## Facts

- Warren L. Baker, Jr. served as a State Farm insurance agent from 1963 to 1997 and built a substantial policyholder base through his agency operations.
- Baker’s relationship with State Farm was governed by an Agent’s Agreement characterizing him as an independent contractor.
- The Agent’s Agreement restricted transferability: Baker could not sell, assign, or pledge the agreement or any interest in it without State Farm’s written consent.
- State Farm retained ownership and control of key materials and information, including manuals, forms, and records used in the agency relationship.
- Upon termination of the Agent’s Agreement in 1997, State Farm owed Baker “termination payments” computed primarily by reference to premiums from “in force” business and paid in declining installments over time.
- The Bakers reported $38,622 of termination payments as long-term capital gain on their 1997 joint return.
- The IRS issued a deficiency, recharacterizing the payments as ordinary income; the Tax Court sustained the deficiency, and the Bakers appealed.

## Issues

1. Whether the termination payments received upon cancellation of the State Farm Agent’s Agreement were proceeds from the sale or exchange of a capital asset taxable as long-term capital gain, or ordinary income as a substitute for future commissions.

## Decision

- The Seventh Circuit affirmed the Tax Court.
- The termination payments were ordinary income, not long-term capital gain.
- The court treated the payments as replacing future renewal commissions and similar earnings, rather than as consideration for a sold or exchanged capital asset.

## Legal Principles

- Tax characterization turns on the substance of what the payment replaces; a payment is ordinary income when it functions as a substitute for amounts that would otherwise be received as future ordinary income.
- Capital-gain treatment generally requires a sale or exchange of a distinct, legally cognizable, transferable property interest; economic value developed through work is not enough if the taxpayer lacks alienable rights in the asserted asset.
- Payments triggered by cancellation of a personal-service contractual relationship are commonly taxed as ordinary income when they compensate for lost future service-related earnings rather than a transferred asset.

## Conclusion

The court held that State Farm’s termination payments to Baker were taxable as ordinary income because they substituted for future commission-type income and did not arise from any sale or exchange of a transferable capital asset under the Agent’s Agreement.


Baker v. Commissioner, 338 F.3d 789 (7th Cir. 2003)