated and are so found.
The stipulated facts and the related exhibits are incorporated
herein by this reference. At the time of filing the petition,
petitioners resided in Fairview Heights, Illinois.
I. Petitioner’s Agreement With State Farm
a. General
Petitioner began his relationship with State Farm Insurance
Cos. (State Farm) on January 19, 1963. State Farm consisted of
State Farm Mutual Automobile Insurance Co., State Farm Life
2
(...continued)
Court Rules of Practice and Procedure, unless otherwise
indicated.
3
Petitioners concede that they failed to report dividend
income of $919 from Magna Group, Inc.
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Insurance Co., State Farm Fire & Casualty Co., and State Farm
General Insurance Co.
Petitioner conducted his business as the Warren L. Baker
Insurance Agency (the agency). He sold policies exclusively for
State Farm. When he began his relationship with State Farm, he
was not assigned customers. Instead, he developed a customer
base. He selected the location of his office with State Farm’s
approval. He also hired and paid employees. He was responsible
for paying the expenses of an office such as rent, utilities,
telephones, and other equipment. He was obligated to establish a
trust fund into which he deposited premiums collected on behalf
of State Farm.
Petitioner entered into a series of contracts with State
Farm known as agent’s agreements. The agent’s agreement at issue
was executed on March 1, 1977. While the agreement contains
approximately 6 pages, there are numerous attachments including
schedules of payments, amendments, addenda, and memoranda that
total 61 pages. The agreement was prepared by State Farm.
Petitioner did not have the ability to change the terms of the
agreement, but he had the option to refuse a new or revised
agreement.
The preamble to the agreement reads, in part, as follows:
“The Companies believe that agents operating as independent
contractors are best able to provide the creative selling,
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professional counseling, and prompt and skillful service
essential to the creation and maintenance of successful multiple-
line companies and agencies.”
Section I of the agreement, Mutual Conditions and Duties,
provides that petitioner was an independent contractor of State
Farm. As a State Farm agent, petitioner agreed to write policies
exclusively for State Farm, its affiliates, and government and
industry groups. Paragraph C, section I of the agreement states
that State Farm “will furnish you, without charge, manuals,
forms, records, and such other materials and supplies as we may
deem advisable to provide. All such property furnished by us
shall remain the property of the Companies [State Farm].”
Further, State Farm considered any and all information regarding
policyholders to be its property, as follows:
D. Information regarding names, addresses, and
ages of policyholders of the Companies; the
description and location of insured property;
and expiration or renewal dates of State Farm
policies acquired or coming into your
possession during the effective period of
this Agreement, or any prior Agreement,
except information and records of
policyholders insured by the Companies
pursuant to any governmental or insurance
industry plan or facility, are trade secrets
wholly owned by the Companies. All forms and
other materials, whether furnished by State
Farm or purchased by you, upon which this
information is recorded shall be the sole and
exclusive property of the Companies.
Essentially, any data relating to a policyholder recorded by an
agent on any paper was the property of State Farm.
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Petitioner’s compensation was based on a percentage of the
net premiums. The compensation varied by the type of insurance,
such as automobile and homeowner’s. Petitioner was also assigned
policies for which he received a smaller commission than those
policies he personally produced. State Farm assigned existing
policies to petitioner because the policyholders moved to the
geographic location covered by his agency. Similarly, when
policyholders covered by petitioner moved to a different
geographic location, the policies were assigned to another agent
in that geographic area. Petitioner did not compensate other
agents for policies he assumed, and he did not receive payments
for policies assigned to other agents.
The commissions payable for assigned policies are provided
for in the schedule of payments attached to the agreement in
relevant part as follows:
an amount equal to 66-2/3 percent of the graded
commission scale in Section I, provided, however, no
commission shall be payable to you on any premium
collections on business credited to your account from
the account of an agent whose agreement with * * *
[State Farm] has been terminated, or as a result of an
agreement between an agent and * * * [State Farm]
pursuant to the applicable paragraph of Section IV of *
* * [an agreement], until a one-year period has elapsed
following the date of such termination, except as
provided for in paragraph IV-B-2 of this Schedule of
Payments.
b. Termination
Section III of the agreement addresses termination. Either
party could terminate the agreement by written notice. The
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agreement also provided for termination upon the death of
petitioner. Within 10 days after termination of the agreement,
“all property belonging to the Companies shall be returned or
made available for return to the Companies or their authorized
representative.”
