Insurance agency termination payments were ordinary income.

P was employed as an independent insurance agent of Y life insurance company, first in his individual capacity and later on behalf of T Agency, Inc., which he wholly owned. P wished to retire and so advised Y. T became entitled to termination payments under its agreement with Y; Y made the payments from 1996 to 1999.

When T liquidated in 1997, P exchanged his stock for T's assets, including the right to collect the termination payments. Y began making termination payments to P rather than T.

P first reported the termination payments as ordinary income, but subsequently amended his 1997 and 1998 returns to report them as long-term capital gains, rather than ordinary income. The IRS accepted the 1997 and 1998 amendments and granted the refund. However, when P amended his 1999 return, the IRS denied the refund claim.

Legal Standards

P maintains that the termination payments are long-term capital gains under Sec. 1222(3), because the termination of the corporate agreement was a "sale" of the agency back to Y. Sec. 1222(3) defines long-term capital gain as "gain from the sale or exchange of a capital asset held for more than one year.... "To treat the termination payments as long-term capital gain, P must prove both that he owned a capital asset and sold it in exchange for the termination payments; see Baker, 338 F3d 789 (7th Cir. 2003).

P does not argue that policyholder information, policy manuals, drafting tools or other implements of the insurance trade are the capital assets at issue here. Such an argument would fail, as Y owned all such property under the corporate agreement's terms; see Baker, 338 F3d at 793 (finding that taxpayer owned no capital assets under a nearly identical insurance agent agreement). Instead, P asserts that the agreement itself constituted the capital asset sold in exchange for the termination payments.

However, it is difficult to see how a contract declaring that P owns no assets may itself he an asset. Although P possessed certain rights under the agreement (e.g., the right to solicit customers, submit applications for insurance and collect premiums), he could not sell, assign or pledge any of these interests without Y's prior written consent. Unlike Ferret, 3(i)4 F2d 125 (1962), cited by P in support of the proposition that contractual rights may be assets, P lacked even a "negative power" to prevent Y from certain behavior. He had no ability to obtain value from the corporate agreement other than through compliance with its terms. Even the simple termination of his rights under the agreement would not result in the accretion of value through termination payments, unless P also complied with additional terms pertaining to the return of Y property and solicitation of policyholders.

Even if the agreement could be deemed a P asset, he must nevertheless prove that it was sold or exchanged for the termination payments. However, they were not received in exchange for the sale of the agreement; they were received under the agreement in exchange for compliance with other terms. The discharge of a contract by payment in accordance with its terms does not constitute the sale or exchange of property; see Spray Water Power & Land Co., TC Memo 1961-73 and Gann, 41 BTA 388 (1940). Thus, as a matter of law, the termination payments do not qualify as long-term capital gains. CHARLES E. TRANTINA, DC AZ, 5/16/05

REFLECTIONS: P's amended 1999 return stated that "the Return is amended to reflect the reclassification of payments from Y on the sale of the taxpayer's agency back to the company." In court, P also contended that the termination payments were capital assets because they were received in the corporate liquidation exchange. However, the court concluded that it lacked jurisdiction to decide that claim, because it was not properly raised in P's refund claim.