In Re: Michael James and Mary McClure Pexa

Filing 12

ORDER AFFIRMING JUDGMENT OF BANKRUPTCY COURT signed by District Judge Troy L. Nunley on 5/7/18. (Kaminski, H)

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UNITED STATES DISTRICT COURT

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EASTERN DISTRICT OF CALIFORNIA

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MICHAEL JAMES PEXA; MARY
MCCLURE PEXA,
Appellants,

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ORDER AFFIRMING JUDGMENT OF
BANKRUPTCY COURT

v.

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No. 2:16-cv-00994-TLN

UNITED STATES OF AMERICA,
Appellee.

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The matter is before the Court pursuant to Michael James Pexa and Mary McClure Pexa’s

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(“Appellants”) appeal of a judgment of the United States Bankruptcy Court for the Eastern

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District of California overruling Appellant’s objection to the claim of the Internal Revenue

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Service (“IRS”) pursuant to 11 U.S.C. § 502(a). (ECF No. 4.) The United States of America

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(“Appellee”) filed an opposition (ECF No. 6), and Appellant filed a reply, (ECF No. 8). For the

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reasons discussed below, the judgment of the bankruptcy court is AFFIRMED.

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I.

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In June 1984, Appellant Michael Pexa (“Pexa”) began working as an insurance agent for

FACTUAL BACKGROUND

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Farmers Insurance Group (“Farmers”), where he sold auto, home, life, and commercial insurance

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policies to customers he developed through his marketing efforts. (ECF Nos. 4 at 3; 7-11 at 4.)

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Pexa was extremely successful as an agent, becoming a member of the “Championship Club,”

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which represents the top three or four percent of the entire Farmers’ national agency force for the

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year. (ECF Nos. 4 at 3; 7-11 at 4.)

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On May 1, 1998, Pexa was promoted to the position of district manager. (ECF No. 7-11

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at 18–19.) A district manager is not an insurance agent and serves a different role than an

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insurance agent. (ECF No. 7-11 at 19.) As a district manager, Pexa recruited, trained, and

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supervised insurance agents, and was forbidden from selling insurance. (ECF No. 7-11 at 19.)

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Pexa received compensation from Farmers in the form of commissions on the policies sold by the

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insurance agents that he recruited, trained, and supervised. (ECF No. 7-11 at 19.)

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When Pexa became a district manager, he testified that he needed to get rid of his

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“agency.” (ECF No. 7-11 at 5.) Pexa sold his “agency” to his sister for about $323,000 (payable

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over 20 years), the amount of the contract value set by Farmers. (ECF No. 7-11 at 5.) Pexa is

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still receiving payments from his sister for this transaction. (ECF No. 7-11 at 5.) Pexa contends

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that he has been treating the interest on his sister’s payments as ordinary income and the principal

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as capital gains. (ECF No. 7-11 at 5.) According to Pexa, he has been audited on several

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occasions and in none of those audits were major issues raised by the IRS. (ECF No. 7-11 at 5.)

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In early 2009, Pexa was unhappy with his relationship with Farmers and sent a letter to

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Farmers discussing his unhappiness with changes in Farmers’ practices. (ECF No. 7-11 at 5–6,

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19.) This letter was interpreted by Farmers as an invitation by Pexa to terminate his relationship

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as a district manager. (ECF No. 7-11 at 19.) On January 26, 2009, Farmers issued Pexa a 30 day

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notice of termination pursuant to paragraph (d) of Pexa’s District Manager Appointment

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Agreement (the “Agreement”), which provided that the Agreement “may be cancelled without

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cause by either the District Manager or [Farmers] on 30 day written notice.” (ECF Nos. 7-5 at 2;

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7-11 at 6.) Pursuant to the Agreement, upon termination, Farmer’s was required to pay Pexa the
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“contract value,” an amount determined based on the number of years Pexa worked as a district

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manager and the commissions he received during the six months immediately preceding his

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termination. (ECF Nos. 7-5 at 2; 7-11 at 6–7.) In the event that Farmers elected to pay the

