Filed: Dec. 26, 2018
Latest Update: Mar. 12, 2020
Summary: T.C. Memo. 2018-213 UNITED STATES TAX COURT ROBERT A. CONNELL AND ANN P. CONNELL, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent ROBERT A. CONNELL, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 14947-16, 14948-16.1 Filed December 26, 2018. Barry H. Frank, Gordon Fairle Moore II, and Tiffany W. Donio, for petitioners. Kirsten E. Brimer and Audra M. Dineen, for respondent. 1 The Court granted the parties’ joint motion to consolidate docket numbers 14947-16 and
Summary: T.C. Memo. 2018-213 UNITED STATES TAX COURT ROBERT A. CONNELL AND ANN P. CONNELL, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent ROBERT A. CONNELL, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 14947-16, 14948-16.1 Filed December 26, 2018. Barry H. Frank, Gordon Fairle Moore II, and Tiffany W. Donio, for petitioners. Kirsten E. Brimer and Audra M. Dineen, for respondent. 1 The Court granted the parties’ joint motion to consolidate docket numbers 14947-16 and ..
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T.C. Memo. 2018-213
UNITED STATES TAX COURT
ROBERT A. CONNELL AND ANN P. CONNELL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
ROBERT A. CONNELL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 14947-16, 14948-16.1 Filed December 26, 2018.
Barry H. Frank, Gordon Fairle Moore II, and Tiffany W. Donio, for
petitioners.
Kirsten E. Brimer and Audra M. Dineen, for respondent.
1
The Court granted the parties’ joint motion to consolidate docket numbers
14947-16 and 14948-16 on August 8, 2017.
-2-
[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge: Respondent determined deficiencies in petitioners’
Federal income tax for 2009, 2010, and 2011 (years involved) as follows (all
amounts are rounded to the nearest dollar):
Docket No. 14947-16--Robert A. Connell & Ann P. Connell
Penalty
Year Deficiency sec. 6662(a)
2009 $169,552 $36,701
Docket No. 14948-16--Robert A. Connell
Penalty
Year Deficiency sec. 6662(a)
2010 $147,198 $29,440
2011 1,312,943 262,589
-3-
[*3] After concessions,2 the issue for decision in these consolidated cases is
whether an award by the Financial Industry Regulatory Authority (FINRA)3
Dispute Resolution Panel (FINRA Panel) that extinguished a debt owed by Mr.
Connell to Merrill Lynch, Pierce, Fenner & Smith, Inc. (Merrill Lynch), should be
taxed as ordinary income or as capital gain. Respondent asserts that the
extinguishment constitutes cancellation of debt income and taxable as ordinary
income; Mr. Connell maintains the award was for the taking of his book of
business and taxable as capital gain.
All section references are to the Internal Revenue Code, as amended, in
effect for the years involved, and unless otherwise indicated, all Rule references
are to the Tax Court Rules of Practice and Procedure.
2
Pursuant to the joint stipulation of settled issues, the parties agree that
petitioners are entitled to deduct certain nonpassive activity losses for 2009; Mr.
Connell is entitled to deduct nonpassive activity losses for 2010 and 2011; Mr.
Connell’s 2011 “Smith Barney Citi Group Deferred Compensation Loss” is a
capital loss; Mr. Connell is not entitled to a carryforward loss of $209,437 for
2011; petitioners are liable for the sec. 6662(a) penalty for 2009; and Mr. Connell
is liable for sec. 6662(a) penalties for 2010 and 2011.
3
FINRA is a private corporation that acts as a self-regulatory organization.
-4-
[*4] FINDINGS OF FACT
I. Introduction
Some of the facts have been stipulated and are so found. The stipulation of
facts and the exhibits attached thereto are incorporated herein by this reference.
When they timely filed their petitions, petitioners resided in Pennsylvania.
Petitioners were husband and wife in 2009; they filed a joint Federal income
tax return for that year. Petitioners divorced in 2010 and, as is relevant in this
matter, Mr. Connell filed as a single individual on his 2011 Federal income tax
return.4
Mr. Connell has been a financial adviser since 1974; he began his career
with Bache, now Prudential Bache. He has been a certified financial planner since
1979. In 1980 Mr. Connell joined the financial services firm now known as Smith
Barney, remaining there until 2009. At Smith Barney Mr. Connell generated a
group of approximately 200 clients. To service those clients, Mr. Connell worked
with a five-person team of brokers and assistants.5 By 2009 Mr. Connell and his
4
The record does not indicate whether Mr. Connell filed as a single
individual for 2010.
5
Mr. Connell’s team members were employees of Smith Barney, but they
worked exclusively for Mr. Connell. Although Mr. Connell did not have the
authority to fire a team member, management usually honored his request or
(continued...)
-5-
[*5] team had assets under management (AUM) exceeding $350 million. The
value of the assets under Mr. Connell’s direct management was $291,556,000.
Mr. Connell and his team produced over $3,150,000 in “T12”6 annual revenue for
Smith Barney, with Mr. Connell’s clients generating $2,609,835 in T12 revenue.7
The size of his book of business made Mr. Connell one of Smith Barney’s top
financial advisers. He was first in his office and in the North Atlantic region, and
in the top 20 nationally.
II. Mr. Connell’s Brief Merrill Lynch Career
In early 2009 Mr. Connell learned that Morgan Stanley intended to acquire
Smith Barney. He decided to explore other employment opportunities. Merrill
Lynch made him the best offer; Mr. Connell was offered their highest
compensation package, called “quintille one”.
5
(...continued)
reassigned the person.
6
T12 is trailing revenue, i.e., fees paid to the firm for the financial adviser’s
services over the preceding 12 months.
7
In 2009 another member of Mr. Connell’s team (who moved with Mr.
Connell to Merrill Lynch, see infra p. 9) had AUM of $54,524,000, and T12 of
$473,415.