Petitioner was required to abide by a covenant not to
compete for a period of 12 months following termination. The
covenant not to compete provides as follows:
E. For a period of one year following
termination of this Agreement, you will not
either personally or through any other
person, agency, or organization (1) induce or
advise any State Farm policyholder credited
to your account at the date of termination to
lapse, surrender, or cancel any State Farm
insurance coverage or (2) solicit any such
policyholder to purchase any insurance
coverage competitive with the insurance
coverages sold by the Companies.
Pursuant to section IV of the agreement, petitioner
qualified for a termination payment if he met certain
requirements. First, he must work for 2 or more continuous years
as an agent. Second, within 10 days of termination, he must
return or make available for return all property belonging to
State Farm.
The amount of the termination payment payable is different
for each of the State Farm companies. With two of the State Farm
companies, the amount of the termination payment is based on a
percentage of policies that either remained in force after
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termination of the agreement or those that had been in force for
the 12 months preceding termination.4 The formulas for the
amount of termination payment are as follows:
State Farm Mutual Automobile Insurance Company * * *
the lesser of (1) or (2)-
(1) twenty percent (20%) of the service compensation on
“personally produced” policies, you earned under the
Schedule of Payments for Other than Health Insurance
Policies in the twelve (12) preceding months, or twenty
percent (20%) of the service compensation on
“personally produced” policies credited to your
account, as of the date of termination, which remain in
force in the same state, during the first twelve (12)
months following the date of termination; whichever is
greater, or
(2) thirty percent (30%) of the service compensation on
“personally produced” policies credited to your account
as of the date of termination, which remain in force in
the same state during the first twelve (12) months
following the date of termination.
State Farm Fire and Casualty Company and State Farm
General Insurance Company * * * the lesser of (1) or
(2)-
(1) twenty percent (20%) of the commissions you were
paid on “personally produced” policies for those lines
of insurance * * * of the applicable Schedule of
Payments, in the twelve (12) preceding months, or
twenty percent (20%) of the commissions on “personally
produced” renewal premiums you would have been paid
under the applicable Schedule of Payments, if this
Agreement had not been terminated, in the twelve (12)
months following the date of termination on “personally
produced” policies which remain in the same state, for
those lines of insurance designated above and credited
4
It is not clear from the record whether the termination
payment that petitioner received was calculated based upon
policies that remained in force after termination or instead had
been in force for the 12 months preceding termination. These
facts have no bearing on our decision.
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to your account as of the date of termination;
whichever is greater, or
(2) thirty percent (30%) of the commissions on
“personally produced” renewal premiums you would have
been paid under the applicable Schedule of Payments, if
this Agreement had not been terminated, in the twelve
(12) months following the date of termination on those
“personally produced” policies designated in (1) and
credited to your account as of the date of termination.
State Farm Life Insurance Company-
An amount equal to the same compensation for the second
and subsequent policy years as would have been due and
payable to you for the first five years following the
date of termination on all State Farm life policies
personally written by you or assigned to you by the
Company for compensation, under the terms of the
applicable Schedule of Payments attached hereto, if
this Agreement had not been terminated.
State Farm and petitioner did not negotiate the amount or
conditions of the termination payment. State Farm agreed to pay
petitioner a termination payment over either a 2- or 5-year
period.
Section V of the agreement provides for an extended
termination payment if petitioner worked for State Farm for at
least 20 years, of which 10 years were consecutive. The extended
termination payment would begin 61 months after termination and
continue until petitioner’s death. The extended termination
payment is also based on policies personally produced by
petitioner during his last 12 months as an agent for State Farm.
State Farm paid commissions for new business personally
written by the agent as a percentage of the first policy year
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premium due according to the percentage established in table I of
the “Schedule of Payments Referred to in State Farm Agent’s
Agreement” (schedule of payments) attached to the agreement. For
many of the policies, commissions would be paid during the first,
second, third, fourth, and fifth policy year, depending upon the
type of policy and its length. Section VI of the schedule of
payments provides as follows:
Upon termination of this Agreement by death or
otherwise any unpaid compensation provided for under
this Schedule of Payments then due and payable shall be
paid as soon as ascertainable, and there shall be no
further liability on the part of the Company under the
terms of this Schedule of Payments.
