Taxpayer Had No Asset to Sell, Income Was Ordinary

In the case of Pexa v. United States, Case No. 2:16-cv-00994, U.S. District Court, Eastern District of California the taxpayer was attempting to defend his treatment of termination payments for his termination payments received from Farmers Insurance as long term capital gain income.  The District Court had this matter before it on appeal from the Bankruptcy Court, which had ruled against the taxpayer.

Mr. Pexa had been involved first as an insurance agent and, eventually, a district manager for Farmers Insurance.  When he was promoted to district manager he was no longer allowed to sell insurance, rather now being in charge of recruiting, training, and supervising agents.  As such, he sold his agency to his sister in 1998, with a note payable over 20 years. 

Mr. Pexa reported the interest on the note as ordinary income and the principal as capital gain from the sale of intangible asset.  Mr. Pexa indicated he had been audited by the IRS on several occasions, and this treatment was not questioned nor were any other major issues raised.

Eventually Mr. Pexa and Farmers parted ways.  As the opinion describes the matter:

In early 2009, Pexa was unhappy with his relationship with Farmers and sent a letter to Farmers discussing his unhappiness with changes in Farmers' practices. (ECF No. 7-11 at 5-6, 19.) This letter was interpreted by Farmers as an invitation by Pexa to terminate his relationship as a district manager. (ECF No. 7-11 at 19.) On January 26, 2009, Farmers issued Pexa a 30 day notice of termination pursuant to paragraph (d) of Pexa's District Manager Appointment Agreement (the "Agreement"), which provided that the Agreement "may be cancelled without cause by either the District Manager or [Farmers] on 30 day written notice." (ECF Nos. 7-5 at 2; 7-11 at 6.) Pursuant to the Agreement, upon termination, Farmer's was required to pay Pexa the "contract value," an amount determined based on the number of years Pexa worked as a district manager and the commissions he received during the six months immediately preceding his termination. (ECF Nos. 7-5 at 2; 7-11 at 6-7.) In the event that Farmers elected to pay the "contract value," Pexa agreed to "transfer and assign all of his interest under the agency to the nominee acceptable to [Farmers] or to [Farmers]." (ECF No. 7-5 at 3.)

These contract value payments were reported to Mr. Pexa by Farmers on a Form 1099-MISC as non-employee compensation for the years in question.

Mr. Pexa had his returned prepared by a paid preparer, Mr. Allen.  The Court described how the information was provided to Mr. Allen:

Pexa did not provide detailed documentation to Mr. Allen for the preparation of the 2009 and 2010 returns. (ECF No. 7-11 at 43.) Mr. Allen simply accepted summary worksheets that included the items of income and deductions that Pexa believed he should claim on his returns. (ECF No. 7-11 at 43.) Mr. Allen took Pexa's word for what his income and expenses were and prepared the returns accordingly. (ECF No. 7-11 at 44.) Mr. Allen was not provided with the 1099 forms, nor was he provided with the Agreement. (ECF No. 7-11 at 44.)

Mr. Allen attempted to determine the proper way to report the amounts received even though he did not have the underlying agreements.  Based on what Mr. Pexa told him, he did the following:

Mr. Allen believed that the “contract value” payments Pexa received from Farmers were for work that Pexa performed as an insurance agent, and he was unfamiliar with the term district manager and the responsibilities associated with the position. (ECF No. 7-11 at 21.) Mr. Allen testified that he found the case Johnson v. Commissioner, which discusses “contract value” relating to insurance agents, and he used that case as a basis for classifying the "contract value" payments as capital gains income. (ECF Nos. 7-8 at 13; 7-11 at 21-22.)

On Pexa’s 2009 and 2010 tax returns, the “contract value” payments were included as gross receipts on his Schedule C. (ECF No. 7-11 at 22.) On both returns, the same amount of the “contract value” payments was then deducted by being listed under “other expenses” of the relevant Schedule C. (ECF No. 7-11 at 22.) For the 2009 tax year, a portion of the “contract value” payments was reported as capital gains. (ECF No. 7-11 at 22.) For the 2010 tax year, none of the “contract value” payments were reported as capital gains. (ECF No. 7-11 at 22.)

The issue before the Court was whether the income from the contract value proceeds should be treated as a capital gain.  To be taxed as a long term capital gain, the payments had to arise from the sale or exchange of a capital asset.  The opinion notes that a key precondition to being able to sell a capital asset is owning the capital asset purported to be sold.

The taxpayer argued that his insurance agency was the capital asset that was sold to Farmers, essentially arguing that he had a sale of goodwill.  But the Court found that he actually never owned the goodwill.

The opinion pointed out that in 2003, the Seventh Circuit had ruled on these termination payments, finding that, based on the terms of the agreement with the insurance company, the agent did not own an asset that could be sold:

The Seventh Circuit addressed this exact issue in Baker. 338 F.3d at 793. In Baker, the insurance agent sought to have his termination payments treated as long-term capital gains and argued the payments were in consideration of goodwill. Id. However, the court held that because the agent's contract contained a blanket reservation of property rights to the insurance company, the agent did not “own any assets related to the business,” and could not transfer goodwill “apart from the business with which it was connected.” Id. at 793-94. The Ninth Circuit adopted Baker's reasoning in Trantina, holding that because the express terms of the agent's agreement contained a blanket reservation of all property rights to the insurance company, the agent “simply had no property that could be sold or exchanged.” 512 F.3d at 573.

The opinion notes that Mr. Pexa’s contract with Farmers contained the very same restrictions as found in Baker and Trantina.  As the Court concluded in finding the income was not from the sale of a capital asset:

The only “interest under the agency” that Pexa retained was a contractual right to perform services for Farmers and receive compensation for those services as long as the Agreement remained in effect. However, a contractual right to perform services is not a capital asset. Trantina, 512 F.3d at 571-72 (“[T]he courts have quite uniformly held that contracts for the performance of personal services are not capital assets and that the proceeds from their transfer or termination will not be accorded capital gains treatment but will be considered to be ordinary income.”). Therefore, because Pexa owned no capital asset, he could not sell or exchange a capital asset. Accordingly, the “contract value” payments that Pexa received are ordinary income, not long term capital gains.

The Court also sustained the Bankruptcy Court’s holding that Mr. Pexa was subject to the accuracy related penalty under IRC §6662 on this understatement.  Mr. Pexa argued first that he had relied on the expertise of his preparer, but the opinion rejected that view:

There is no dispute that Pexa did not provide Mr. Allen with the material information necessary to make an appropriate determination of whether the “contract value” payments were long term capital gain. Namely, Pexa did not provide Mr. Allen with the Agreement — the single most important document in this determination and the document that dictated the payments Pexa would receive. Therefore, the evidence supports a finding that Pexa could not have reasonably relied on Mr. Allen. See 26 C.F.R. § 1.6664-4(c)(i) (“The advice must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances.”)

The Court also rejected the claim that he had acted reasonably since the IRS, in various prior audits, had never objected to treating the payments from his sister for the earlier sale of the agent business as long-term capital gain income:

However, the fact that Pexa classified payments arising out of one transaction as long term capital gains does not necessarily have bearing on whether or not Pexa reasonably and in good faith classified the payments at issue, arising out of a different transaction, as long term capital gains. Moreover, there is no evidence that Pexa classified these prior payments reasonably and in good faith. Therefore, the facts support a finding that Pexa did not make a reasonable and good faith effort to assess his tax liability and could not reasonably and in good faith rely on Mr. Allen or former tax returns in determining whether the “contract value” payments constituted long term capital gains.