-6-
[*6] On June 26, 2009, Mr. Connell signed a “relatively standard” employment
agreement with Merrill Lynch. Paragraph 3(c) governed Mr. Connell’s
compensation (hereinafter transition compensation).
Clause (i) stated:
(a) Connell shall be entitled to monthly transition compensation
payments of Forty-Two Thousand Nine Hundred Eighty and
07/100 Dollars ($42,980.07) during each month from October
2009 through June 2017. The transition compensation
payments described in this paragraph are not eligible for
computation of benefits (usually known as “non eligible
compensation”). Connell shall cease to be entitled to the
above-described transition compensation upon the termination
of his employment for any reason.
(b) In the event that Connell’s employment is terminated by
Merrill Lynch and/or Bank of America, other than for Cause
(as defined below) or in the event that Connell’s employment is
terminated by reason of death or disability (as defined in the
Merrill Lynch & Co. Long Term Disability Plan), Connell will
no longer be entitled to monthly transition compensation
payments under this Agreement. Instead, Merrill Lynch agrees
to pay Connell or his estate a lump sum payment equal to the
remaining transition compensation payments through June
2017, less any outstanding debts Connell owes Merrill Lynch.
Subject to paragraph 3(c)(v), such lump sum shall be paid as
soon as practicable after the close of the calendar year after the
calendar year in which the termination occurs, but in no event
later than March 15 of the year after the calendar year in which
the termination occurs. In the event that Connell resigns or his
employment is terminated by Merrill Lynch and/or Bank of
America for Cause, Connell shall cease to be entitled to the
above-described transition compensation payments and will not
receive any lump sum payment as described in this paragraph.
-7-
[*7] “Cause” was defined in paragraph 4 as:
i. violation of Federal securities laws, rules, or regulations;
ii. violation of any rules or regulations of any regulatory or self-
regulatory organization;
iii. violation, as reasonably determined by Merrill Lynch
management, of Merrill Lynch’s rules, regulations, policies,
practices, directions, and/or procedures;
iv. criminal conduct that could either result in Mr. Connell’s
statutory disqualification or could reasonably result in harm to
Merrill Lynch’s reputation, as reasonably determined by
Merrill Lynch management;
v. a suspension, bar, or limitation on Mr. Connell’s activities for
Merrill Lynch by any regulatory or self-regulatory
organization;
vi. violation of Merrill Lynch’s policies against discrimination and
harassment;
vii. failure to maintain licenses and required registrations;
viii. dishonesty in connection with Mr. Connell’s employment; or
ix. failure to fulfill or to meet any financial obligations that exist
between Mr. Connell and Merrill Lynch for a period of four
consecutive months that occur outside the first six months of
employment.
In addition to his monthly transition compensation payments, Mr. Connell
was eligible to participate in Merrill Lynch’s incentive compensation bonus
programs.
As previously noted, Mr. Connell was to receive $42,980 in monthly
transition compensation from October 2009 through June 2017. Upon his
agreeing to work for Merrill Lynch, the firm lent Mr. Connell $3,637,217. To
evidence the loan Mr. Connell signed a promissory note on June 26, 2009.
-8-
[*8] Pursuant to the note’s terms, $42,980.07 was due and payable each month by
Mr. Connell. However, “[f]or the convenience of the undersigned [i.e., Mr.
Connell], such amount shall be deducted from the undersigned compensation from
Merrill Lynch at the time compensation is paid during each month from October
2009 through June 2017.” This arrangement, common to the industry, allowed
Mr. Connell to receive the full amount of his transition compensation upfront,
while recognizing income only as each monthly payment came due. No moneys
changed hands with respect to each monthly “repayment” of the loan. The loan
became immediately repayable under the following conditions: “Notwithstanding
anything to the contrary contained herein, all outstanding principal and accrued
but unpaid interest on this Note shall become due and immediately payable if
(a) the undersigned’s employment with Merrill Lynch is terminated for any reason;
or (b) the undersigned becomes insolvent or files for bankruptcy.”
Mr. Connell was offered this high level of compensation in anticipation of
his clients’ moving with him and his team to Merrill Lynch. Mr. Connell’s efforts
to contact his clients and persuade them to leave Smith Barney and join him at
Merrill Lynch were governed by the Protocol for Broker Recruiting (protocol).
The protocol is an agreement entered into by participating financial services
-9-
[*9] firms,8 including Merrill Lynch and Smith Barney, which sets forth five
specific types of information which a financial adviser may take with him when
he/she leaves one financial services firm to join another:
1. client names;
2. client addresses;
3. client email addresses;
4. client telephone numbers; and
5. types of accounts the clients maintained.
Financial advisers are prohibited from taking any other document or information
with them when changing financial services firms.
Seeking to bring his clients to Merrill Lynch, Mr. Connell consulted with
Merrill Lynch’s attorneys to interpret the protocol. Relying on the attorneys’
interpretation of the protocol, Mr. Connell brought his client information with him
to Merrill Lynch and used it to contact the clients, inform them of the move, and
invite them to change financial services firms.
Mr. Connell’s relationship with his clients was important to him. He
negotiated special terms in his employment agreement which allowed him to
solicit his longtime clients (i.e., those clients who came with him from Smith
Barney) if he should ever leave Merrill Lynch:
8
As many as 1,400 financial services firms are signatories to the protocol.
- 10 -
[*10] 6. For a period of one year following the termination of Connell’s
employment with Merrill Lynch for any reason, Connell agrees
not to solicit, or initiate contact or communication with, either
directly or indirectly, any account, customer, client, customer
lead, prospect, or referral whom Connell served or whose name
became known to Connell during his employment at Merrill
Lynch. This restriction will not apply to clients whom Connell
served as a registered representative at his prior employer or
who became clients of Merrill Lynch within one year after he
begins employment with Merrill Lynch. In addition, if Connell
terminates his employment and joins a firm that is part of the
Protocol for Broker Recruiting (“Protocol”) and Merrill Lynch
is part of the Protocol at the time, Connell will be entitled to
follow the Protocol. * * *
Mr. Connell brought his entire team to Merrill Lynch and secured for each
team member a higher rate of compensation than each had received at Smith
Barney. As part of the transition Mr. Connell brought various spreadsheets and
documents used by his group at Smith Barney. These were developed by Mr.
