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Agency contract payments are ordinary incomeInsurance agents enter into contracts that allow for payments of commissions on renewals after the contract is terminated. Agents believe they own their lists of clients, the renewals and commissions earned on renewal. In the following case, Charles Trantina, an agent who tried to collect his earnings after terminating a contract with State Farm, found the terms of the contract were costly and converted what he thought was a capital asset into ordinary income.

If an agent has a contract like the one between State Farm and Trantina and earns the income in an area governed by the 7th or 9th Circuit Courts of Appeal, he or she will find that all earnings must be reported as ordinary income.In Trantina v. United States, No. 05-16102 (9th Cir. 01/09/2008), the 9th Circuit Federal Court of Appeal found that a contract to provide insurance services cannot be treated as a capital asset under 26 U.S.C. 1221(a). Rather, such a contract was found to not be a capital asset, and payments under the contract were taxed as ordinary income rather than as capital gains. The 9th Circuit’s finding joined with that of the 7th Circuit’s decision in Baker v. Commissioner, 338 F.3d 789, 793 (7th Cir. 2003).The court found that Charles E. Trantina served as an insurance agent for State Farm in the Phoenix area from 1958 until his retirement in 1996. He operated his agency as a sole proprietorship until 1978, when he incorporated the agency as an Arizona corporation of which he was the sole shareholder. State Farm and the corporation executed a corporation agent agreement, which formed the center of the dispute.This governed all aspects of the corporation’s relationship with State Farm. It also provided that all information relating to policyholder names, addresses and ages–and information about policy details such as expiration or renewal dates and the location of insured property–were trade secrets of State Farm.State Farm compensated the corporation for its services by paying commissions for generating or servicing policies, providing higher commissions for servicing policies that the corporation had generated. When Trantina began his career as a State Farm insurance agent in 1958, he was assigned 20 policies to service. When he retired and liquidated the corporation in 1996, it was servicing more than 17,000 policies, many of which Trantina himself had generated.In addition to the regular commission payments, the corporate agreement required State Farm to pay the corporation termination payments when the agreement terminated, payable monthly for five years.Trantina retired in 1996 after serving as State Farm’s insurance agent for 38 years. The corporation received the termination payments until its dissolution in March 1997; Trantina, as the corporation’s sole shareholder, received the payments following dissolution.In 1999, Trantina and his wife filed a joint tax return classifying the termination payments that Trantina received from State Farm as ordinary income. On April 10, 2003, they timely filed an amendment to their 1999 income tax return, seeking to reclassify the termination payments as a long-term capital gain and thereby reduce their tax liability for 1999.The Trantinas accordingly claimed a refund for the 1999 tax year in the amount of $15,982 plus interest. The IRS denied their claim for a refund on June 30, 2003, and the Trantinas timely filed suit for a refund in the federal district court for the District of Arizona on Dec. 24, 2003. Both parties moved for summary judgment, which the district court granted for the U.S. on May 17, 2005. The district court reasoned that the corporate agreement was not a capital asset and that even if it was, no exchange or sale of the corporate agreement had occurred.The Trantinas argued that the termination payments qualified as long-term capital gains, which are taxed at a lower rate than ordinary income. The U.S. asserted that the termination payments are ordinary income.The Trantinas argued that the termination payments satisfied the definition of a long-term capital gain because the corporate agreement itself constituted a capital asset, and it was exchanged with State Farm for the termination payments. The U.S., in turn, insisted that the termination payments do not meet the definition of long-term capital gain because Trantina and his corporation had no property rights under the corporate agreement beyond the contractual obligation to perform and be compensated for those services.Agreeing with the government, the 9th Circuit held that the corporate agreement was not a capital asset. A literal reading of the broad statutory language would cause every conceivable property interest, even an employment contract, to fall within the category of “capital asset,” the termination of which would result in a capital gain or loss.The courts have 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. Md. Coal & Coke Co. v. McGinnes (350 F.2d 293, 294 [3d Cir. 1965] finds a contract giving the taxpayer an exclusive sales agency not to be a capital asset because it did not confer on the taxpayer “some interest or estate in or encumbrance upon some property with which the contract is concerned.”The 9th Circuit had previously addressed this issue, albeit in a slightly different context. In Furrer v. Commissioner, the taxpayer, an insurance agent, successfully sued the insurance company for which he worked for breach of contract (566 F.2d at 1116). The taxpayer argued that the resulting damages should be treated as capital gain and not as ordinary income because his contract rights under the agency agreement “were in themselves capital assets.” The 9th Circuit rejected that argument, viewing the essential right under an