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“contract value,” Pexa agreed to “transfer and assign all of his interest under the agency to the

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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” payments1

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totaling $958,383.20, the amount equal to five times (due to the number of years of service as a

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district manager) the last six months of commissions Pexa received as a district manager. (ECF

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Nos. 6 at 4; 7-11 at 7, 19.) These “contract value” payments were first applied to Pexa’s

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outstanding loan balances and liabilities with Farmers. (ECF No. 7-11 at 20.) The remainder of

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the “contract value” payments was distributed to Pexa through four installments over the course

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of 2009 and 2010. (ECF No. 7-11 at 20.) Upon Pexa’s termination, Farmers also collected

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records and materials that Pexa had in his possession. (ECF No. 7-11 at 21.) As per the

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Agreement, “all records, levy lists, cards, books, manuals, papers, forms, or other material of

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whatsoever kind, and all copies thereof, whether or not furnished by any of the Companies,

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having to do with any manner with the business or [Farmers]” were required to be returned to

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Farmers. (ECF No. 7-5 at 1.) Moreover, “all lists and records of any kind pertaining to the

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policyholders or expiration, and also the information contained therein, [were] the secret and

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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,

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miscellaneous income as non-employee compensation. (ECF No. 7-11 at 20.) Pexa received

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letters dated March 3, 2009, August 18, 2009, March 3, 2010, and September 16, 2010 stating the

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following: “Please note that Farmers must report your Contract Value to the IRS, via form 1099-

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MISC, as non-employee compensation paid to you. You may benefit by consulting an

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independent tax professional for advice on meeting the associated tax obligation.” (ECF No. 7-11

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at 20.) Pexa never contacted Farmers requesting that the amount be reported differently, and

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In the Farmers vernacular, these “contract value” payments are interchangeably referred to as termination
payments. (ECF No. 7-11 at 20.) For clarity, the Court will refer to them only as “contract value” payments.

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Pexa reported the “contract value” payments he received as either gross receipts (2009) or other

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income (2010) on his Schedule C for each tax year. (ECF No. 7-11 at 20.)

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For the 2009 and 2010 tax years, Pexa (who lives in Roseville and worked in the greater

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Sacramento area) hired Mr. Gary Allen of Yreka, California (approximately 250 miles away) to

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assist with preparing and filing his 2009 and 2010 tax returns. (ECF No. 7-11 at 21.) Pexa did

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not provide detailed documentation to Mr. Allen for the preparation of the 2009 and 2010 returns.

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(ECF No. 7-11 at 43.) Mr. Allen simply accepted summary worksheets that included the items of

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income and deductions that Pexa believed he should claim on his returns. (ECF No. 7-11 at 43.)

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Mr. Allen took Pexa’s word for what his income and expenses were and prepared the returns

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accordingly. (ECF No. 7-11 at 44.) Mr. Allen was not provided with the 1099 forms, nor was he

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provided with the Agreement. (ECF No. 7-11 at 44.)

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Mr. Allen believed that the “contract value” payments Pexa received from Farmers were

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for work that Pexa performed as an insurance agent, and he was unfamiliar with the term district

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manager and the responsibilities associated with the position. (ECF No. 7-11 at 21.) Mr. Allen

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testified that he found the case Johnson v. Commissioner, which discusses “contract value”

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relating to insurance agents, and he used that case as a basis for classifying the “contract value”

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payments as capital gains income. (ECF Nos. 7-8 at 13; 7-11 at 21–22.)

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On Pexa’s 2009 and 2010 tax returns, the “contract value” payments were included as

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gross receipts on his Schedule C. (ECF No. 7-11 at 22.) On both returns, the same amount of the

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“contract value” payments was then deducted by being listed under “other expenses” of the

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relevant Schedule C. (ECF No. 7-11 at 22.) For the 2009 tax year, a portion of the “contract

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value” payments was reported as capital gains. (ECF No. 7-11 at 22.) For the 2010 tax year,

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none of the “contract value” payments were reported as capital gains. (ECF No. 7-11 at 22.)

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II.