Connell over his years of work. Specifically, Microsoft Word documents used by
Mr. Connell and his group contained historical records of telephone conversations
and personal meetings with clients, and the spreadsheets used by Mr. Connell and
his group contained detailed financial planning information. These Microsoft
Word documents and spreadsheets were treated as Mr. Connell’s personal property
at Smith Barney.9
9
Although the standard Smith Barney employment agreement stated that all
(continued...)
- 11 -
[*11] III. Mr. Connell’s Departure From Merrill Lynch
Less than a year after Mr. Connell joined Merrill Lynch, their relationship
collapsed. Merrill Lynch launched an investigation, conducted by outside counsel,
with respect to how Mr. Connell brought his team’s Smith Barney clients to
Merrill Lynch and whether he violated the protocol and/or his employment
agreement. Mr. Connell fully cooperated with all information requests made as
part of the investigation, but he engaged Thomas B. Lewis as his counsel10 to
accompany him to a followup interview. Merrill Lynch’s outside counsel
concluded that Mr. Connell should be issued a letter of reprimand and that
thereafter the matter should be ended.
Merrill Lynch declined to follow its outside counsel’s advice. On July 27,
2010, four days before Mr. Connell’s one-year anniversary with Merrill Lynch, a
date which would have entitled Mr. Connell to a bonus, Deborah Shepard, Mr.
9
(...continued)
files were property of Smith Barney, Mr. Connell crossed out this provision in his
employment agreement and this revision was approved by Smith Barney’s senior
management.
10
Mr. Connell retained the legal services of Mr. Lewis in July 2010 to
counsel and represent him in connection with both the Merrill Lynch investigation
and the ensuing litigation. See infra p. 12. Mr. Lewis has represented hundreds of
individual financial advisers and financial services companies before the FINRA
Panel, and he has appeared as a commentator on the subjects of FINRA arbitration
and employment and securities litigation in the media.
- 12 -
[*12] Connell’s manager, and Christopher Romano, a Merrill Lynch compliance
officer, met with Mr. Connell in his office. Mr. Connell was “basically told that
* * * [he] was going to be resigning.” Mr. Connell contacted his counsel, Mr.
Lewis, and asked him whether he should resign. Mr. Lewis recommended that he
should voluntarily resign, which Mr. Connell did, effective immediately.
Although Mr. Connell believed there were no grounds for his termination,
he realized that he could not effectively continue his employment with Merrill
Lynch and that if he were fired he would be unable to gain employment at any
other reputable financial services firm. When a financial adviser leaves his/her
financial services firm, the firm is required to file with FINRA a Form U5,
Uniform Termination Notice for Securities Industry Registration. Form U5
provides details regarding the termination of an individual’s employment.
Generally, reputable financial services firms will not hire a financial adviser for
whom a negative Form U5 has been filed, and Mr. Connell was concerned that if
he were fired a negative Form U5 would be filed.
As soon as Mr. Connell resigned, Merrill Lynch froze his account with the
firm11 and took legal action against him. On August 3, 2010, the firm filed a
11
Financial advisers are required to keep their assets and money at their
employing financial services firm. Mr. Connell had several million dollars in his
(continued...)
- 13 -
[*13] complaint against Mr. Connell as well as an emergency motion for a
temporary restraining order and preliminary injunction in the U.S. District Court
for the Eastern District of Pennsylvania. In a consent order signed on August 3,
2010, Mr. Connell agreed to an injunction governing his solicitation of clients and
requiring him to return certain listed Merrill Lynch property. The consent order
provided that it would
remain in full force and effect until such time as either an FINRA
arbitration panel renders a decision on Merrill Lynch’s request for
permanent injunctive relief or this Court specifically orders
otherwise. * * * Pending a preliminary injunction hearing before this
Court, and pursuant to the requirements of sections 3 and 4 of the
Federal Arbitration Act, 9 U.S.C. §§ 3-4, the parties are directed to
proceed toward expedited arbitration hearings on the merits before a
duly appointed panel of arbitrators pursuant to Rule 13804 of the
Financial Industry Regulatory Authority Code of Arbitration
Procedure.
Days later, on or about August 9, 2010,12 Merrill Lynch initiated such an
arbitration proceeding before the FINRA Panel. Merrill Lynch was the claimant;
Mr. Connell was the respondent.
11
(...continued)
personal account at Merrill Lynch. As soon as he resigned, Mr. Connell’s account
was frozen, thus preventing him from paying for his livelihood.
12
The parties in this matter entered a copy of Merrill Lynch’s amended
statement of claim, which was filed on August 9, 2010, into the record. It is
unknown when Merrill Lynch filed its original claim.
- 14 -
[*14] After Merrill Lynch commenced legal action against Mr. Connell, he
attempted to put his career back together by seeking employment at another
financial services firm. He was stymied, however, because Merrill Lynch did not
immediately file a Form U5 with respect to his leaving. Form U5 is usually filed
within a week of an adviser’s departure, and without such a filing, normally no
reputable financial services firm would have entertained his employment
application. Consequently, for a time after he left Merrill Lynch, Mr. Connell
could not service his clients.
As Mr. Connell’s career remained in limbo, Merrill Lynch actively solicited
Mr. Connell’s clients. Merrill Lynch had Mr. Connell’s former team members
contact each client in an attempt to convince each client to abandon Mr. Connell
and remain with Merrill Lynch.13 Merrill Lynch also retained Mr. Connell’s
Microsoft Word documents and spreadsheets, which the team members continued
to use to service clients.
