                     T.C. Summary Opinion 2009-165



                        UNITED STATES TAX COURT



        STEVEN LENARD AND JAMIE TEAGUE-LENARD, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



        Docket No. 27826-07S.            Filed November 9, 2009.



        Steven Lenard and Jamie Teague-Lenard, pro sese.

        Thomas L. Fenner, for respondent.



     DEAN, Special Trial Judge:     This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect when the petition was filed.     Pursuant to section 7463(b),

the decision to be entered is not reviewable by any other court,

and this opinion shall not be treated as precedent for any other

case.     Unless otherwise indicated, subsequent section references

are to the Internal Revenue Code in effect for the year in issue,
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and all Rule references are to the Tax Court Rules of Practice

and Procedure.

     Respondent determined a deficiency in petitioners’ 2005

Federal income tax of $14,129, an addition to tax for failure to

file timely under section 6651(a)(1) of $707, and an accuracy-

related penalty under section 6662(a) of $2,826.

     The parties agree that petitioners are entitled to deduct

expenses for the insurance agency business of Steven Lenard

(petitioner) of $78,952 for 2005.   The parties also agree that,

without taking into consideration certain contested payments by

Farmers Insurance Group of Companies (Farmers), petitioner’s

insurance agency business generated gross receipts of $111,632 in

2005.    The parties further agree that petitioners are not liable

for the addition to tax under section 6651(a)(1).1   The issues

for decision2 are whether:   (1) Unreported “Contract Value”

payments by Farmers to petitioners in 2005 are ordinary income;

(2) the contract value payments by Farmers to petitioners are

subject to self-employment tax; and (3) petitioners are liable

for the accuracy-related penalty under section 6662(a).


     1
      The stipulation of settled issues states the parties’
agreement that petitioners are not liable for the addition to tax
under sec. 6651(a)(2), but the notice of deficiency does not
determine that addition to tax.
     2
      Adjustments to petitioners’ child   tax credit, earned
income credit, itemized deductions, and   self-employment tax
deduction are computational and will be   resolved consistent with
the Court’s decision. See secs. 24(b),    32, 67(a), 164(f), 1401.
                               - 3 -

                            Background

     Some of the issues and facts have been stipulated and are so

found.   The stipulation of facts and the exhibits received in

evidence are incorporated herein by reference.    Petitioners

resided in Texas when their petition was filed.

History of the Insurance Agency

     During the year at issue petitioner was a property and

casualty insurance agent for Farmers conducting his business as

Steve Lenard Agency (the agency).   He was introduced to the

insurance business by his father, who started doing business with

Farmers in 1956.   Petitioner began working with his father in

1982, and in 1983 he signed an agency agreement with Farmers

known as the 32-0389 contract (old contract).    In 1987 petitioner

signed a revised agreement known as the 32-1106 contract that is

the subject of this litigation.

The 1987 Agreement

     Under the 32-1106 contract, the “Agent’s Appointment

Agreement” (AAA), petitioner accepted an appointment as “agent”

for Farmers.   Among other items under the agreement, Farmers

agreed to:   (1) Pay petitioner as an agent “new business and

service commissions or any other commission” according to

established schedules; and (2) provide approved manuals, forms,

and policyholder records necessary to carry out the provisions of

the agreement.
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     The AAA provided that petitioner agreed to several items,

including:   (1) To sell insurance for Farmers in accordance with

their rules and manuals; (2) to provide facilities necessary to

furnish insurance services, including collecting and remitting

money, receiving and adjusting claims, notifying the company of

claims, and servicing all policyholders of Farmers; and (3) to

permit the authorized representatives of Farmers to review and

examine agency records.   There was a series of other pertinent

provisions in the AAA.

     Provision F

     Provision F of the AAA allowed for the agent or the agent’s

heirs to “sell all or any part of this Agency” to a member of the

agent’s immediate family if acceptable to Farmers, provided the

“sale price does not exceed the proportionate share of the

‘Contract Value’” of the agency.

     Provision G

     If the agency is terminated other than by a “sale” under

provision F, provision G stated that Farmers agreed to pay the

“Contract Value” to the agent or heirs.   The contract value is an

amount based on:   (1) The amount of service commissions paid to

the agent on active policies during either the “six month or

twelve month period immediately preceding termination”; (2) “the

number of policies in the agent’s active code number”; and (3)

“the number of years of continuous service as an Agent” for
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Farmers immediately before termination.3   Provision G stated that

if an agent had fewer than 50 policies in an active code number,

“there is no Contract Value”.

     Provision G also provided for an “Underwriting Contract

Value Bonus” (bonus).   The bonus was to be a percentage based on

the contract value at the time of termination, in accordance with

the bonus program as modified by Farmers from time to time.

