Agency contract payments are ordinaryincome
Insurance agents enter into contracts thatallow for payments of commissions on renewals after the contract isterminated. Agents believe they own their lists of clients, therenewals and commissions earned on renewal. In the following case,Charles Trantina, an agent who tried to collect his earnings afterterminating a contract with State Farm, found the terms of thecontract were costly and converted what he thought was a capitalasset into ordinary income.

If an agent has a contract like the one between State Farmand Trantina and earns the income in an area governed by the 7th or9th Circuit Courts of Appeal, he or she will find that all earningsmust 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 acontract to provide insurance services cannot be treated as acapital asset under 26 U.S.C. 1221(a). Rather, such a contract wasfound to not be a capital asset, and payments under the contractwere taxed as ordinary income rather than as capital gains. The 9thCircuit's finding joined with that of the 7th Circuit's decision inBaker v. Commissioner, 338 F.3d 789, 793 (7th Cir.2003).
The court found that Charles E. Trantina served as an insuranceagent for State Farm in the Phoenix area from 1958 until hisretirement in 1996. He operated his agency as a sole proprietorshipuntil 1978, when he incorporated the agency as an Arizonacorporation of which he was the sole shareholder. State Farm andthe corporation executed a corporation agent agreement, whichformed the center of the dispute.
This governed all aspects of the corporation's relationship withState Farm. It also provided that all information relating topolicyholder names, addresses and ages–and information about policydetails such as expiration or renewal dates and the location ofinsured property–were trade secrets of State Farm.
State Farm compensated the corporation for its services by payingcommissions for generating or servicing policies, providing highercommissions for servicing policies that the corporation hadgenerated. When Trantina began his career as a State Farm insuranceagent in 1958, he was assigned 20 policies to service. When heretired and liquidated the corporation in 1996, it was servicingmore than 17,000 policies, many of which Trantina himself hadgenerated.
In addition to the regular commission payments, the corporateagreement required State Farm to pay the corporation terminationpayments when the agreement terminated, payable monthly for fiveyears.
Trantina retired in 1996 after serving as State Farm's insuranceagent for 38 years. The corporation received the terminationpayments until its dissolution in March 1997; Trantina, as thecorporation's sole shareholder, received the payments followingdissolution.
In 1999, Trantina and his wife filed a joint tax return classifyingthe termination payments that Trantina received from State Farm asordinary income. On April 10, 2003, they timely filed an amendmentto their 1999 income tax return, seeking to reclassify thetermination payments as a long-term capital gain and thereby reducetheir tax liability for 1999.
The Trantinas accordingly claimed a refund for the 1999 tax year inthe amount of $15,982 plus interest. The IRS denied their claim fora refund on June 30, 2003, and the Trantinas timely filed suit fora refund in the federal district court for the District of Arizonaon Dec. 24, 2003. Both parties moved for summary judgment, whichthe district court granted for the U.S. on May 17, 2005. Thedistrict court reasoned that the corporate agreement was not acapital asset and that even if it was, no exchange or sale of thecorporate agreement had occurred.
The Trantinas argued that the termination payments qualified aslong-term capital gains, which are taxed at a lower rate thanordinary income. The U.S. asserted that the termination paymentsare ordinary income.
The Trantinas argued that the termination payments satisfied thedefinition of a long-term capital gain because the corporateagreement itself constituted a capital asset, and it was exchangedwith State Farm for the termination payments. The U.S., in turn,insisted that the termination payments do not meet the definitionof long-term capital gain because Trantina and his corporation hadno property rights under the corporate agreement beyond thecontractual obligation to perform and be compensated for thoseservices.
Agreeing with the government, the 9th Circuit held that thecorporate agreement was not a capital asset. A literal reading ofthe broad statutory language would cause every conceivable propertyinterest, even an employment contract, to fall within the categoryof “capital asset,” the termination of which would result in acapital gain or loss.
The courts have uniformly held that contracts for the performanceof personal services are not capital assets and that the proceedsfrom their transfer or termination will not be accorded capitalgains treatment but will be considered to be ordinary income.Md. Coal & Coke Co. v. McGinnes (350 F.2d 293, 294 [3dCir. 1965] finds a contract giving the taxpayer an exclusive salesagency not to be a capital asset because it did not confer on thetaxpayer “some interest or estate in or encumbrance upon someproperty with which the contract is concerned.”