On August 18, 2010, nearly a month after Mr. Connell’s resignation, Merrill
Lynch filed the Form U5. Under the heading “Reason for Termination” the form
13
Mr. Connell’s former team members were not pressured into leaving.
Rather, to motivate them to remain, Merrill Lynch gave his junior partner a raise.
Moreover, to motivate Mr. Connell’s clients to remain with Merrill Lynch, the
firm offered them reduced management fees.
- 15 -
[*15] stated “Permitted to Resign”. Under the heading “Termination Explanation”
the form states: “If the reason for Termination entered above is Permitted to
Resign, Discharged or Other, provide an explanation below”. In response Merrill
Lynch wrote: “Conduct resulting in loss of management’s confidence, including
conduct relating to the handling of customer information and lack of cooperation
in the firm’s review of the matter.” Testifying in this Court, Mr. Lewis stated:
“That’s the kiss of death. Because no firm would want to hire Bob Connell with
that type of a U5.”
IV. The FINRA Arbitration
A. Introduction
On August 9, 2010, Merrill Lynch filed an amended statement of claim,
wherein it sought (1) repayment of the outstanding balance of Mr. Connell’s loan,
(2) damages for breach of contract, (3) injunctive relief regarding the return of
Merrill Lynch property and proprietary information, and (4) legal fees and costs.
Merrill Lynch asserted that the outstanding balance of the loan should be repaid
because the terms of the promissory note to Merrill Lynch called for such
repayment upon termination of Mr. Connell’s employment.
On September 16, 2010, Mr. Connell filed an answer, affirmative defenses,
and counterclaim to Merrill Lynch’s claim. In the answer Mr. Connell denied all
- 16 -
[*16] of Merrill Lynch’s claims. In his counterclaim Mr. Connell requested that
he be awarded the following:
1. transition compensation of $3,200,000 paid when he joined
Merrill Lynch;
2. first year back end compensation of $950,000;
3. back end compensation for years 2 to 5 of $4,600,000;
4. lost commission compensation for 14 years of $26 million;
5. interest on the above mentioned amounts;
6. unspecified punitive damages; and
7. attorney’s fees, costs, and other such relief as the FINRA Panel
deems equitable.
Mr. Connell’s counterclaim also requested the FINRA Panel to order Merrill
Lynch to: (1) amend his Form U5; (2) release to him his portable electronic
storage devices, including the information contained thereon (i.e., the Microsoft
Word documents and spreadsheets); (3) provide him a spreadsheet fully compliant
with the protocol; (4) unfreeze his Merrill Lynch account; and (5) provide him
with replacement computers for those destroyed by Merrill Lynch.
B. Mr. Connell’s Pleadings
The issue before us involves the character of the balance of the Merrill
Lynch upfront forgivable loan, $3,242,248, which was extinguished as a result of
the award determination of the FINRA Panel. Specifically, we must determine
whether that award constitutes capital gain, as Mr. Connell maintains, or ordinary
income, as respondent maintains. To resolve the characterization of the award, we
- 17 -
[*17] focus on Mr. Connell’s arguments raised before the FINRA Panel in his
filings, specifically:
1. answer, affirmative defenses, and counterclaim (answer);
2. respondent/counterclaimant Robert A. Connell’s prehearing
brief (prehearing brief); and
3. respondent/counterclaimant Robert A. Connell’s response to
claimant/counterclaim respondent Merrill Lynch, Pierce,
Fenner & Smith, Inc.’s prehearing brief (response to claimant).
1. Mr. Connell’s Answer
Mr. Connell’s answer began by stating that the FINRA Panel should reject
Merrill Lynch’s demand that he repay the outstanding balance of the upfront
forgivable loan:
Merrill Lynch’s claim for breach of contract resulting from Mr.
Connell’s nonrepayment of a forgivable loan should fail because, if
Merrill Lynch is allowed to collect the amount allegedly remaining
due under the forgivable loan, Merrill lynch will have been permitted
to freeze Mr. Connell out of the financial services industry, thus
receiving the entire benefit of Mr. Connell’s substantial book of
business, all without having to provide any compensation to Mr.
Connell for that book of business. * * * This amount, as well as
subsequent compensation and bonuses that Mr. Connell was to
receive from Merrill Lynch during the first five years of his
employment, was directly tied to the amount of revenue his book of
business generated the year before he joined Merrill Lynch.
Continuing, Mr. Connell’s answer asserted that if Merrill Lynch were permitted to
collect the outstanding balance of the upfront forgivable loan, “then Merrill Lynch
- 18 -
[*18] will have benefited from the revenues generated from Mr. Connell’s entire
book of business without having provided to Mr. Connell any compensation for
that book of business.” Further, the answer posited that requiring Mr. Connell to
pay the outstanding balance of the upfront forgivable loan would amount to the
unjust enrichment of Merrill Lynch.
As previously stated, Merrill Lynch, by filing Mr. Connell’s Form U5
in the manner it did, has effectively prevented Mr. Connell from
securing employment in the financial services industry. By doing so,
Merrill Lynch has secured its ability to solicit and reap the benefit of
Mr. Connell’s entire book of business free from competition. If, in
addition to reaping the benefits from servicing Mr. Connell’s clients,
Merrill Lynch is also allowed to collect amounts allegedly due under
Mr. Connell’s forgivable loan, Merrill Lynch will have received the
benefits from Mr. Connell (the revenues generated from his clients)
without having provided any compensation to Mr. Connell for those
benefits.
Mr. Connell’s counterclaim consisted of 10 counts. We review only those
counts that are relevant to this matter.14
In count I (breach of contract demanding repayment of transition
compensation), Mr. Connell argued that “[b]y seeking the return of compensation
paid to Mr. Connell, which was paid to Mr. Connell to induce him to transfer his
14
The remaining counts were as follows: count II (breach of contract non-
payment of backend compensation); count III (breach of the implied covenant of
good faith and fair dealing); count IV (common law fraud and fraud in the
inducement); count V (Form U5 defamation); and count VII (conversion of
personal accounts).
