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Pexa v. United States

United States District Court, E.D. California

May 7, 2018




         The matter is before the Court pursuant to Michael James Pexa and Mary McClure Pexa's (“Appellants”) appeal of a judgment of the United States Bankruptcy Court for the Eastern District of California overruling Appellant's objection to the claim of the Internal Revenue Service (“IRS”) pursuant to 11 U.S.C. § 502(a). (ECF No. 4.) The United States of America (“Appellee”) filed an opposition (ECF No. 6), and Appellant filed a reply, (ECF No. 8). For the reasons discussed below, the judgment of the bankruptcy court is AFFIRMED.

         I. Factual Background

         In June 1984, Appellant Michael Pexa (“Pexa”) began working as an insurance agent for Farmers Insurance Group (“Farmers”), where he sold auto, home, life, and commercial insurance policies to customers he developed through his marketing efforts. (ECF Nos. 4 at 3; 7-11 at 4.) Pexa was extremely successful as an agent, becoming a member of the “Championship Club, ” which represents the top three or four percent of the entire Farmers' national agency force for the year. (ECF Nos. 4 at 3; 7-11 at 4.)

         On May 1, 1998, Pexa was promoted to the position of district manager. (ECF No. 7-11 at 18-19.) A district manager is not an insurance agent and serves a different role than an insurance agent. (ECF No. 7-11 at 19.) As a district manager, Pexa recruited, trained, and supervised insurance agents, and was forbidden from selling insurance. (ECF No. 7-11 at 19.) Pexa received compensation from Farmers in the form of commissions on the policies sold by the insurance agents that he recruited, trained, and supervised. (ECF No. 7-11 at 19.)

         When Pexa became a district manager, he testified that he needed to get rid of his “agency.” (ECF No. 7-11 at 5.) Pexa sold his “agency” to his sister for about $323, 000 (payable over 20 years), the amount of the contract value set by Farmers. (ECF No. 7-11 at 5.) Pexa is still receiving payments from his sister for this transaction. (ECF No. 7-11 at 5.) Pexa contends that he has been treating the interest on his sister's payments as ordinary income and the principal as capital gains. (ECF No. 7-11 at 5.) According to Pexa, he has been audited on several occasions and in none of those audits were major issues raised by the IRS. (ECF No. 7-11 at 5.)

         In early 2009, Pexa was unhappy with his relationship with Farmers and sent a letter to Farmers discussing his unhappiness with changes in Farmers' practices. (ECF No. 7-11 at 5-6, 19.) This letter was interpreted by Farmers as an invitation by Pexa to terminate his relationship as a district manager. (ECF No. 7-11 at 19.) On January 26, 2009, Farmers issued Pexa a 30 day notice of termination pursuant to paragraph (d) of Pexa's District Manager Appointment Agreement (the “Agreement”), which provided that the Agreement “may be cancelled without cause by either the District Manager or [Farmers] ¶ 30 day written notice.” (ECF Nos. 7-5 at 2; 7-11 at 6.) Pursuant to the Agreement, upon termination, Farmer's was required to pay Pexa the “contract value, ” an amount determined based on the number of years Pexa worked as a district manager and the commissions he received during the six months immediately preceding his termination. (ECF Nos. 7-5 at 2; 7-11 at 6-7.) In the event that Farmers elected to pay the “contract value, ” Pexa agreed to “transfer and assign all of his interest under the agency to the nominee acceptable to [Farmers] or to [Farmers].” (ECF No. 7-5 at 3.)

         Over the course of 2009 and 2010, Farmers issued Pexa “contract value” payments[1]totaling $958, 383.20, the amount equal to five times (due to the number of years of service as a district manager) the last six months of commissions Pexa received as a district manager. (ECF Nos. 6 at 4; 7-11 at 7, 19.) These “contract value” payments were first applied to Pexa's outstanding loan balances and liabilities with Farmers. (ECF No. 7-11 at 20.) The remainder of the “contract value” payments was distributed to Pexa through four installments over the course of 2009 and 2010. (ECF No. 7-11 at 20.) Upon Pexa's termination, Farmers also collected records and materials that Pexa had in his possession. (ECF No. 7-11 at 21.) As per the Agreement, “all records, levy lists, cards, books, manuals, papers, forms, or other material of whatsoever kind, and all copies thereof, whether or not furnished by any of the Companies, having to do with any manner with the business or [Farmers]” were required to be returned to Farmers. (ECF No. 7-5 at 1.) Moreover, “all lists and records of any kind pertaining to the policyholders or expiration, and also the information contained therein, [were] the secret and confidential property of [Farmers].” (ECF Nos. 7-5 at 2; 7-11 at 21.)

