In the
    United States Court of Appeals
                For the Seventh Circuit
                          ____________

No. 02-3262
WARREN L. BAKER, JR. and DORRIS J. BAKER,
                                         Petitioners-Appellants,
                                v.

COMMISSIONER OF INTERNAL REVENUE,
                                           Respondent-Appellee.
                          ____________
             Appeal from the United States Tax Court.
                           No. 599-00
                          ____________
       ARGUED MAY 12, 2003—DECIDED AUGUST 4, 2003
                      ____________


    Before BAUER, KANNE, and WILLIAMS, Circuit Judges.
  BAUER, Circuit Judge. The Commissioner of Internal
Revenue determined a deficiency in Warren and Dorris
Baker’s1 1997 joint federal income tax return because of
Baker’s treatment of $38,622 in termination payments as
a long-term capital gain. The Commissioner says that
the termination payments were ordinary income, and



1
   Dorris Baker is a party to this matter because the appellants
filed a joint return. Since only Warren Baker’s income is disputed
in this appeal, the remainder of the opinion will refer to Mr. Baker
only.
2                                                No. 02-3262

asserted a deficiency of $2,519. Baker filed a petition with
the United States Tax Court seeking a redetermination
of this deficiency. The Tax Court found the termination
payments constituted ordinary income and upheld the
Commissioner’s deficiency determination. Baker appeals,
and for the reasons stated herein, we affirm the Tax Court’s
judgment.


                      BACKGROUND
  Warren Baker worked as an insurance agent for State
Farm Insurance Company from 1963 to 1997 and conducted
business as the Warren L. Baker Insurance Agency.2 Bak-
er started the agency from scratch. He had no assigned
customers and was responsible for developing a cus-
tomer base. He selected the location of his office with State
Farm’s approval. He was also responsible for office ex-
penses and for hiring and paying employees. Finally, Bak-
er established a trust fund into which he deposited premi-
ums collected on behalf of State Farm.
  Baker’s daily duties entailed soliciting applications for
insurance, collecting payments, and assisting State Farm
policyholders. His compensation consisted of commissions
on new policies and renewals of existing policies. Over the
course of thirty-four years, Baker generated a customer
base of approximately 1800 households, with more than
4000 policies in force.
  The terms of Baker’s relationship with State Farm
were governed by an Agent’s Agreement. Baker could not
sell, assign, or pledge the Agreement or any interest
therein without prior written consent from State Farm.


2
  State Farm consisted of State Farm Mutual Automobile
Insurance Co., State Farm Life Insurance Co., State Farm Fire &
Casualty Co., and State Farm General Insurance Co.
No. 02-3262                                             3

Under the Agreement, Baker was required to operate as
an independent contractor. The Agreement provided that
State Farm would furnish, without charge, manuals, forms,
records, and other supplies to the agent. The Agreement
further denoted that such materials would remain the
property of State Farm and State Farm would be responsi-
ble for providing promotional materials and sharing the
cost of the agent’s advertisements. The Agreement also
required State Farm to supply information and guidance
regarding sales promotion, agency procedures, and new
products and services. State Farm considered any and all
information regarding policyholders to be its property, as
specified in the Agreement:
   Information regarding names, addresses, and ages of
   policyholders of the Companies; the description and
   location of insured property; and expiration or renewal
   dates of State Farm policies acquired or coming into
   your possession during the effective period of this
   Agreement, or any prior Agreement, except informa-
   tion and records of policyholders insured by the Com-
   panies pursuant to any governmental or insurance
   industry plan or facility, are trade secrets wholly
   owned by the Companies. All forms and other materi-
   als, whether furnished by State Farm or purchased
   by you, upon which this information is recorded shall
   be the sole and exclusive property of the Companies.
  The Agreement also addressed compensation for agents
discontinuing their work with State Farm by providing
them with termination payments. Termination payments
were payable to those who worked for two or more con-
tinuous years and returned all property belonging to
State Farm within ten days of termination. The number
of policies in force during the last twelve months of the
agent’s affiliation with the company determined the
value of the payments. An agent forfeited his right to
termination payments if he solicited policyholders within
4                                              No. 02-3262