During the operation of the agency and pursuant to the
agreement, petitioner operated a trust fund. When petitioner
terminated his relationship with State Farm, the trust account
was closed and audited by State Farm.
II. Petitioner’s Retirement
Petitioner retired and terminated his relationship with
State Farm on February 28, 1997. At that time, he held
approximately 4,000 existing policies generated from 1,800
households. Approximately 90 percent of the policies were
assigned to one successor agent. The successor agent received
reduced compensation (that is, a lower percentage) for the
assigned policies.
Petitioner returned State Farm’s property, such as policy
and policyholder descriptions, which he gathered in master
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folders that he purchased, claim draft books, rate books, agent’s
service texts, and a computer. He maintained much of the
information regarding the policies and policyholders on the
computer. He fully complied with the provision in the agreement
for return of property to State Farm.
The successor agent hired the two employees previously
employed by petitioner and assumed petitioner’s telephone number.
The successor agent also worked with petitioner on occasion prior
to petitioner’s retirement to meet policyholders and to ask
questions. The successor agent opened an office in the vicinity
of petitioner’s office. When the termination was completed,
petitioner had returned all of the assets used in the agency to
State Farm and the successor agent.
III. Tax Return and Notice of Deficiency
Petitioners timely filed their 1997 Federal income tax
return. They reported the income of $38,622 from the termination
payment which petitioner received in 1997 as long-term capital
gain on Schedule D, Capital Gains and Losses. Petitioners
attached a two-page statement to Schedule D on which the
termination payment was described as an annuity payable over 5
years.5 The annuity was described as a sale of assets to State
5
Timing of the recognition of income is not at issue. The
record does not indicate how State Farm treated the termination
payment on its return.
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Farm that included “personally produced policies and other
intangible assets”.
Petitioners attached Form 8594, Asset Acquisition Statement
Under Section 1060, to their tax return. On Form 8594,
petitioners indicated the fair market value for the Class IV
asset as $164,140.6 Petitioners answered “yes” to the following
question on line 6 of Form 8594: “did the buyer also purchase *
* * a covenant not to compete?” Petitioners did not assign a
value for the covenant not to compete.
In a notice of deficiency, respondent determined that the
termination payment from State Farm was ordinary income and did
not qualify for capital gain treatment.
Discussion
I. Positions of the Parties
Respondent argues that petitioner did not sell any property
to State Farm because all of the property was owned by State Farm
and reverted to State Farm when petitioner terminated his
relationship with State Farm. Respondent contends that the
agreement does not evidence a sale because the contract does not
list a seller or purchaser. Respondent also argues that
petitioners failed to establish that the termination payment
represents proceeds from the sale of a business, business assets,
6
A taxpayer may treat goodwill acquired before Feb. 14,
1997, as a Class IV asset. Sec. 1.1060-1T(a)(2)(ii), Temporary
Income Tax Regs., 62 Fed. Reg. 2272 (Jan. 16, 1997).
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or goodwill. Respondent also suggests that the termination
payment is in the nature of income from self-employment, but
hedges that position in arguing that the payment is “similar to
an annuity” and a “retirement benefit”. We note that respondent
did not determine that petitioners were liable for self-
employment tax with respect to the termination payment.
Petitioners argue that the termination payment was for the
sale or buyout of a business resulting in capital gain. They
assert that petitioner developed a customer base and the
termination payment was designed to protect the existing customer
base for the successor agent as well as compensate petitioner for
the goodwill and going business concern he developed.
Petitioners rely on the concurring opinion in Jackson v.
Commissioner, 108 T.C. 130, 141 (1997), which characterizes a
termination payment similar to the one at issue as a buyout of
the taxpayer’s business.
The Coalition of Exclusive Agent Associations, Inc. (CEAA),
filed with leave of the Court an amicus brief pursuant to
conditions specified in the Court’s order. The CEAA’s argument
is similar to the arguments made by petitioners: State Farm
purchased the goodwill generated by petitioner; therefore,
petitioner is entitled to capital gain treatment.
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II. Evidentiary Issue
We first deal with an evidentiary issue presented at trial.