PROCEDURAL HISTORY

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On November 21, 2014, Appellants filed a Chapter 7 bankruptcy petition. (ECF No. 6 at

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11.) On February 11, 2015, the Commissioner of the IRS issued a notice of deficiency, which set

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forth the results of the audit examination of Appellants’ 2009 and 2010 tax returns and asserted a

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proposed assessment of additional tax liabilities for these two years. (ECF No. 6 at 11.) On May
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7, 2015, the IRS filed an amended proof of claim (Claim 4-2), asserting the exact same amounts

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of additional taxes and penalties owed that were asserted in the notice of deficiency.2 (ECF No. 6

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at 11). On July 27, 2015, Appellants objected to the IRS’s proof of claim, creating the underlying

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contested issue. (ECF No. 7-1 at 1–2.) Appellee opposed the objection. (ECF No. 7-1 at 46.)

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By the time of trial, the issues in dispute were narrowed to the following: (1) whether the

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“contract value” payments should be classified as ordinary income or long term capital gains and

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2) whether Appellants’ could be excused from accuracy-related penalties under the defense of

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reasonable cause and good faith. (ECF No. 6 at 12.)

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On March 14, 2016, the bankruptcy court conducted a one-day bench trial, and issued

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findings of fact and conclusions of law orally on the record on March 30, 2016. (ECF Nos. 7-1 at

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99, 121, 124; 7-10; 7-11.) On April 27, 2016, the bankruptcy court issued a written judgment,

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incorporating its findings of fact and conclusions of law issued orally on March 30, 2016. (ECF

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No. 7-1 at 125.) The bankruptcy court decided against Appellants on both issues, holding

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Appellants’ income tax liabilities should have been characterized as ordinary income rather than

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long term capital gains, and finding Appellants’ did not fall under the reasonable cause and good

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faith penalty exception. (ECF Nos. 7-1 at 125; 7-11 at 31–45.) On May 9, 2016, Appellants filed

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a Notice of Appeal. (ECF No. 7-1 at 127.)

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III.

STANDARD OF REVIEW

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In reviewing decisions of the bankruptcy court, legal conclusions are reviewed de novo

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and factual determinations are reviewed for clear error. In re Comer, 723 F.2d 737, 739 (9th Cir.

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1984). A finding of fact is clearly erroneous if the reviewing court is left with a “definite and

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firm conviction that a mistake has been committed.” In re Contractors Equip. Supply Co., 861

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F.2d 241, 243 (9th Cir. 1988). “The ‘characterization of a transaction for tax purposes is a

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question of law subject to de novo review, but the particular facts from which that

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characterization is made are reviewed for clear error.’” Brinkley v. C.I.R., 808 F.3d 657, 664 (5th

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Following Appellant’s objection, the IRS filed two amended proof of claims, issuing the most recent proof
of claim on May 18, 2016 (Claim 4-4). These amendments removed claims for tax years no longer being audited,
correctly classified certain accuracy-related penalties as general unsecured claims, and included the correct interest
accruals on the unsecured priority claims. (ECF No. 6 at 11.)

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Cir. 2015); see Trantina v. United States, 512 F.3d 567, 570 n.2 (9th Cir. 2008) (holding that

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whether “the district court correctly ruled that the termination payments should be taxed as

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ordinary income and not as a long term capital gain” is a legal question reviewed de novo).

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Whether a taxpayer has satisfied the reasonable cause and good faith defense to an accuracy-

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related penalty under 26 U.S.C. § 6664(c) is a finding of fact reviewed for clear error. Brinkley,

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808 F.3d at 668; Hansen v. Commissioner, 471 F.3d 1021, 1029 (9th Cir. 2006).

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IV.

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Appellants argue the bankruptcy court erred for two reasons. First, Appellants argue the

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ANALYSIS

bankruptcy court incorrectly treated the “contract value” payments as ordinary income rather than

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long term capital gains. Second, Appellants argue the bankruptcy court erred in finding

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Appellants subject to certain accuracy-related penalties because Appellants had reasonable cause

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for the positon they took.