     Provision H

     Provision H provided that the agent, upon tender of the

payment described in provision G, agreed to assign all of his

“interest under this Agreement and Agency” including any interest

in the telephone numbers and leased or rented office space to

Farmers, at their request.   The agent also agreed to accept

tender of contract value and for 1 year to not “directly or

indirectly solicit, accept, or service the insurance business” of

a policyholder of record as of the date of payment.

     Provision I

     Provision I stated that the agent acknowledges that all

manuals, lists, and records of any kind (including policyholder

and expiration information) are the confidential property of

Farmers.   This provision of the AAA further states that the



     3
      Percentage increases were activated at the fifth, tenth,
and fifteenth year of service.
                                 - 6 -

manuals, lists, and records “shall be returned” to Farmers upon

termination of the agency.

Termination of the Agency by Petitioner

     In May 2005 petitioner faxed a letter to the Texas State

executive of Farmers in which he offered his official resignation

as an agent.    By the end of June 2005 petitioner had returned to

Farmers all manuals, lists, and records as required by his

contract, including information pertaining to policyholders and

all other property of Farmers.    Farmers did not request or

receive petitioner’s business phone number or leasehold.      On June

30, 2005, petitioner and Farmers terminated the AAA.    The

contract value of the AAA was $60,596 as of the termination date.

The contract value calculation for petitioner included the three

required items of provision G.

     Petitioner’s AAA contract value of $60,596 included a bonus

of $3,430.    Of the $60,596 due to petitioner, he received

$51,009.56 in 2005.

Petitioners’ Tax Return for 2005

     Petitioners, pursuant to an extension of time to file,

timely mailed their Federal income tax return for 2005 on October

16, 2006.    Included with the return was a Schedule C, Profit or

Loss From Business, for the agency, reporting gross receipts of

$98,848.    The contract value payments petitioners received in

2005 were not reported on the return.
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                             Discussion

     Generally, the Commissioner’s determinations in a notice of

deficiency are presumed correct, and the taxpayer has the burden

of proving that those determinations are erroneous.    See Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).    In some

cases the burden of proof with respect to relevant factual issues

may shift to the Commissioner under section 7491(a).    As there is

no dispute as to a factual issue, section 7491(a) is inapplicable

to this case.

Capital Gain or Ordinary Income

     Petitioners do not dispute that the termination payments

constitute gross income.    Petitioners, however, believe that they

“sold” the agency, including goodwill of the business, to

Farmers.    According to petitioners, Farmers’ payment of the

contract value was in exchange for the agency, “including the

files, data, phone lines, etc” and the “contractual non-compete

clause.”    Their belief is based in part on provision F of the AAA

that allows for the agent or the agent’s heirs to “sell all or

any part of this Agency” to a member of the agent’s immediate

family for a price not in excess of the contract value of the

agency.    Because of their belief that the agency was sold to

Farmers, petitioners assert that the proceeds qualify for capital

gain treatment.
                                 - 8 -

     Respondent takes a different view.    Respondent argues that

petitioners did not sell any property to Farmers; there was no

transfer of title, so there could be no sale of a capital asset.

Because petitioners sold no assets to Farmers, they could not

have sold Farmers any goodwill.

     Respondent cites as support for his position the Court’s

Opinion in Baker v. Commissioner, 118 T.C. 452 (2002), affd. 338

F.3d 789 (7th Cir. 2003).   The facts of that case are

surprisingly similar to those of the case at hand.    The taxpayer

was an insurance agent for State Farm Insurance Co. (State Farm)

whose compensation consisted of commissions on new policies and

renewals of existing policies.    The taxpayer was an independent

contractor who was responsible for his own office expenses and

hiring and paying his own employees.     His relationship with State

Farm was governed by an agent’s agreement that could not be sold,

assigned, or pledged without the consent of State Farm.    State

Farm supplied the taxpayer with manuals, records, forms, and

supplies, but the agreement provided that those items as well as

information regarding policyholders constituted the “sole and

exclusive property” of State Farm.

     The agent agreement in Baker also provided for termination

payments to agents who had:   (1) Worked for 2 or more continuous

years, (2) returned all property belonging to State Farm upon

termination, and (3) agreed not to compete for business from
                                - 9 -

State Farm policyholders for a year following termination.    The

issue for decision in Baker was whether the termination payments

were for the sale of a capital asset, the same issue being

contested here.

     The Court held in Baker that the taxpayer’s State Farm

insurance agency was not a capital asset.   Since he did not own a

capital asset that he could sell, the termination payment could

not represent gain from the sale of a capital asset.   And because

he did not own and sell his agency as a capital asset, he did not

sell any “goodwill” to the insurance company he represented.