Petitioners proffered a list of questions and answers dated
February 14, 1991, which was marked for identification as Exhibit
12-P. The questions were prepared by a representative of
respondent, and the answers were provided by a representative of
State Farm. Respondent objected to the admission of the document
and asked for an opportunity to authenticate the document. The
Court admitted the document, although it was not admitted for the
truth of the assertions contained therein. In a supplemental
stipulation of facts the parties agreed that the State Farm
representative who provided the answers to Exhibit 12-P, if
called as a witness, would testify as set forth in a declaration
attached to the supplemental stipulation as Exhibit 13-R. In the
declaration the representative states that he provided the
answers contained in Exhibit 12-P and further explains the
answers set forth in Exhibit 12-P. Petitioners, however, object
to the admission of Exhibit 13-R on the ground that State Farm’s
“view” of certain matters is not relevant. In this regard, the
objection appears inconsistent with petitioners’ proffer of
Exhibit 12-P, which expresses the “view” or opinion of the same
individual.
Considering Exhibits 12-P and 13-R together, we are
satisfied that our initial ruling was correct and that Exhibit
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12-P should not be admitted for the truth of the contents because
it contains hearsay. To be consistent with our treatment of
Exhibit 12-P, we admit Exhibit 13-R for the limited purpose of
supplementing Exhibit 12-P but not for the truth of the
assertions made therein. Fed. R. Evid. 401, 701, 801.
III. Burden of Proof
Generally the taxpayer bears the burden of proof. Rule
142(a)(1). Section 7491, which is effective with respect to
court proceedings arising in connection with examinations by the
Commissioner commencing after July 22, 1998, the date of its
enactment by section 3001(a) of the Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, 112 Stat.
726, does not apply to place the burden of proof on respondent.
Petitioners have neither alleged that section 7491 is applicable
nor established that they complied with the requirements of
section 7491(a)(2)(A) and (B) to substantiate items, maintain
required records, and fully cooperate with respondent’s
reasonable requests.
IV. Sale or Exchange of a Capital Asset
We must decide the proper characterization of the
termination payment made by State Farm to petitioner. We first
consider whether petitioner owned a capital asset and whether
petitioner sold or exchanged a capital asset for Federal income
tax purposes. We also consider whether petitioner sold a
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business to which goodwill attached. If petitioner did not sell
or exchange a capital asset, then the termination payment is
taxable as ordinary income.
Long-term capital gain is defined as gain from the sale or
exchange of a capital asset held for more than 1 year. Sec.
1222(3). A “capital asset” means property held by the taxpayer
(whether or not connected with his trade or business) that is not
covered by one of five specifically enumerated exclusions. Sec.
1221.
In Schelble v. Commissioner, T.C. Memo. 1996-269, affd. 130
F.3d 1388 (10th Cir. 1997), we considered whether the taxpayer
received gain from the sale or exchange of a capital asset.
Pursuant to the terms of the agreement with the insurance company
for which he was an agent, the taxpayer was required to return
all records, manuals, materials, advertising, and supplies or
other property of the company. Id. We concluded that there was
no evidence of “vendible business assets”, and the record did not
support a finding of a sale of assets of a business.
The Court of Appeals in Schelble v. Commissioner, 130 F.3d
at 1394, held that there was “no evidence in the record of
vendible assets to support the sale of Mr. Schelble’s insurance
business”. It observed the following:
By transferring policy records to * * * [the insurance
company] pursuant to the Agreement, * * * [the
taxpayer] maintains he transferred insurance business
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goodwill developed by him. * * * [The taxpayer] has
failed, however, to show a sale of assets occurred.
Id.In Foxe v. Commissioner, 53 T.C. 21, 26 (1969), we
considered whether payments made to an insurance agent were made
pursuant to the sale or exchange of a capital asset to his former
insurance company upon the cancellation of his employment
contract. The taxpayer claimed that in the course of his
business he built up “something of value, an organization” that
the insurance company acquired. Id. Moreover, his personal
contacts with customers, which were important to the insurance
company, were “something of real value”. Id.We concluded that even if the taxpayer had “built up an
organization of value, it was not his to sell since * * * [the
insurance company] under the contract owned all the property
comprising such organization. As to the customer contacts
* * *. They were not his to sell.” Id. It was held that the
taxpayer did not sell or exchange a capital asset, and the
payments were taxable as ordinary income.
Section 1001(c) provides that gain is recognized upon the
sale or exchange of property. “The word ‘sale’ means ‘a transfer
of property for a fixed price in money or its equivalent’”.
