Insurance Agency Termination Payments Were Ordinary Income

I worked as an insurance agent for O Insurance Company for 34 years, conducting business as the I Insurance Agency. He started the agency from scratch, had no assigned customers, was responsible for developing a customer base and selected his office location with Os approval. He was also responsible for office expenses and for hiring and paying employees. For over 34 years, I generated a customer base of approximately 1,800 households, with more than 4,000 policies in force.

Is relationship with O was governed by an agents agreement; O considered all policyholder information to be its property, as specified in the agreement. The agreement also provided for termination payments for agents discontinuing their work with O. The payments value depended on the number of policies in force during the last 12 months of the agents affiliation with the company. Under a covenant not to compete, an agent forfeited his or her right to termination payments if he or she solicited policyholders within one year after terminating the affiliation.

I terminated his relationship with O on Feb. 28, 1997, and under the terms of the agreements, he returned policy and policyholder descriptions, claim draft books, rate books, agents service texts and a computer containing much of the policy information. Approximately 90% of Is 4,000 existing policies were as-signed to his successor. The successor agent, appointed by O, hired Is two employees and assumed his telephone number. The successor agent also opened an office in the vicinity of Is office.

Because I had fully complied with the agreement, O made termination payments of $38,622 in 1997, which  I reported as long-term capital gain on his 1997 Schedule D. He noted on the return that the payments were made pursuant to contracts that contain specific provisions for the purchase and sale of business intangible assets and that the money would be paid in the form of a five-year certain annuity designated as termination payments.

Analysis

The sole contention on appeal is whether Os termination payments were consideration for the sale of a capital asset. I must establish that he: (1) owned a capital asset that he held for more than one year; (2) sold or exchanged this asset; and (3) received termination payments in consideration for this sale or exchange.

Fundamentally, to have the ability to sell something, one must own it. According to the agreement, I did not own anything related to the policies. He returned everything used in the daily course of business to O, including books, records and customer lists, because the agreement designated these items as Os sole and exclusive property.

Goodwill

I claims that the payments were in consideration for goodwill. He contends that he developed and maintained goodwill over the course of 34 years and that the customer base was loyal to him, not to O.

Goodwill is the expectation of continued patronage (Newark Morning Ledger Co., 507 US 546 (1993)). Courts have recognized that the insurance industry treats policy records and policyholder information as goodwill (Schelble,130 F3d 1388 (10th Cir. 1997); Marsh & McLennan, Inc., 420 F2d 667 (3d Cir. 1969)).

However, I did not own any assets related to the business. Goodwill cannot be transferred apart from the business with which it is connected. Even though I built the insurance agency, he used Os tools. Os termination payments were not for the sale of a business in which a buyer could step into the sellers shoes. I owned nothing; thus, he could sell no assets, including goodwill. Thus, I failed to establish that the payments were consideration for the sale or exchange of a capital asset.

A portion of Os payments were for a covenant not to compete under the agreement. The tax consequences of such language are settled; the consideration a buyer pays a seller for a covenant not to compete is taxable as ordinary income (Patterson, 810 F2d 562 (6th Cir. 1987); Sonnleitner, 598 F2d 464 (5th Cir. 1979)).

Warren Baker, 7th Cir., 8/4/03

Reflections: Although the court acknowledged that insurance  policyholder and records information is generally treated as goodwill, the agreement specifically precluded the agents ownership. A similar issue often arises in other cases, such as in a sale of a corporation, when a key shareholder-employee allocates purchase price to personal goodwill; see Arnes and Hamill, Separating Personal and Business Goodwill, TTA, June 2003.  Allocation to goodwill can be even more significant now due to reduced capital gain rates after the Jobs and Growth Tax Relief Reconciliation Act of 2003.