- 19 -
[*19] entire client base to Merrill Lynch, after Mr. Connell had effectively
transferred his entire book of business to Merrill Lynch, Merrill Lynch has
breached the [employment] Agreement it entered into with Mr. Connell.”
In count VI (quantum meruit, unjust enrichment, and conversion of client
accounts), Mr. Connell argued that Merrill Lynch enticed him to join that firm
with bonus compensation, including the $3,637,217 upfront forgivable loan.
Upon Mr. Connell’s departure from Merrill Lynch, the firm demanded that he pay
the outstanding balance of the upfront forgivable loan. And by delaying the filing
of the Form U5 and then “filing a false and defamatory Form U5, * * * [Merrill
Lynch] has virtually assured that Mr. Connell will not be able to find competitive
employment in the financial services industry, thereby allowing Merrill Lynch to
continue to service Mr. Connell’s clients, free from competition. This would
unjustly enrich Merrill Lynch because the firm would hold Mr. Connell’s entire
book of business without having paid any compensation.”
In count VIII (tortious interference with contracts and/or business
relationship), Mr. Connell argued that by forcing his resignation and filing Form
U5, Merrill Lynch “virtually assured that Mr. Connell would be unable to secure
comparable employment in the financial services industry”. As a result he “is
- 20 -
[*20] unable to service his clients, and he is, therefore, unable to generate any
revenue from servicing those clients’ accounts.”
In count IX (misappropriation of trade secrets), Mr. Connell asserted that
the spreadsheets and Microsoft Word documents containing his client information,
which he had developed over the preceding 36 years, were “trade secrets that are
proprietary to Mr. Connell”. Mr. Connell accused Merrill Lynch of “utilizing
these programs for its own benefit” after his resignation.
In count X (unfair competition), Mr. Connell asserted that
Merrill Lynch has engaged in acts of unfair competition by luring Mr.
Connell--and by extension, his lucrative book of business--to Merrill
Lynch with the promise of high compensation only to, one year later:
(1) force his voluntary resignation; (2) decline to provide to him his
promised compensation; (3) seek to recoup compensation already
paid to him; (4) file a false and defamatory Form U5, preventing Mr.
Connell from securing employment in the industry; and then (5) all
the while continuing to service and generate revenue from Mr.
Connell’s clients entirely free from competition.
2. Mr. Connell’s Prehearing Brief
The preliminary statement to Mr. Connell’s prehearing brief asserted that
Merrill Lynch sabotaged Mr. Connell’s career.
Interestingly, none of Mr. Connell’s team, including his partner and
the four sales assistants who transitioned with him, seem to have
faced any repercussions for the actions in which they all engaged and
which allegedly constituted violations of the Protocol. The rest of
Mr. Connell’s team remains at Merrill Lynch servicing Mr. Connell’s
- 21 -
[*21] entire book of business. Forcing Mr. Connell’s resignation and
retaining his entire book of business was not enough for Merrill
Lynch, though; instead, Merrill Lynch saw fit to seek repayment of
compensation paid to Mr. Connell and to file actions against him in
Federal Court and with FINRA, all in an effort to ensure that Merrill
Lynch would have total, unrestricted access to Mr. Connell’s book of
business free from competition and to prevent Mr. Connell from
securing competitive employment at a comparable financial services
firm.
Continuing, the prehearing brief asserted that by “luring Mr. Connell and his
lucrative book of business to Merrill Lynch” the firm took action to ensure that
Mr. Connell would resign and be unable to find future work. Thus, Mr. Connell
claims:
Merrill Lynch has thereby secured for itself exclusive access to Mr.
Connell’s book of business, including the revenue generated by and
the assets held in Mr. Connell’s clients’ accounts. It has done so by
forcing his resignation--manufacturing an alleged violation of the
Protocol for Broker Recruiting as its reason for doing so--and then
filing a Form U5 Notice of Termination regarding Mr. Connell’s
separation with an intentionally false statement explaining the
circumstances of Mr. Connell’s resignation. The statement made on
Mr. Connell’s Form U5, which is meritless and was made without
justification, render [sic] Mr. Connell virtually unemployable with the
major financial services firms in the securities industry. Additionally,
as if this were not enough, Merrill Lynch, since Mr. Connell’s
resignation, has sought the return of the very compensation paid to
Mr. Connell in return for his decision to transfer his book of business
to Merrill Lynch. Moreover, the manner in which Merrill Lynch has
handled Mr. Connell’s resignation from the firm may have irreparably
damaged his relationship with his clients, who, after Mr. Connell’s
resignation, were left to speculate as to the true nature of Mr.
Connell’s abrupt departure from Merrill Lynch.
- 22 -
[*22] Mr. Connell’s prehearing brief further stated:
By seeking the return of compensation paid to Mr. Connell,
which was paid to Mr. Connell to induce him to transfer his entire
client base to Merrill Lynch, after Mr. Connell had effectively
transferred his entire book of business to Merrill Lynch, Merrill
Lynch has breached the Agreement it entered into with Mr. Connell.
Merrill Lynch’s breach has caused Mr. Connell to suffer damages.
Under the [employment] Agreement, Merrill Lynch is obligated “to
pay and indemnify [Mr.] Connell for all expenses, including
attorneys’ fees and costs, incurred by [Mr.] Connell if he is successful
in enforcing any of his rights under this agreement.” See Exhibit 10,
Agreement at ¶10. Therefore, Mr. Connell requests that the Panel
issue an Award in his favor, along with compensatory damages,
punitive damages, attorneys’ fees, costs of arbitration, interest, and
such other and further relief as the Panel deems equitable.
In its “Discussion of Mr. Connell’s Claims Against Merrill Lynch”, the
prehearing brief sets forth seven arguments.