one year after terminating the affiliation. The covenant
not to compete provided:
    For a period of one year following termination of this
    Agreement, you will not either personally or through
    any other person, agency, or organization (1) induce
    or advise any State Farm policyholder credited to your
    account at the date of termination to lapse, surrender,
    or cancel any State Farm insurance coverage or (2)
    solicit any such policyholder to purchase any insurance
    coverage competitive with the insurance coverages
    sold by the Companies.
  Baker terminated his relationship with State Farm on
February 28, 1997. Baker abided by the terms of the
Agreement, returning policy and policyholder descriptions,
claim draft books, rate books, agent’s service texts, and a
computer which contained much of the policy information.
Approximately 90% of Baker’s 4000 existing policies were
assigned to his successor agent. The successor agent,
appointed by State Farm, hired the two employees previ-
ously employed by Baker and assumed Baker’s telephone
number. In addition, the successor agent opened an office
in the vicinity of Baker’s office.
  Because Baker had fully complied with the require-
ments in the Agreement, State Farm made termination
payments of $38,622 in 1997. On his 1997 federal income
tax return, Baker reported the termination payments as
long-term capital gain on Schedule D. He attached a two-
page statement to the return which noted that the pay-
ments were made pursuant to contracts that “contain
specific provisions for the purchase and sale of business
intangible assets” and that the money would be paid “in
the form of a five year certain annuity designated ‘termina-
tion payments.’ ” Baker also specified that the fair market
value of the goodwill and going concern was $164,140, but
did not assign a value to the covenant not to compete.
No. 02-3262                                                 5

  In a notice of deficiency, the Commissioner determined
that the 1997 termination payments from State Farm were
ordinary income and did not qualify for capital gain treat-
ment. Baker filed a petition in the Tax Court contesting
the Commissioner’s notice of deficiency. The Tax Court
ruled in favor of the Commissioner. It found that under
the terms of the Agreement, Baker did not own any assets,
and thus could not have sold them to State Farm. Accord-
ingly, there was no sale or exchange of a capital asset
and the termination payments constituted ordinary in-
come. Baker appeals.


                        ANALYSIS
  The sole contention on this appeal is whether State
Farm’s termination payments were consideration for the
sale of a capital asset. We review questions of law de novo
and factual determinations, along with application of legal
principles to those factual determinations, for clear error.
Cline v. Commissioner, 

, 484 (7th Cir. 1994).
  The Internal Revenue Code defines “capital asset” in the
negative: it is property held by the taxpayer that is not
covered by an enumerated exception. I.R.C. § 1221(a). The
exceptions listed in § 1221 are not pertinent to our analysis.
  Long-term capital gain is gain from the sale or exchange
of a capital asset held for more than one year. I.R.C.
§ 1222(3). It is beneficial for a taxpayer to be able to
designate a source of income as long-term capital gain
because it is taxed at more favorable rates.
  Baker has the burden of proving that the Commissioner’s
deficiency determination was incorrect. See, e.g., Welch v.
Helvering, 

, 115 (1933); Gold Emporium v.
Commissioner, 

, 1378 (7th Cir. 1990). Baker
must establish that he: (i) owned a capital asset which he
held for more than one year; (ii) sold or exchanged this
6                                                No. 02-3262

