Termination Payment Was Ordinary Income Subject to Self-Employment Tax

(Parker Tax Publishing September 2018)

The Tax Court held that a termination payment to the taxpayer, a sales representative who worked for as an independent contractor for a garden soil company, was ordinary income, not capital gain, because the payment was based on the taxpayer's commissions earned the previous year and was not for the sale of the taxpayer's trade or business. The court also held that the taxpayer's prize money winnings in cowboy mounted shooting competitions were income not of the taxpayer but of the C corporation owned by the taxpayer. Potter v. Comm'r, T.C. Memo. 2018-153.

Background

Jeff Potter worked as a sales representative for Green Country Soils, Inc. (Green Country), a garden soil company, under a compensation agreement he entered in 1995. Potter was treated as an independent contractor and received commission on all sales of Green Country products to anyone whose account he either served or obtained. If either Potter or Green Country terminated the agreement, Potter was entitled to 1-1/2 times his commissions for the previous year. He could also declare the agreement terminated if Green Country was ever sold or transferred. Potter could not assign or transfer his obligations under the agreement without Green Country's written consent.

In 1998, Potter incorporated Potter Sales, a Subchapter C corporation, and was its sole shareholder and president. From the incorporation until 2010, Potter performed his duties under the compensation agreement with Green Country as Potter Sales. All commissions Potter earned were paid to Potter Sales. Beginning around 2005, Potter Sales paid a salary to Potter and issued him Forms W-2, Wage and Tax Statement. Potter Sales' only client was Green Country. At no time was Potter a shareholder or officer of Green Country.

Green Country and Potter Sales sold all of their assets to Oldcastle, a competitor of Green Country, in 2010. As Green Country's number one sales representative, Potter, in his individual capacity, was listed as a party to the purchase agreement. The assets Oldcastle acquired from Potter Sales included office equipment, furniture, and vehicles. Neither Potter Sales nor Potter received any compensation for those items. The purchase agreement specifically excluded the assumption of certain liabilities, including any termination payments.

Potter's compensation agreement with Green Country terminated on the sale to Oldcastle. Potter and Green Country agreed that Potter was entitled to a termination payment equal to 1-1/2 times his commissions from the previous year, totaling approximately $1.7 million. In October 2010, Green Country transferred the termination payment to Potter Sales' bank account. Potter Sales recorded the transfer as a liability to Potter, and the next month transferred the funds to him in satisfaction of the liability.

Several years before the Oldcastle sale, Potter had been introduced to cowboy mounted shooting, which is a timed event where an individual rides a horse through a designated course while shooting a firearm at targets. Cowboy mounted shooting is governed by the Cowboy Mounted Shooting Association (CMSA). Potter began taking lessons in 2009 and trained his horse, which he had previously purchased for pleasure riding, for use in the activity. During 2010 and 2011, Potter entered CMSA events. Potter Sales paid the entry fees and other expenses related to the activity. CMSA paid prize money won at the events directly to Potter and issued him Forms 1099-MISC, Miscellaneous Income. All prize money won was deposited in Potter Sales' bank account. In 2010, after Potter successfully competed in the CMSA world competition, Potter Sales purchased a pickup truck for approximately $48,000, a large horse trailer with living quarters for $104,500, and a tractor for $9,000 to be used in the activity. Each asset was recorded on Potter Sales' books as a capital asset subject to depreciation and reported on the depreciation schedule attached to the company's 2010 Form 1120, U.S. Corporation Income Tax Return.

On his 2010 individual tax return, Potter reported the $1.7 million termination payment as the sale of goodwill. He also attached a Schedule C, Profit or Loss From Business, for the cowboy mounted shooting activity. Potter reported the prize money won at CMSA events as gross receipts, claimed cost of goods sold as equal to the gross receipts, and reported a net profit of zero on the basis that Potter was paid the prize money as the nominee of Potter Sales. The 2011 prize money was reported the same way. Potter Sales claimed deductions for expenses related to the cowboy mounted shooting on its return.

The same CPA prepared the returns for Potter and Potter Sales. Potter discussed the termination payment and the cowboy mounted shooting activity with his CPA on several occasions. Potter gave the CPA all the information necessary to prepare the returns. The CPA 35 years of experience and had prepared Potter's income tax returns for approximately the same amount of time. He had also prepared Potter Sales' returns since its incorporation.

Upon auditing the tax returns of Potter and Potter Sales, the IRS determined that the termination payment was not taxed as a capital gain but instead was ordinary income subject to self-employment tax. The IRS also determined that the cowboy mounted shooting activity was not entered into for profit under Code Sec. 183 and disallowed all of the claimed deductions associated with the activity and included the prize money as income to Potter. The IRS also assessed an accuracy-related penalty. Potter petitioned the Tax Court for a redetermination of the deficiencies and penalties.

Potter argued that the termination payment was a transfer of goodwill because he sold his relationships with the buyers of Green Country's products. He contended that he performed the cowboy mounted shooting activity as a nominee for Potter Sales, and pointed out that the Code Sec. 183 hobby loss rules do not apply to C corporations. As to the penalties, Potter argued that he acted with reasonable cause and good faith in relying on his CPA to prepare his and Potter Sales' returns.

Analysis

The Tax Court held that the termination payment was ordinary income subject to self-employment tax, but agreed with Potter that he performed the cowboy mounted shooting as a nominee of Potter Sales and thus Code Sec. 183 did not apply to bar the deductions taken by Potter Sales. The court also held that no penalty applied because Potter and Potter Sales reasonably relied on their CPA.

The termination payment was ordinary income, in the court's view, because Potter did not sell a trade or business to which any goodwill attached. The court reasoned that although Potter was a party to the sale of Green Country's assets to Oldcastle, he did not sell any assets; Potter Sales' office furniture and other assets were included in the sale but Oldcastle paid nothing for them. Moreover, the court found that because Potter Sales had only one client, Green Country, the relationships Potter fostered with Green Country's clients belonged to Green Country and were not Potter's to sell. The court concluded that the termination payment was for Potter's right to service Green Country's clients and receive ordinary income.

The Tax Court determined that the termination payment was subject to SE tax because Green Country and Potter agreed that he was an independent contractor and the parties stipulated that the payment was to Potter, not Potter Sales. The court found that the payment was derived from Potter's services for Green Country because it was tied to the quantity and quality of his work, and no adjustments unrelated to his prior services were made in calculating it.

With respect to the cowboy mounted shooting activity, the court determined that Potter Sales performed the activity through Potter as a nominee, and that as a C corporation, Potter Sales was not subject to the hobby loss rules in Code Sec. 183. The court noted that there was no question as to the corporate validity of Potter Sales and that the IRS had conceded that the deductions related to the activity belonged to Potter Sales. The court reasoned that there was nothing to preclude Potter Sales from operating multiple trades or businesses or changing from one to another. In the court's view, Potter Sales stopped selling potting soil and began operating the cowboy mounted shooting activity as its trade or business. The fact that Potter was the named rider in the competitions did not preclude the activity from being that of Potter Sales, in the court's view.

Finally, the Tax Court held that Potter and Potter Sales were not liable for an accuracy related penalty because they reasonably relied on their CPA. The court noted that the CPA had been given all the necessary information to prepare the returns and that Potter and the CPA discussed the termination payment and the cowboy mounted shooting activity several times.

For a discussion of self-employment taxes, see Parker Tax ¶13,100. For a discussion of the hobby loss rules, see Parker Tax ¶97,500. For a discussion of abatement of penalties for reasonable cause and good faith, see Parker Tax ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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