Mr. Connell’s first argument was that “Mr. Connell’s Claim for Breach of
Contract * * * Should Be Granted Because if Merrill Lynch is Permitted to Obtain
the Return of Those Funds Then Merrill Lynch Will Have the Benefit of Being
Able to Service Mr. Connell’s Entire Book of Business without Having to Provide
any Compensation to Mr. Connell for that Benefit”. With respect to this
argument, Mr. Connell asserted that
after Mr. Connell had effectively transferred his entire book of
business to Merrill Lynch, Merrill Lynch has breached the Agreement
it entered into with Mr. Connell. Merrill Lynch’s breach has caused
Mr. Connell to suffer damages. Under the Agreement, Merrill Lynch
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[*23] is obligated “to pay and indemnify [Mr.] Connell for all expenses,
including attorney’s fees and costs, incurred by [Mr.] Connell if he is
successful in enforcing any of his rights under this agreement.” See
Exhibit 10, Agreement at ¶10.
Mr. Connell’s second argument was that “Mr. Connell’s Claim for Breach
of the Implied Covenant of Good Faith and Fair Dealing Should be Granted
Because, by inducing Mr. Connell to Transfer his Entire Book of Business only to
Force his Resignation one Year Later and Avoid Paying Compensation Owed to
Mr. Connell, Merrill Lynch Breached the Covenant of Good Faith and Fair
Dealing Implied in its Agreement with Mr. Connell”. This argument is premised
on the law of contracts, positing that Merrill Lynch breached the State of
Pennsylvania’s15 implied covenant of good faith by inducing Mr. Connell to
transfer his entire book of business and then forcing his resignation less than one
year later to avoid paying compensation owed to him.
Mr. Connell’s third argument was that “Mr. Connell’s Claim for Fraud in
the Inducement Should be Granted [because], by inducing Mr. Connell to Transfer
his Entire Book of Business only to Force his Resignation one Year Later and
Avoid Paying Compensation Owed to Mr. Connell, Merrill Lynch Fraudulently
induced Mr. Connell to Sign the Agreement with Merrill Lynch and Transfer his
15
Mr. Connell’s employment agreement with Merrill Lynch was governed
by Pennsylvania law.
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[*24] Entire Client Base to the Firm”, which is related to common law fraud and
fraudulent inducement committed under the auspices of Pennsylvania tort law.
Mr. Connell’s fourth argument was that
Mr. Connell’s Claim for Quantum Meruit, Unjust Enrichment, and
Conversion of Clinet [sic] Accounts Should be Granted Because, by
Inducing Mr. Connell to Transfer his Entire Book of Business to
Merrill Lynch only to Force his Resignation one Year Later and
Avoid Paying Compensation Owed to Mr. Connell, Merrill Lynch is
Effectively Receiving all the Benefits of Servicing Mr. Connell’s
Entire Book of Business without Providing any Remuneration to Mr.
Connell for that Benefit * * *
In making this contention Mr. Connell argued that Merrill Lynch essentially
converted his book of business via a plan whereby Merrill Lynch: (1) lured Mr.
Connell to join the firm with a large compensation package “the initial of which
was in the amount of $3,637,217.00”, i.e., the amount of the monthly transition
compensation and the upfront forgivable loan that was based on the value of his
book of business; (2) forced his resignation just before his first year bonus was
due to be paid; (3) demanded he repay the upfront forgivable loan; and (4) filed “a
false and defamatory Form U5”, which “virtually assured that Mr. Connell * * *
[would] not be able to find comparable employment in the financial services
industry, thereby allowing Merrill Lynch to continue to service Mr. Connell’s
clients almost entirely free from competition.”
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[*25] Mr. Connell’s fifth argument was that “Mr. Connell’s Claim for Tortious
Interference Should be Granted Because, in the Methods it has Used to Ensure that
Mr. Connell Would Not be Permitted to Secure Comparable Employment, Merrill
Lynch tortiously Interfered with Mr. Connell’s Relationship with his Clients”.
Similar to the fourth argument, this argument adds a tort claim to Mr. Connell’s
position that Merrill Lynch converted Mr. Connell’s book of business.
Mr. Connell’s sixth argument was that “[b]y Continuing to use for its own
Pecuniary Gain the Client Financial Planning Spreadsheets and Documents that
Mr. Connell Developed, Merrill Lynch has Misappropriated Mr. Connell’s Trade
Secrets”. With respect to this argument, Mr. Connell asserted that “[w]hen Mr.
Connell resigned from Merrill Lynch, he was not permitted to retain copies of his
client financial planning spreadsheets or Microsoft Word documents, and, upon
information and belief, Merrill Lynch is still utilizing these programs for its own
benefit.”
Mr Connell’s seventh argument was that “Merrill Lynch, by Forcing Mr.
Connell’s Resignation, by Filing a False Form U5, and by Taking Other Actions
Against Mr. Connell[,] has Violated FINRA Rule 2010 and has Engaged in Unfair
Competition”. With respect to this argument, Mr. Connell asserted that Merrill
Lynch violated the spirit and letter of FINRA rule 2010, which provides that a
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[*26] member firm is to “observe high standards of commercial honor and just and
equitable principles of trade” in conducting business. Merrill Lynch violated this
rule, Mr. Connell argued, by luring him to the firm, forcing him to resign, filing a
“false and defamatory Form U5”, demanding he pay the outstanding balance of the
upfront forgivable loan, and “continuing to service and generate revenue from Mr.
Connell’s clients entirely free from competition.”
3. Response to Claimant
In the response to claimant Mr. Connell reiterated that he (1) was not in
breach of his employment contract, (2) did not misappropriate trade secrets,
(3) did not convert Merrill Lynch property, (4) did not breach his duty of loyalty,
and (5) did not take unfair competitive actions. Mr. Connell further argued that
Merrill Lynch’s claim for breach of contract for nonrepayment of the balance of
the upfront forgivable loan should be denied because it would be manifestly unjust
to allow the firm to essentially freeze Mr. Connell out of the financial services
industry, and permit Merrill Lynch to freely solicit and generate revenue from Mr.