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A. The Characterization of the “Contract Value” Payments
Appellants argue the “contract value” payments Pexa received qualify as long term capital

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gains, and thus they do not face additional tax liability. Appellee, conversely, contends the

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“contract value” payments merely constitute ordinary income, and therefore Appellants have

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understated their income tax liability. “The ‘characterization of a transaction for tax purposes is a

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question of law subject to de novo review, but the particular facts from which that

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characterization is made are reviewed for clear error.’” Brinkley, 808 F.3d at 668. The only

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question at issue here is the legal question of whether the bankruptcy court correctly ruled that the

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“contract value” payments should be taxed as ordinary income and not as long term capital gains.

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See Trantina, 512 F.3d at 570 n.2. Therefore, the Court reviews this issue de novo.

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The Commissioner’s determination of a tax deficiency is presumed correct, and the

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taxpayer bears the burden of proving the determination to be erroneous. Welch v. Helvering, 290

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U.S. 111, 115 (1933). To prove that Pexa’s “contract value” payments should be classified as

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long term capitals gains, Appellants must demonstrate that the payments: (1) arose from the sale

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or exchange, (2) of a capital asset held longer than one year, (3) and were given in consideration

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of this sale or exchange. Trantina, 512 F.3d at 571. The main issue in contention is whether
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Appellants sold or exchanged a capital asset. However, a precondition to selling or exchanging a

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capital asset is the ownership of a capital asset. Id. at 573; Baker v. Commissioner, 338 F.3d 789,

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793 (7th Cir. 2003) (“Fundamentally, in order to have the ability to sell something, one must own

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it.”). Therefore, before the Court determines whether Appellants sold or exchanged a capital

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asset, it must determine whether Appellants owned a capital asset.

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Appellants assert that the “district manger’s insurance agency was the [capital] asset

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transferred to Farmers pursuant to the contract.” (ECF No. 4 at 13.) Appellants then define the

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“district manager’s insurance agency” as Pexa’s business that was “built over eleven years” and

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was “well-developed, smooth-operating and generating significant cash flows.” (ECF No. 4 at

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15.) Simply put, Appellants are asserting the capital asset transferred was goodwill. (ECF No. 4

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at 15 (“[T]he development of [Pexa’s] business generated goodwill that effectively was

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transferred to Farmers.”).)

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The Seventh Circuit addressed this exact issue in Baker. 338 F.3d at 793. In Baker, the

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insurance agent sought to have his termination payments treated as long-term capital gains and

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argued the payments were in consideration of goodwill. Id. However, the court held that because

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the agent’s contract contained a blanket reservation of property rights to the insurance company,

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the agent did not “own any assets related to the business,” and could not transfer goodwill “apart

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from the business with which it was connected.” Id. at 793–94. The Ninth Circuit adopted

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Baker’s reasoning in Trantina, holding that because the express terms of the agent’s agreement

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contained a blanket reservation of all property rights to the insurance company, the agent “simply

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had no property that could be sold or exchanged.” 512 F.3d at 573.

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As noted by the bankruptcy court, the Agreement here contains substantially the same

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reservation of property rights as the agreements in Baker and Trantina. (See ECF No. 7-11 at

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32.) Therefore, Pexa did not own any assets related to his “agency.” Rather, all assets related to

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the “agency” belonged to Farmers. (See ECF Nos. 7-5 at 1; 7-5 at 2; 7-11 at 21.) Thus, because

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goodwill cannot be transferred apart from the business with which it is connected, Pexa “could

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sell no assets, including goodwill.” See Baker, 338 F.3d at 794.

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The only “interest under the agency” that Pexa retained was a contractual right to perform
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services for Farmers and receive compensation for those services as long as the Agreement

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remained in effect. However, a contractual right to perform services is not a capital asset.

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Trantina, 512 F.3d at 571–72 (“[T]he courts have quite uniformly held that contracts for the

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performance of personal services are not capital assets and that the proceeds from their transfer or

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termination will not be accorded capital gains treatment but will be considered to be ordinary

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income.”). Therefore, because Pexa owned no capital asset, he could not sell or exchange a

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capital asset. Accordingly, the “contract value” payments that Pexa received are ordinary

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income, not long term capital gains.

