July 31, 2007

Insurance Agents Repayment of Advanced Commissions was Cancellation of Debt Income

Houston Tax Attorney Blog

Houston Tax Attorney

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In Harper v. Commissioner, T.C. Summary Opinion 2007-133, the U.S. Tax Court concluded that advances received by life insurance agent were loans in the year earned and the agent had cancellation of indebtedness income in the year the advances were used to repay costs to the insurance company. Insurance agents often fail to report this type of income correctly.

The facts and procedural history are as follows:

  • Mrs. Harper was in the insurance industry.
  • She was an independent insurance agent selling life and mortgage refinancing insurance policies with Primerica Financial Services, Inc. (Primerica) from February 25, 2002, through July 18, 2003.
  • Mrs. Harper was paid on commission. She received an advance equal to a percentage of one year’s premium payments upon receipt of an application for insurance. She was not entitled to retain this income until the one year period ended.
  • Mrs. Harper was also paid net income commissions which were calculated on a policy-by-policy basis as premiums were paid by policyholders. These earned commissions were applied in the following order: (1) to recover outstanding debits in the form of advance commissions; (2) to reimburse Primerica for advanced business expenses such as license fees, etc.; and (3) to cover any outstanding amounts that had been charged to a sales representative’s account (Chargeback Recovery).
  • Primerica issued two Forms 1099-MISC to Mrs. Harper for the taxable year 2003; the first reflecting nonemployee compensation in the amount of $1,125.93 ($1,113.17 in Gross Earned Commissions and $12.76 in Imputed Interest) and the second, reflecting nonemployee compensation in the amount of $158.70 (Intercompany Recovery).
  • Mrs. Harper did not include this income in her 2003 Federal income tax return.
  • Instead, she included a note saying that she did not receive the income in 2003 and that she had terminated her relationship with Primerica in 2002.

The primary issue was whether Mrs. Harper earned income based on commissions that were not paid directly to her “in a check” but, rather, were diverted or applied to offset a negative balance in her commission account.

The IRS argued that the commissions were unreported income for Mrs. Harper.

The court noted that In the context of insurance agents who receive advances based on future commission income, whether those advances constitute income depends on whether, at the time of the making of the payment, the agent had unfettered use of the funds and whether there was a bona fide obligation on the part of the agent to make repayment.

The court’s analysis can be summarized as follows: When repayment is made out of future income and the taxpayer is not liable to make payment if the future income does not materialize, the commissions are disguised salary. When the repayment is is actually a loan that must be repaid, the taxpayer will either have commission income or cancellation of indebtedness income at the time of the offsets.

The court concluded that when Primerica previously made advances to Mrs. Harper, she was not taxed on those advances because the advances were loans secured and payable through future earned commissions. So Mrs. Harper did not have commission income to report in 2002. The court held that Mrs. Harper had cancellation of indebtedness income in 2003 when the repayments were made, however. So Mr. Harper should have reported the income in 2003 as asserted by the IRS.

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