The 9th Circuit had previously addressed this issue, albeit in aslightly different context. In Furrer v. Commissioner, thetaxpayer, an insurance agent, successfully sued the insurancecompany for which he worked for breach of contract (566 F.2d at1116). The taxpayer argued that the resulting damages should betreated as capital gain and not as ordinary income because hiscontract rights under the agency agreement “were in themselvescapital assets.” The 9th Circuit rejected that argument, viewingthe essential right under an insurance agency contract to be “theright to earn commission income.” The court concluded that “[t]hisattempted transubstantiation of income into capital must failbecause the essential element–the capital asset, tangible orintangible–is not present.”
More recently, the 7th Circuit faced essentially the same situationas the Trantina case. In Baker v. Commissioner, Baker hadreceived termination payments under an agency agreement with StateFarm that was nearly identical to the corporate agreement inTrantina (338 F.3d at 791-92). Baker reported the terminationpayments that State Farm made under the agreement as long-termcapital gain on his 1997 federal income tax return. Thecommissioner of internal revenue issued a notice of deficiency toBaker, finding that the State Farm termination payments constitutedordinary income, not capital gain. Baker contested the ruling inthe tax court, which found for the commissioner.
On appeal to the 7th Circuit, Baker contended that the terminationpayments were in consideration of the goodwill he established overhis 34-year career. The 7th Circuit rejected his arguments andagreed with the tax court's finding. Citing a provision in Baker'sagency agreement with State Farm reserving to State Farm allproperty rights over the policies and policyholder information, thecourt wrote that “[b]ecause Warren Baker did not own any propertyrelated to the policies, he could not sell anything.”
As a result, the court found that Baker had not sold or exchanged acapital asset; his termination payments were therefore ordinaryincome.
The 9th Circuit adopted the reasoning of the 7th Circuit. Aprecondition to realizing a long-term capital gain is the ownershipof a capital asset. Yet under the express terms of Trantina'scorporate agreement with State Farm, Trantina had no property thatcould be sold or exchanged. Given this blanket reservation of allproperty rights to State Farm, it is unclear exactly what Trantinacould have sold or exchanged.
Trantina attempted to avoid the plain language of the corporateagreement by characterizing the agreement itself as a capital assetthat was exchanged with State Farm for the termination paymentswhen Trantina retired.
Trantina did not have any property rights in the policies under theexpress terms of the agreement. The policies, including allidentifying information which might have been taken or conveyed toanother insurance agency, belonged to State Farm, not Trantina.Furthermore, the corporate agreement expressly forbade Trantinafrom transferring or assigning his interest in the agreementitself.
Trantina pointed to several aspects of the agreement as evidencethat he had enforceable rights beyond a contractual right toperform services for State Farm and receive compensation for thoseservices. To support this contention, Trantina curiously pointed toa provision that imposed an obligation upon himself, not upon StateFarm. The agreement provides that “[t]he Agent will respect therights and interests of other agents in policies credited to theiraccounts by refraining from raiding or otherwise diverting policiesfrom 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 raidother agents' customers for his own account (and presumably StateFarm placed a similar duty on all of its other agents). However,the provision said nothing about Trantina's ability to preventState Farm from assigning the policies to other agents.
Trantina also highlighted a provision in the corporate agreementthat permitted him to release to State Farm one-quarter of thepolicies assigned to his account as evidence that he had someproperty interest in the policies beyond the right to receivecompensation or perform services. Yet this provision demonstratedonly that Trantina could obtain an early, partial release from hisobligations to service the policies, not that he possessed anyproperty right in the actual policies themselves.
Trantina pointed the court to the covenant of good faith and fairdealing implied in every contract under Arizona law as evidencethat he possessed some interest greater than the right to performservices for and receive commissions from State Farm. But thisargument proves too much: Assuming that such a requirement existsunder Arizona law, its existence would not transform every contractfor services into a capital asset. If the 9th Circuit acceptedTrantina's argument, the same could be said of every servicescontract, and the result would be contrary to its previousinstructions. Simply because Trantina may have been able to enforcehis rights under the contract through a breach of contract actionif State Farm had transferred all of his policies to a differentagent does not mean that the contract was a capital asset.
The duties and obligations of Trantina under the corporateagreement clearly indicated that the corporation contracted withState Farm to provide services to State Farm–namely, the sale andservicing of insurance policies.
Because the court concluded that Trantina did not have any propertyrights that he could sell under the express terms of the corporateagreement, the termination payments were properly characterized asordinary income. The grant of summary judgment to the U.S. wasproper.
Trantina v. United States, No. 05-16102 (9th Cir.01/09/2008).

Barry Zalma, Esq., CFE, is a California attorneyspecializing in providing expert witness testimony and consulingwith plaintiffs and defendants on insurance coverage, claimshandling and bad faith. He founded Zalma Insurance Consultants in2001 and serves as its senior consultant. He can be reached at[email protected]. His consultingpractice's Web site is www.zic.bz.