Schelble v. Commissioner, supra at 1394 (quoting Iowa v.
McFarland, 110 U.S. 471, 478 (1885)); see also Commissioner v.
Brown, 380 U.S. 563, 570 (1965). “Exchange” means an exchange of
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property for another property that is materially different either
in kind or in extent. Sec. 1.1001-1, Income Tax Regs.
The key to deciding whether there has been a sale for
Federal income tax purposes is whether the benefits and burdens
of ownership have passed. Highland Farms, Inc. v. Commissioner,
106 T.C. 237 (1996); Grodt & McKay Realty, Inc. v. Commissioner,
77 T.C. 1221, 1237 (1981). Among the many factors we may
consider in deciding whether there has been a sale are the
following: Whether legal title passes; how the parties treat the
transaction; whether an equity was acquired in the property;
whether the contract creates a present obligation on the seller
to execute and deliver a deed and a present obligation on the
purchaser to make payments; whether the right of possession is
vested in the purchaser; which party pays the property taxes;
which party bears the risk of loss or damage to the property; and
which party receives the profits from the operation and sale of
the property. Levy v. Commissioner, 91 T.C. 838, 860 (1988);
Grodt & McKay v. Commissioner, supra at 1237-1238.
Cases addressing whether there has been a sale or exchange
of a capital asset often combine the issue of whether the
taxpayer owned a capital asset with the issue of whether the
taxpayer sold the asset. For example, in Erickson v.
Commissioner, T.C. Memo. 1992-585, affd. 1 F.3d 1231 (1st Cir.
1993), we concluded that there was no sale of the taxpayer’s
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assets to his former insurance company because there was nothing
in the facts showing that there was a sale of “vendible tangible
assets” of a business. In Erickson, the Court stated:
[The taxpayers] maintain that * * * certain
indicia of a sale exist. They assert that employees
who formerly worked for * * * [the taxpayer] went over
to Union Mutual and that all records, supplies, and
equipment were turned over to Union Mutual. * * *
however, the individuals who had worked with * * * [the
taxpayer] had always been salaried employees of Union
Mutual. * * * And by his own admission, * * * [the
taxpayer] had owned very little in the way of supplies
and equipment * * *
Id.Respondent cites Jackson v. Commissioner, 108 T.C. 130(1997), Milligan v. Commissioner, T.C. Memo. 1992-655, revd. 38
F.3d 1094 (9th Cir. 1994), and similar cases for the proposition
that the taxpayer did not sell or exchange the assets in his
business. These cases bear a factual resemblance to the case at
hand in that the taxpayer, a former insurance agent, received a
termination payment after the termination of his agreement with
the insurance company. But these cases focus on whether the
taxpayer was subject to self-employment tax under sections 1401
and 1402.
The holdings by the Court of Appeals in Milligan and by this
Court in Jackson do not require a conclusion that the termination
payment paid to petitioner represents proceeds from the sale or
exchange of a capital asset. Both Jackson and Milligan left open
the question of whether termination payments constitute the sale
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or exchange of capital assets subject to capital gain treatment
or whether they should be treated as ordinary income (other than
income subject to self-employment tax).
V. The Controlling Facts of This Case
We now apply the above discussion to the facts before us in
this case. Upon his retirement, petitioner returned all assets
used in the daily course of business, including a computer, books
and records, and customer lists to State Farm pursuant to the
agreement. Thus, much like the taxpayers in Foxe v.
Commissioner, supra, and Schelble v. Commissioner, 130 F.3d 1388(10th Cir. 1997), petitioner did not own these assets and,
therefore, could not have sold them to State Farm.
Petitioner argues that the successor agent assumed his
telephone number and hired the two employees of the agency, and
that petitioner taught the successor agent about the agency and
introduced him to policyholders, all of which support the
argument that he sold the agency to State Farm.
The successor agent obtained the right to use the telephone
number utilized by petitioner’s agency. Petitioner did not
argue, and we do not conclude, that the telephone number was a
capital asset in the hands of petitioner. Additionally, there
are no facts in the record that indicate that petitioner received
any portion of the termination payment as payment for the
successor agent’s use of the telephone number.