         Farmers reported the “contract value” payments to the IRS via Form 1099-MISC, miscellaneous income as non-employee compensation. (ECF No. 7-11 at 20.) Pexa received letters dated March 3, 2009, August 18, 2009, March 3, 2010, and September 16, 2010 stating the following: “Please note that Farmers must report your Contract Value to the IRS, via form 1099-MISC, as non-employee compensation paid to you. You may benefit by consulting an independent tax professional for advice on meeting the associated tax obligation.” (ECF No. 7-11 at 20.) Pexa never contacted Farmers requesting that the amount be reported differently, and Pexa reported the “contract value” payments he received as either gross receipts (2009) or other income (2010) on his Schedule C for each tax year. (ECF No. 7-11 at 20.)

         For the 2009 and 2010 tax years, Pexa (who lives in Roseville and worked in the greater Sacramento area) hired Mr. Gary Allen of Yreka, California (approximately 250 miles away) to assist with preparing and filing his 2009 and 2010 tax returns. (ECF No. 7-11 at 21.) Pexa did not provide detailed documentation to Mr. Allen for the preparation of the 2009 and 2010 returns. (ECF No. 7-11 at 43.) Mr. Allen simply accepted summary worksheets that included the items of income and deductions that Pexa believed he should claim on his returns. (ECF No. 7-11 at 43.) Mr. Allen took Pexa's word for what his income and expenses were and prepared the returns accordingly. (ECF No. 7-11 at 44.) Mr. Allen was not provided with the 1099 forms, nor was he provided with the Agreement. (ECF No. 7-11 at 44.)

         Mr. Allen believed that the “contract value” payments Pexa received from Farmers were for work that Pexa performed as an insurance agent, and he was unfamiliar with the term district manager and the responsibilities associated with the position. (ECF No. 7-11 at 21.) Mr. Allen testified that he found the case Johnson v. Commissioner, which discusses “contract value” relating to insurance agents, and he used that case as a basis for classifying the “contract value” payments as capital gains income. (ECF Nos. 7-8 at 13; 7-11 at 21-22.)

         On Pexa's 2009 and 2010 tax returns, the “contract value” payments were included as gross receipts on his Schedule C. (ECF No. 7-11 at 22.) On both returns, the same amount of the “contract value” payments was then deducted by being listed under “other expenses” of the relevant Schedule C. (ECF No. 7-11 at 22.) For the 2009 tax year, a portion of the “contract value” payments was reported as capital gains. (ECF No. 7-11 at 22.) For the 2010 tax year, none of the “contract value” payments were reported as capital gains. (ECF No. 7-11 at 22.)

         II. Procedural History

         On November 21, 2014, Appellants filed a Chapter 7 bankruptcy petition. (ECF No. 6 at 11.) On February 11, 2015, the Commissioner of the IRS issued a notice of deficiency, which set forth the results of the audit examination of Appellants' 2009 and 2010 tax returns and asserted a proposed assessment of additional tax liabilities for these two years. (ECF No. 6 at 11.) On May 7, 2015, the IRS filed an amended proof of claim (Claim 4-2), asserting the exact same amounts of additional taxes and penalties owed that were asserted in the notice of deficiency.[2] (ECF No. 6 at 11). On July 27, 2015, Appellants objected to the IRS's proof of claim, creating the underlying contested issue. (ECF No. 7-1 at 1-2.) Appellee opposed the objection. (ECF No. 7-1 at 46.) By the time of trial, the issues in dispute were narrowed to the following: (1) whether the “contract ...

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