July 2003

Tax Court Opinion Opens Potential State Tax Issues

By Irwin Mittleman, Esq., Maplewood, N.J.

A recent Tax Court decision may have state tax ramifications, raising potentially interesting tax consequences for individuals in certain circumstances. The decision, Baker v. IRS Commissioner [118 TC 28 (5/29/02)], involved an independent insurance agent who retired and sold his business assets back to the company that he wrote insurance for.

Warren L. Baker was an insurance agent working as an independent contractor for State Farm Insurance. His agency agreement provided him a percentage of net premiums that he wrote, based on the type of policy. The agreement stipulated that Baker was entitled to a termination payment based on existing policies that either remained in force after his termination, or were in force for the 12 months preceding termination. The agreement also provided that all property, including information about policyholders, belonged to State Farm. Upon his retirement, Baker returned his computer, claim draft books, rate books, and agent service texts to State Farm and the successor agent. Baker received a termination payment of $38,622 in 1997 and reported the payment as a long-term capital gain on his 1997 tax return. Capital gain treatment was disallowed by the IRS, which treated the payment as ordinary income. The Tax Court agreed, holding that the termination payment was not for the sale or buyout of a business, which would have allowed for capital gain rate taxation, but was instead ordinary income.
The court reasoned that the termination agreement did not specify any purchaser or seller of the equipment, but was merely a reversion back to State Farm of their own assets.

Potential State Issues

Many individuals who own businesses often sell those businesses as a prelude to retirement, moving to states with low or no income taxes, such as Florida. The facts of this case indicate that Baker was a resident of Illinois at the time of the filing of this petition. If Baker transacted the business in Illinois and changed his residence to Florida prior to receiving this termination payment, this payment would still be taxable by Illinois based on 35 ILCS 5/302, which states, “All items of compensation paid in this state to an individual who is a nonresident at the time of such payment and all items of deduction directly allocable, shall be allocated to this state.”

The result might be different if Baker had moved to Florida from New York, which provides in New York Tax Law section 631(b)(5), “In the case of a nonresident individual or partner of a partnership doing an insurance business as a member of the New York insurance exchange described in section 6201 of the insurance law, any item of income, gain, loss or deduction of such business which is the individual’s distributive or pro rata share for federal income tax purposes or which the individual is required to take into account separately for federal income tax purposes, shall not constitute income, gain, loss or deduction derived from New York sources.”

In a somewhat analogous decision [Gow v. Director of Rev., (1989) 556 A.2d 190] the Delaware State Supreme Court decided that a voluntary termination incentive program instituted by the Dupont Corporation would not be considered “compensation … as an employee in the conduct of the business of [the Delaware] employer for personal services” [30 Del.C. section 1122(b)(1)], and accordingly would not be subject to Delaware personal income tax for a nonresident. In this decision, the court noted that the voluntary payments by Dupont were not for past or present personal services rendered, but were instead as an incentive to leave the Dupont payroll.

Mark H. Levin, CPA
H.J. Behrman & Company LLP

Contributing Editors:
Henry Goldwasser, CPA
Weiser LLP

Neil H. Tipograph
Imowitz Koenig & Co., LLP

Warren Weinstock, CPA
Marks Paneth & Shron, LLP

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