Having determined that the termination payment was not gain from

the sale of a capital asset, the Court found that it was taxable

as ordinary income.

     Petitioners admit that they have searched for a tax case

with an opinion contrary to that of Baker but “we could find

none.”   Petitioners have attempted to distinguish their case from

Baker, relying on the wording of provision F of the AAA.   That

provision provides that the agent may “sell” the agency to a

member of the agent’s immediate family “if acceptable to

Farmers”, provided the price does not exceed the contract value

of the agency.    Despite petitioners’ argument, it is not apparent

to the Court how the language of provision F allowing a sale to a

family member if acceptable to Farmers is different in substance

from the provision in the agreement in Baker allowing a sale,
                               - 10 -

assignment, or pledge of the agency (apparently to anyone) only

with the consent of State Farm.   In fact, it appears that the

AAA’s provision on “sale” was more restrictive than was the

taxpayer’s agreement in Baker.

     Petitioners’ pretrial memorandum referenced the case of

Heston v. Farmers Ins. Group, 206 Cal. Rptr. 585 (Ct. App. 1984).

In Heston, an insurance agent sought declaratory and injunctive

relief to prevent Farmers from removing policyholder files and

information from his agency.   That court held that the agent

involved could terminate the agency, refuse to accept contract

value, retain possession of policyholder files and records, and

compete against Farmers for policyholder business.   The court’s

holding resulted from its interpretation of Farmers’ old contract

using, in part, parol evidence.

     Petitioner, however, admits in his pretrial memorandum that

on account of the decision in Heston, Farmers began exerting

“tremendous pressure” and threatened termination of petitioner’s

agency.   As a result petitioner “relented and signed the new, 32-

1106 AAA.”   The new AAA, among other items, revised provision H

in part by adding language that says:   “The Agent agrees to

accept tender of Contract Value”.   Because of the new contract

provision in the AAA, an agent could not refuse to accept

contract value, as the agent did in Heston, without breaching the

agreement.
                              - 11 -

     The Court finds that the case of Heston v. Farmers Ins.

Group, supra, does not affect the application of the reasoning

and the holding of the Court’s Opinion in Baker v. Commissioner,

supra.   See also Trantina v. United States, 512 F.3d 567, 572

(2008) (payment to terminate service contract is not capital gain

unless contract is for more than right to perform service or

receive payment for services).   Petitioners’ termination payment

received in 2005 constitutes ordinary income, not capital gain.

Self-Employment Tax

     Generally, the tax on self-employment income applies to the

“net earnings from self-employment” of an individual.      Secs.

1401, 1402(b).   In simplified terms, net earnings from self-

employment means the “gross income derived by an individual from

any trade or business carried on by such individual,” less the

deductions attributable to the trade or business.    Sec. 1402(a).

In order for income to be taxable as self-employment income,

“there must be 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).     The Court’s

interpretation of the “nexus” standard requires that “any income

must arise from some actual (whether present, past, or future)

income-producing activity of the taxpayer before such income

becomes subject to” self-employment tax.     Id. at 446.   Gross

income derived from an individual’s trade or business may be
                              - 12 -

subject to self-employment tax even when it is attributable in

whole or in part to services rendered in a prior taxable year.

Sec. 1.1402(a)-1(c), Income Tax Regs.

     In applying the definition of self-employment income, the

Court must decide whether the termination payments were:

(1) Derived (2) from a trade or business (3) carried on by

petitioner.   See sec. 1402(a).

     Petitioners rely primarily on Milligan v. Commissioner, 38

F.3d 1094 (9th Cir. 1994), revg. T.C. Memo. 1992-655, to support

their position that the termination payments are not self-

employment income.   The agent’s agreement in Milligan conditioned

termination payments to the agent upon terminating the agreement

no sooner than 2 years after its effective date, returning State

Farms’ property, and refraining from competition with State Farm

for 1 year.   The agent’s agreement also conditioned the

termination payments upon adjustments to reflect the amount of

income received by State Farm on the taxpayer’s “book of

business” during the first year after termination and the number

of the policies produced by the taxpayer that were canceled

during the first year after termination.

     The court found that to be “derived” from a taxpayer’s trade

or business, income must arise from some actual income-producing

activity, past or present, of the taxpayer.   Id. at 1098.    “To be

taxable as self-employment income, earnings must be tied to the
                              - 13 -

quantity or quality of the taxpayer’s prior labor”.   Id.    The

court found that the payments were subject to adjustments related

not to the taxpayer’s business activity but to that of his

successor.