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B. The Accuracy-Related Penalty
Whether a taxpayer has satisfied the reasonable cause and good faith defense to an

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accuracy-related penalty under 26 U.S.C. § 6664 is a finding of fact reviewed for clear error.

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Brinkley, 808 F.3d at 668.

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Under 26 U.S.C. § 6662, a 20 percent penalty is imposed for any underpayment of tax

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attributable to a “substantial understatement of income tax.” 26 U.S.C. §§ 6662(a), (b)(2). An

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understatement is substantial if it “exceeds the greater of . . . 10 percent of the tax required to be

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shown on the return for the taxable year, or . . . $5,000.” Id. § 6662(d)(1)(A). However,

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taxpayers may be excused from accuracy-related penalties imposed by 26 U.S.C. § 6662 to the

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extent “it is shown that there was a reasonable cause for such portion and that the taxpayer acted

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in good faith with respect to such portion.” 26 U.S.C. § 6664(c)(1). “The taxpayer bears the

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burden of proof on this defense, and the determination of whether the taxpayer has successfully

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discharged this burden ‘is made on a case-by-case basis, taking into account all pertinent facts

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and circumstances.’” Brinkley, 808 F.3d at 668–69 (citation omitted) (quoting 26 C.F.R.

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§ 1.6664-4(b)(1)). “The most important factor is the extent of the taxpayer’s effort to assess his

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proper liability in light of all the circumstances.” Id. at 669.

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The bankruptcy court found Appellants failed to prove there was reasonable cause for

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their understatement and failed to prove they acted in good faith. The court reasoned that Pexa, a

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seasoned businessman, had not provided his tax preparer, Mr. Allen, with the Agreement or the

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1099s, and given these material omissions, it was not persuaded by a preponderance of the
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evidence that there was reasonable cause, or that Pexa was acting in good faith, with respect to

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the understatements. (ECF No. 7-11 at 44–45.) Appellants argue that the bankruptcy court erred

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for two reasons, which will each be discussed in turn.

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First, Appellants argue Pexa reasonably and in good faith relied on Mr. Allen in making

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the determination that his “contract value” payments constituted long term capital gains. This

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conclusion is unsupported by the evidence. (ECF No. 4 at 19.) There is no dispute that Pexa did

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not provide Mr. Allen with the material information necessary to make an appropriate

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determination of whether the “contract value” payments were long term capital gain. Namely,

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Pexa did not provide Mr. Allen with the Agreement — the single most important document in this

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determination and the document that dictated the payments Pexa would receive. Therefore, the

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evidence supports a finding that Pexa could not have reasonably relied on Mr. Allen. See 26

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C.F.R. § 1.6664-4(c)(i) (“The advice must be based upon all pertinent facts and circumstances

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and the law as it relates to those facts and circumstances.”)

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Second, Appellants argue the IRS did not object to Pexa’s classification of his sister’s

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payments as long term capital gains, and thereby they reasonably and in good faith believed the

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IRS had approved of long term capital gain treatment for “contract value” payments. (ECF No. 4

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at 19.) However, the fact that Pexa classified payments arising out of one transaction as long

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term capital gains does not necessarily have bearing on whether or not Pexa reasonably and in

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good faith classified the payments at issue, arising out of a different transaction, as long term

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capital gains. Moreover, there is no evidence that Pexa classified these prior payments

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reasonably and in good faith. Therefore, the facts support a finding that Pexa did not make a

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reasonable and good faith effort to assess his tax liability and could not reasonably and in good

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faith rely on Mr. Allen or former tax returns in determining whether the “contract value”

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payments constituted long term capital gains. Accordingly, the court finds no clear error in

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bankruptcy court’s finding that Appellants did not carry their burden to prove they acted with

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reasonable cause and in good faith.

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V.

CONCLUSION

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For the foregoing reasons, the Court hereby AFFIRMS the judgment of the bankruptcy
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court.

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IT IS SO ORDERED.

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Dated: May 7, 2018

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Troy L. Nunley
United States District Judge

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