Connell’s book of business without providing him with any compensation.
Mr. Connell was provided with an up-front loan by Merrill Lynch as
an inducement to join Merrill Lynch. The loan was based on the
amount of revenue he generated the year before he joined Merrill
Lynch, but, unlike the scenario described above [wherein a
hypothetical financial planner leaves one firm to work at another with
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[*27] an outstanding balance remaining on a forgivable loan] when Mr.
Connell resigned from Merrill Lynch, he did not join a competitor
and, in the several months since his resignation, has only managed to
acquire 11 clients. Instead, Merrill Lynch filed a Form U5 with
language that makes it impossible for Mr. Connell to find comparable
employment in the financial services industry. Having effectively
sidelined Mr. Connell, Merrill Lynch has been able to solicit free
from competition, Mr. Connell’s entire book of business. Now
Merrill Lynch, through its breach of contract claim, seeks to force Mr.
Connell to repay to Merrill Lynch the amounts it originally paid to
him to bring his book of business to Merrill Lynch. It would be
manifestly unjust to permit Merrill Lynch to continue to solicit and
reap the benefits of Mr. Connell’s entire book of business, without
competition, and also allow Merrill Lynch to collect the amounts
allegedly outstanding on Mr. Connell’s up-front loan. Therefore,
Merrill Lynch’s breach of contract claim for non-repayment of Mr.
Connell’s up-front loan should be denied.
Mr. Connell further posits that Merrill Lynch’s claim against him for unjust
enrichment should be rejected because, among other things, if any party has been
unjustly enriched, it was Merrill Lynch.
C. Outcome of the FINRA Arbitration
On May 5, 2011, the FINRA Panel rendered its decision. With respect to
Merrill Lynch’s claims, the FINRA Panel stated “Claimant’s [i.e., Merrill Lynch’s]
claims are denied in their entirety.” Thus, the FINRA Panel declined to order Mr.
Connell to pay the balance owing under the promissory note.
With respect to Mr. Connell’s counterclaims, the FINRA Panel ruled that
“[t]he restrictions on Respondent’s [i.e., Mr. Connell’s] personal account(s) with
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[*28] Claimant are stricken. Respondent is entitled to retain the $3,285,228.26
paid by Claimant to Respondent.” Thus, the FINRA Panel made it clear that Mr.
Connell was not obligated to pay the balance of the upfront forgivable loan to
Merrill Lynch. Mr. Connell was also awarded compensatory damages of
$476,500. The FINRA Panel did not specify its reasoning or the basis of this
award. Mr. Connell was further awarded attorney’s fees of $288,732 and costs of
$22,734.
The FINRA Panel ordered Merrill Lynch to deliver to Mr. Connell the
templates for his Microsoft Word documents and spreadsheets but expressly stated
that the templates were to be delivered to Mr. Connell without any data. Upon
delivery, Merrill Lynch was ordered to certify that it had removed the “Connell
Proprietary Excel Spreadsheet and MS Word templates from its own computer
systems”. The order did not prevent Merrill Lynch from retaining the substantive
client information, however. Mr. Connell’s request that his Form U5 be expunged
was denied. The FINRA Panel further ruled that all other elements of the
injunction agreed to under the consent order were to remain in effect.
Mr. Connell’s victory before the FINRA Panel was, according to Mr. Lewis,
“very unusual. Typically, a promissory note is awarded because there’s a contract
and there are terms, and the terms are fairly one-sided when the financial advisor
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[*29] signs the terms. So there’s an awful lot of protections for the financial
institutions. So it’s rare for something like this to occur.”
V. Mr. Connell’s 2011 Federal Income Tax Return
Merrill Lynch issued Mr. Connell a Form 1099-C, Cancellation of Debt,
reporting debt cancellation income of $3,285,228. The parties stipulated that the
amount on Form 1099-C was wrong and that the proper amount of cancellation of
indebtedness income should be $3,242,248.16
Mr. Connell timely filed his 2011 Federal income tax return wherein he
reported adjusted gross income of negative $112,635. Mr. Connell attached to his
income tax return a document entitled “Form 8582 and Schedule E 2011”, wherein
he reported the cancellation of indebtedness income as “deferred compensation”
ordinary income. He offset this amount with two ordinary loss items: (1) a
“Merrill Lynch Reduction for 1099C Reported on W-2” of $42,98017 and
(2) “Smith Barney Citi Group Deferred Compensation Loss” of $2,495,732,
resulting in $782,516 in total (net) deferred compensation. This amount,
combined with Mr. Connell’s other reported business losses, was reported on line
16
Merrill Lynch issued Mr. Connell a Form W-2, Wage and Tax Statement,
reporting the other awards made by the FINRA Panel.
17
Respondent agrees that the amount listed on the Form 1099-C should be
decreased by $42,980.
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[*30] 17 of Mr. Connell’s Form 1040, U.S. Individual Income Tax Return, as a
total loss of $577,363. Combining this total with deductions of $65,999 claimed
on Schedule A, Itemized Deductions, Mr. Connell requested a refund of $129,911.
The IRS examined Mr. Connell’s 2011 tax return and determined that the
Smith Barney Citi Group deferred compensation loss was a loss from the sale of
stock and could not be used to offset ordinary income. Mr. Connell has conceded
this recharacterization.
On October 10, 2013, Mr. Connell filed an amended 2011 income tax return
wherein he reported adjusted gross income of $1,047,365. On line 17 of the
amended tax return Mr. Connell reported positive income of $582,637. Also on
the amended return Mr. Connell reported itemized deductions totaling $1,930,999.
As a result, Mr. Connell again claimed entitlement to a refund of $129,911. In
essence, Mr. Connell recharacterized the extinguishment of the balance of the
Merrill Lynch upfront forgivable loan, $3,242,248, from ordinary income to
capital gain.