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There are no facts in the record that indicate that there
was an employment contract between petitioner and the employees
who worked for the agency or that the successor agent was
required to hire the employees. Petitioner did not argue, and we
do not conclude, that the employees constitute capital assets in
the hands of petitioner. There is nothing in the record that
indicates that petitioner received any portion of the termination
payment as payment for the successor agent’s hiring of the
employees. The fact that the successor agent hired petitioner’s
former employees does not support petitioner’s argument that he
sold his agency.
Petitioner may have taught the successor agent about the
agency and introduced him to policyholders when the successor
agent visited petitioner’s office, but there are no facts in the
record that indicate that petitioner received the termination
payment as payment for teaching the successor agent about the
agency and introducing him to policyholders.
We conclude that petitioner did not own a capital asset that
he could sell to State Farm. He did not receive the termination
payment as payment for any asset. Accordingly, the termination
payment does not represent gain from the sale or exchange of a
capital asset.
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Petitioner also argues that State Farm purchased goodwill.
To qualify as the sale of goodwill, the taxpayer must demonstrate
that he sold “‘the business or a part of it, to which the
goodwill attaches’”. Schelble v. Commissioner, 130 F.3d at 1394(quoting Elliott v. United States, 431 F.2d 1149, 1154 (10th Cir.
1970)). Goodwill is “the expectancy of continued patronage, for
whatever reason.” Boe v. Commissioner, 307 F.2d 339, 343 (9th
Cir. 1962), affg. 35 T.C. 720 (1961); see also VGS Corp. v.
Commissioner, 68 T.C. 563, 590 (1977).
Nevertheless, because petitioner, for the reasons already
explained, did not own and sell capital assets in his agency to
State Farm, we conclude that petitioner did not sell goodwill.
VI. Nature of Ordinary Income
Respondent does not clearly explain his position as to the
nature of the termination payment other than to argue that it is
not taxable as capital gain. In the notice of deficiency,
respondent determined that the termination payment was ordinary
income. In his brief, respondent primarily argues that
petitioners did not satisfy their burden of proof to establish
that the termination payment was proceeds of a sale and thus
subject to capital gain treatment.
Having concluded above that the termination payment was not
received for the sale or exchange of a capital asset and is not
entitled to treatment as a capital gain, we conclude that the
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termination payment is taxable as ordinary income. Ordinary
income treatment is accorded to a variety of payments. See,
e.g., Hort v. Commissioner, 313 U.S. 28 (1941) (income received
upon cancellation of lease derived from relinquishment of right
to future rental payments in return for a present substitute
payment and possession of premises); Elliott v. United States,
supra (payment for termination of insurance agency contract was
ordinary income); Foxe v. Commissioner, 53 T.C. at 25 (payment to
insurance agent upon cancellation of employment contract was
ordinary income); General Ins. Agency, Inc. v. Commissioner, T.C.
Memo. 1967-143 (payment for agreement not to compete was ordinary
income), affd. 401 F.2d 324 (4th Cir. 1968).
VII. Covenant Not To Compete
An amount received for an agreement not to compete is
generally taxable as ordinary income. Banc One Corp. v.
Commissioner, 84 T.C. 476, 490 (1985), affd. without published
opinion 815 F.2d 75 (6th Cir. 1987); Warsaw Photographic
Associates, Inc. v. Commissioner, 84 T.C. 21 (1985); Ullman v.
Commissioner, 29 T.C. 129 (1957), affd. 264 F.2d 305 (2d Cir.
1959); General Ins. Agency, Inc. v. Commissioner, supra.
Petitioners reported the sale of a covenant not to compete
on Form 8594 attached to the return. The agreement provides
that, after retiring, petitioner would not solicit State Farm’s
policyholders for 1 year, or petitioner would forfeit the
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termination payment. If petitioner had competed against State
Farm after retiring, he would not have received a termination
payment. We find that petitioner entered into a covenant not to
compete with State Farm and that a portion of the termination
payment was paid for the covenant not to compete.
Proceeds allocable to a covenant not to compete are properly
classified as ordinary income. See General Ins. Agency, Inc. v.
Commissioner, 401 F.2d at 329. Petitioner did not allocate any
portion of the termination payment to the covenant not to
compete, and it is unnecessary for us to make such an allocation
because the termination payment is classified as ordinary income.
We have considered all arguments by the parties and amicus,
and, to the extent not discussed above, conclude they are
irrelevant or without merit.
To reflect the foregoing,
Decision will be
entered for respondent.