     Congress has codified the standard established in Milligan

for termination payments made to an insurance salesman after

December 31, 1997, in section 1402(k).   Taxpayer Relief Act of

1997, Pub. L. 105-34, sec. 922(a), (c), 111 Stat. 879, 880.

Section 1402(k) exempts the termination payments of insurance

salesmen from self-employment tax as long as the payments do not

depend “to any extent” on length of service (except for a length

of service requirement for eligibility) or overall earnings from

service.

     Petitioner’s termination payments fall outside the

protection of section 1402(k) and the court’s holding in

Milligan.

     Provision G of petitioner’s contract specifically provides

that his termination payments are determined by three items:       (1)

The amount of service commissions paid to him on active policies

during either the “six or twelve month period immediately

preceding termination”; (2) “the number of policies in the

agent’s active code number”; and (3) “the number of years of

continuous service as an Agent” for Farmers immediately before

termination.   The termination payments depended on petitioner’s
                                - 14 -

length of service and his overall earnings from service and

therefore fall outside the protection of section 1402(k).

     Petitioners’ case is analogous to that of the taxpayer in

Schelble v. Commissioner, T.C. Memo. 1996-269, affd. 130 F.3d

1388 (10th Cir. 1997).   The taxpayer’s payments in that case

depended in part on how long he had been an agent for the

insurance company.   Like petitioner, to qualify for the lowest

level of payments the taxpayer had to have represented the

company for at least 5 years.    The taxpayer, like petitioner,

earned a higher payment than if he had been an agent for only 5

or 10 years.   The taxpayer had to have 400 or more policies in

force at the time his agency was terminated while petitioner was

required to have 50.   And like petitioner’s, the taxpayer’s

termination payments were based on the commissions received

during the last 6 or 12 months preceding the termination of the

agreement.4

     The Court found in Schelble that the payments received by

the taxpayer were tied to the quantity and quality of his prior

services and were subject to self-employment tax.    The Court

finds that petitioner’s termination payments were tied to the

quantity and quality of his prior service and are subject to



     4
      Respondent points out that while provision E of the AAA
subjects petitioner’s right to receive commissions payable in the
year after termination to a “chargeback”,it would not affect
contract value and would not reduce petitioner’s termination
payments.
                                - 15 -

self-employment tax.   See also Parker v. Commissioner, T.C. Memo.

2002-305; Farnsworth v. Commissioner, T.C. Memo. 2002-29.

The Accuracy-Related Penalty

     Section 7491(c) imposes on the Commissioner the burden of

production in any court proceeding with respect to the liability

of any individual for penalties and additions to tax.      Higbee v.

Commissioner, 116 T.C. 438, 446 (2001); Trowbridge v.

Commissioner, T.C. Memo. 2003-164, affd. 378 F.3d 432 (5th Cir.

2004).   In order to meet the burden of production under section

7491(c), the Commissioner need only make a prima facie case that

imposition of the penalty or addition to tax is appropriate.

Higbee v. Commissioner, supra.

     Respondent determined that petitioners are liable for an

accuracy-related penalty under section 6662(a).    Section 6662(a)

imposes a 20-percent penalty on the portion of an underpayment

attributable to any one of various factors, including a

substantial understatement of income tax.    See sec. 6662(b)(2).

A “substantial understatement” includes an understatement of tax

that exceeds the greater of 10 percent of the tax required to be

shown on the return or $5,000.    See sec. 6662(d); sec.

1.6662-4(b), Income Tax Regs.

     Section 6664(c)(1) provides that the penalty under section

6662(a) shall not apply to any portion of an underpayment if it

is shown that there was reasonable cause for the taxpayer’s
                              - 16 -

position and that the taxpayer acted in good faith with respect

to that portion.   The determination of whether a taxpayer acted

with reasonable cause and in good faith is made on a case-by-case

basis, taking into account all the pertinent facts and

circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.   The most

important factor is the extent of the taxpayer’s effort to assess

his proper tax liability for the year.   Id.

     Petitioners had a substantial understatement of income tax

for 2005 since the understatement amount exceeded the greater of

10 percent of the tax required to be shown on the return or

$5,000.   Petitioners also failed to report $51,009.56 of income.

The Court concludes that respondent has produced sufficient

evidence to show that the accuracy-related penalty under section

6662 is appropriate.

     Petitioners have not shown that their failure to report such

a large amount of income was an action taken with reasonable

cause and in good faith.   Respondent’s determination of the

accuracy-related penalty under section 6662(a) for 2005 is

sustained.

     To reflect the foregoing,


                                         Decision will be entered

                                    under Rule 155.