asset; and (iii) received termination payments in consider-
ation for this sale or exchange.
  Fundamentally, in order to have the ability to sell
something, one must own it. Because Warren Baker did
not own any property related to the policies, he could not
sell anything. Section D of the Agreement provides:
    Information regarding names, addresses, and ages of
    policyholders of the Companies; the description and
    location of insured property; and expiration or re-
    newal dates of State Farm policies . . . are trade secrets
    wholly owned by the Companies. All forms and other
    materials, whether furnished by State Farm or pur-
    chased by you, upon which this information is recorded
    shall be the sole and exclusive property of the Compa-
    nies.
(emphasis added). Thus, according to the terms of the
Agreement, Warren Baker did not own anything related
to the policies.
  As the Tax Court noted, Baker returned everything
used in the daily course of business to State Farm. He
returned the books, records, and customer lists because
the Agreement designated them as the “sole and exclu-
sive property” of State Farm.
  Baker attempts to sidestep this obstacle by claiming that
the payments were in consideration for goodwill. He
contends that he developed and maintained goodwill over
the course of thirty-four years and that the loyalty of
the customer base was to him, not to State Farm.
  Goodwill is the expectation of continued patronage.
Newark Morning Ledger Co. v. United States, 

,
555 (1993). Goodwill enables a purchaser to step into
the shoes of the seller. Decker v. Commissioner, 

, 54 (7th Cir. 1988) (quoting Winn-Dixie Montgomery, Inc.
v. United States, 

, 681 (5th Cir. 1971)). Courts
No. 02-3262                                                7

have recognized that the insurance industry treats policy
records and policyholder information as goodwill. Schelble
v. Commissioner, 

, 1394 (10th Cir. 1997);
Marsh & McLennan, Inc. v. Commissioner, 

,
669-70 (3d Cir. 1969).
   As noted above, Baker did not own any assets related
to the business. Goodwill cannot be transferred apart from
the business with which it is connected. 38 Am. Jur. 2d
Goodwill § 10. We find reliance for our position in Schelble
v. Commissioner, 

(10th Cir. 1997) and Vaaler
v. United States, 

(8th Cir. 1972). In Schelble,
the taxpayer argued that “extended earnings” payments
made to him after terminating his position as an insur-
ance agent constituted proceeds from the sale of goodwill.
The court rejected the taxpayer’s argument, finding that
no sale of vendible assets occurred. 

. Citing Elliott v. United States, 

, 1154
(10th Cir. 1970), the court noted that for tax purposes, a
sale of goodwill takes place “only when the business or a
part of it, to which the goodwill attaches is sold.” 

In Vaaler v. United States, the Eighth Circuit re-
jected a similar argument made by the taxpayer. It also
cited Elliott for the same proposition, adding that as a
general agent, the taxpayer built up goodwill for the
insurance company, which belonged to the company. 

; see also Webster Investors, Inc. v. Com-
missioner, 

, 195 (2d Cir. 1961).
  While Baker built the insurance agency; the tools he
used were on loan from State Farm. State Farm’s termina-
tion payments were not for the sale of a business where
a buyer was able to step into the seller’s shoes. Baker
owned nothing. Thus, he could sell no assets, including
goodwill. We agree that goodwill was developed during
Baker’s tenure; however, it was not his to sell.
 Since Baker has failed to establish that the payments
were consideration for the sale or exchange of a capital
8                                              No. 02-3262

asset, the Commissioner’s deficiency determination is
upheld. One final point we briefly address: Baker asks if
the purpose for the payments are not in consideration
for goodwill, what are they? We agree with the Tax Court’s
conclusion that (a portion of) State Farm’s payments
were for a covenant not to compete. See, e.g., Clark v.
Commissioner, 

(1994); Foxe v. Commis-
sioner, 

(1969). The Agreement provides that
Baker would not induce any State Farm policyholder to
change coverage or solicit coverage through a competitor
for one year. The tax consequences of such language
are settled: the consideration a buyer pays a seller for
a covenant not to compete is taxable as ordinary income.
Patterson v. Commissioner, 

, 569 (6th Cir.
1987); Sonnleitner v. Commissioner, 

, 466 (5th
Cir. 1979).
    Accordingly, the judgment of the Tax Court is AFFIRMED.

A true Copy:
        Teste:

                         ________________________________
                         Clerk of the United States Court of
                           Appeals for the Seventh Circuit




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