OPINION
In general, the Commissioner’s determinations in the notice of deficiency
are presumed correct and taxpayers bear the burden of proving error. Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). Gross income includes all income
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[*31] from whatever source derived unless specifically excluded. Sec. 61(a);
Simpson v. Commissioner, 141 T.C. 331, 338 (2013), aff’d, 668 F. App’x 241 (9th
Cir. 2016).
Proceeds received pursuant to a judgment arising from a dispute constitute
taxable income unless the taxpayer can establish that the proceeds come within the
clear scope of a statutory exclusion. Commissioner v. Schleier, 515 U.S. 323,
328-329, 336-337 (1995). When a solvent debtor’s fixed obligation is reduced or
canceled, the amount of the reduction or cancellation constitutes income. Sec.
61(a)(12); Commissioner v. Jacobson,
336 U.S. 28 (1949); OKC Corp. & Subs. v.
Commissioner,
82 T.C. 638, 647 (1984).
This Court has long recognized the rule that “[t]he taxability of the proceeds
of a lawsuit, or of a sum received in settlement thereof, depends upon the nature of
the claim and the actual basis of recovery.” Sager Glove Corp. v. Commissioner,
36 T.C. 1173, 1180 (1961), aff’d,
311 F.2d 210 (7th Cir. 1962); see also OKC
Corp. & Subs. v. Commissioner,
82 T.C. 650; Gidwitz Family Tr. v.
Commissioner,
61 T.C. 664, 673 (1974). The nature of the litigation is determined
by reference to the origin and character of the claim (origin of the claim doctrine)
which gave rise to the litigation. Gidwitz Family Tr. v. Commissioner,
61 T.C.
673. Thus, to the extent that amounts received for injury or damage to capital
- 32 -
[*32] assets exceed the basis of the property, such amounts are taxable as capital
gain, whereas amounts received for lost profits are taxable as ordinary income.
OKC Corp. & Subs. v. Commissioner, 82 T.C. 650. In deciding the issue before
us (i.e., the character of the $3,242,248 extinguished as a result of the FINRA
Panel’s award) the question we must answer is: “In lieu of what were the damages
awarded?” State Fish Corp. v. Commissioner,
48 T.C. 465, 472 (1967) (quoting
Raytheon Prod. Corp. v. Commissioner,
144 F.2d 110, 113 (1st Cir. 1944), aff’g
1
T.C. 952 (1943)), modified by
49 T.C. 13 (1967).18
18
Respondent argues that Mr. Connell is precluded by the rule of
Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), vacating and remanding
44 T.C. 549 (1965), from relying on the origin of the claim doctrine. We disagree
with respondent’s position.
Respondent argues that Mr. Connell is bound by his employment agreement
and promissory note. The promissory note was made as part of Mr. Connell’s
compensation package with Merrill Lynch (i.e., the monthly transition
compensation). The note makes no mention of Mr. Connell’s book of business.
Moreover, as respondent points out, Mr. Connell treated the monthly transition
compensation he received during his tenure at Merrill Lynch as ordinary income,
which is consistent with the terms of the employment agreement and promissory
note. Respondent also draws our attention to the fact that Mr. Connell did not
assert that the income was capital gain income until the IRS determined that he
erroneously characterized the Smith Barney stock loss as an ordinary loss.
The Danielson rule does not control the outcome of this matter. Mr.
Connell does not seek to change the tax consequences of a transaction by
challenging the underlying agreements and reforming the contractual terms. See
id. at 775-779.
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[*33] The FINRA Panel did not explain the basis of its award; hence, we are left
to infer its reasoning. In similar cases we have looked to the pleadings to
determine the nature of the taxpayers’ claims. “The decided cases seem to be
unanimous in holding that in such circumstances as we have here, the nature of the
recovery is to be determined from the claims made in the pleadings or complaint
filed in the prior action and the issues and evidence there presented to the jury.”
State Fish Corp. v. Commissioner,
48 T.C. 474.
Mr. Connell argues that his filings with the FINRA Panel make it clear that
the award was to compensate him for the taking of his book of business and hence
should be taxed as a capital gain.
The gravamen of * * * [Mr. Connell’s] claim in the FINRA
arbitration was that he was entitled to retain the unpaid portion of the
Loan proceeds because they represented fair compensation for Merrill
Lynch’s having taken his book of business. In fact, that was the only
argument he made with respect to his claim for retention of those
proceeds.
We disagree. Admittedly, the filings heavily emphasize Mr. Connell’s
argument that Merrill Lynch lured Mr. Connell to Merrill Lynch in order to
acquire his book of business and that thereafter it set out to ruin his professional
reputation so as to keep him from working at a competing financial services firm.
But this argument was not the only one Mr. Connell presented to the FINRA
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[*34] Panel. Mr. Connell’s attorney, Mr. Lewis, an experienced and successful
litigator, made certain of that. Mr. Connell’s filings forcefully argue that the
FINRA Panel should reject Merrill Lynch’s position and conclude that Mr.
Connell need not pay the balance of the upfront forgivable loan. Indeed, Mr.
Connell’s filings emphasized that Merrill Lynch breached the terms of the
employment contract, not Mr. Connell, causing Mr. Connell to suffer damages.
This argument, by itself, would relieve Mr. Connell of his obligation to pay the
outstanding balance of the promissory note to Merrill Lynch.
The record herein does not reveal the specific argument the FINRA Panel
found most persuasive when it extinguished the balance of the upfront forgivable
loan. Petitioners bear the burden of answering the question “in lieu of what were
the damages awarded?” On the basis of our examination of the record, we
conclude that petitioners have not met their burden to establish that the amount at
issue was solely for the acquisition of Mr. Connell’s book of business.
Consequently, we sustain respondent’s determination that the extinguishment of
Mr. Connell’s debt to Merrill Lynch constitutes cancellation of debt income and
that the amount of the extinguishment is taxable as ordinary income.
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[*35] To reflect the foregoing, and the concessions included in the joint
stipulation of settled issues,
Decisions will be entered
under Rule 155.