insurance agency contract to be “the right to earn commission income.” The court concluded that “[t]his attempted transubstantiation of income into capital must fail because the essential element–the capital asset, tangible or intangible–is not present.”More recently, the 7th Circuit faced essentially the same situation as the Trantina case. In Baker v. Commissioner, Baker had received termination payments under an agency agreement with State Farm that was nearly identical to the corporate agreement in Trantina (338 F.3d at 791-92). Baker reported the termination payments that State Farm made under the agreement as long-term capital gain on his 1997 federal income tax return. The commissioner of internal revenue issued a notice of deficiency to Baker, finding that the State Farm termination payments constituted ordinary income, not capital gain. Baker contested the ruling in the tax court, which found for the commissioner.On appeal to the 7th Circuit, Baker contended that the termination payments were in consideration of the goodwill he established over his 34-year career. The 7th Circuit rejected his arguments and agreed with the tax court’s finding. Citing a provision in Baker’s agency agreement with State Farm reserving to State Farm all property rights over the policies and policyholder information, the court wrote that “[b]ecause Warren Baker did not own any property related to the policies, he could not sell anything.”As a result, the court found that Baker had not sold or exchanged a capital asset; his termination payments were therefore ordinary income.The 9th Circuit adopted the reasoning of the 7th Circuit. A precondition to realizing a long-term capital gain is the ownership of a capital asset. Yet under the express terms of Trantina’s corporate agreement with State Farm, Trantina had no property that could be sold or exchanged. Given this blanket reservation of all property rights to State Farm, it is unclear exactly what Trantina could have sold or exchanged.Trantina attempted to avoid the plain language of the corporate agreement by characterizing the agreement itself as a capital asset that was exchanged with State Farm for the termination payments when Trantina retired.Trantina did not have any property rights in the policies under the express terms of the agreement. The policies, including all identifying information which might have been taken or conveyed to another insurance agency, belonged to State Farm, not Trantina. Furthermore, the corporate agreement expressly forbade Trantina from transferring or assigning his interest in the agreement itself.Trantina pointed to several aspects of the agreement as evidence that he had enforceable rights beyond a contractual right to perform services for State Farm and receive compensation for those services. To support this contention, Trantina curiously pointed to a provision that imposed an obligation upon himself, not upon State Farm. The agreement provides that “[t]he Agent will respect the rights and interests of other agents in policies credited to their accounts by refraining from raiding or otherwise diverting policies from their accounts to the Agent’s account.” In the agreement, however, the term “Agent” referred to Trantina, not to State Farm. The quoted provision thus imposed a duty on Trantina not to raid other agents’ customers for his own account (and presumably State Farm placed a similar duty on all of its other agents). However, the provision said nothing about Trantina’s ability to prevent State Farm from assigning the policies to other agents.Trantina also highlighted a provision in the corporate agreement that permitted him to release to State Farm one-quarter of the policies assigned to his account as evidence that he had some property interest in the policies beyond the right to receive compensation or perform services. Yet this provision demonstrated only that Trantina could obtain an early, partial release from his obligations to service the policies, not that he possessed any property right in the actual policies themselves.Trantina pointed the court to the covenant of good faith and fair dealing implied in every contract under Arizona law as evidence that he possessed some interest greater than the right to perform services for and receive commissions from State Farm. But this argument proves too much: Assuming that such a requirement exists under Arizona law, its existence would not transform every contract for services into a capital asset. If the 9th Circuit accepted Trantina’s argument, the same could be said of every services contract, and the result would be contrary to its previous instructions. Simply because Trantina may have been able to enforce his rights under the contract through a breach of contract action if State Farm had transferred all of his policies to a different agent does not mean that the contract was a capital asset.The duties and obligations of Trantina under the corporate agreement clearly indicated that the corporation contracted with State Farm to provide services to State Farm–namely, the sale and servicing of insurance policies.Because the court concluded that Trantina did not have any property rights that he could sell under the express terms of the corporate agreement, the termination payments were properly characterized as ordinary income. The grant of summary judgment to the U.S. was proper.Trantina v. United States, No. 05-16102 (9th Cir. 01/09/2008).

Barry Zalma, Esq., CFE, is a California attorney specializing in providing expert witness testimony and consuling with plaintiffs and defendants on insurance coverage, claims handling and bad faith. He founded Zalma Insurance Consultants in 2001 and serves as its senior consultant. He can be reached at [email protected]. His consulting practice’s Web site is www.zic.bz.