Debt Cancelled by Former Employer Was Ordinary Income, Not Capital Gain

(Parker Tax Publishing August 2020)

The Third Circuit affirmed a Tax Court holding that the cancellation of a $3.2 million debt a taxpayer owed to his former employer, which was awarded to the taxpayer after an arbitration hearing, was taxable as ordinary income rather than as a capital gain. The court found that the Tax Court correctly determined that the loan was part of the taxpayer's compensation package and that the taxpayer's arbitration filings emphasized that his former employer breached the terms of the employment contract with the taxpayer, which relieved the taxpayer of his obligation to repay the loan. Connell v. Comm'r, 2020 PTC 233 (3d Cir. 2020).

Background

Robert Connell has been a financial adviser since 1974 and a certified financial planner since 1979. In 1980, Connell joined the financial services firm now known as Smith Barney, remaining there until 2009. At Smith Barney, Connell generated a group of approximately 200 clients. To service those clients, Connell worked with a five-person team of brokers and assistants. By 2009, Connell and his team had assets under management exceeding $350 million. The size of his book of business made Connell one of Smith Barney's top financial advisers.

In early 2009, Connell decided to leave Smith Barney. Merrill Lynch (ML) made him the best offer; Connell was offered their highest compensation package, and Connell accepted ML's offer. Upon his agreeing to work for ML, the firm lent Connell approximately $3.6 million. Connell signed a promissory note which provided that $42,980 was due and payable each month by Connell. However, that amount would be deducted from Connell's compensation at the time compensation was paid during each month from October 2009 through June 2017. This arrangement, common to the industry, allowed Connell to receive the full amount of his transition compensation upfront, while recognizing income only as each monthly payment came due. No money changed hands with respect to each monthly "repayment" of the loan. Under the agreement, the loan would become immediately repayable if Connell's employment was terminated for any reason.

Connell was offered this high level of compensation in anticipation of his clients' moving with him and his team to ML. Connell's efforts to contact his clients and persuade them to leave Smith Barney and join him at ML were governed by a protocol that sets forth certain types of client contact information that a financial adviser may take with him when he/she leaves one firm to join another. Connell consulted with ML's attorneys and, relying their interpretation of the protocol, brought his client information with him to ML and used it to contact the clients and invite them to change firms. Connell brought his entire team to ML. He also brought various spreadsheets and documents which he had developed over his years of work. The documents contained historical records of telephone conversations and personal meetings with clients, while the spreadsheets contained detailed financial planning information. These documents and spreadsheets were treated as Connell's personal property at Smith Barney.

Less than a year after Connell joined ML, his relationship with ML collapsed. ML launched an investigation with respect to how Connell brought his team's clients to ML and whether he violated the protocol and/or his employment agreement. On July 27, 2010, four days before Connell's one-year anniversary with ML, a date which would have entitled Connell to a bonus, Connell was told that he should resign, which he did, effective immediately.

As soon as Connell resigned, ML froze his account and filed a complaint and an emergency motion for injunctive relief in a federal district court. The court ordered the parties to attend an arbitration hearing before a Financial Industry Regulatory Authority (FINRA) dispute resolution panel. In the arbitration, ML sought repayment of the outstanding balance of Connell's loan, plus damages for breach of contract, among other relief. Connell filed a counterclaim requesting an award for the transition compensation of $3.2 million paid when he joined ML plus other compensation and damages. The FINRA panel denied ML's claims in their entirety and declined to order Connell to pay back the balance owing under the promissory note. The panel ruled that Connell was entitled to keep the $3.2 million loan and ordered ML to deliver to Connell the templates for his documents and spreadsheets. However, ML was allowed to retain the substantive client information contained in the documents and spreadsheets.

ML sent Connell a Form 1099-C, Cancellation of Debt, reporting the $3.2 million as debt cancellation income. On his 2011 tax return, Connell characterized the extinguishment of the balance of the ML loan as a capital gain, rather than as ordinary income. After the IRS issued a notice of deficiency, Connell petitioned the Tax Court, arguing that the arbitration award was to compensate him for the taking of his book of business and hence should be taxed as a capital gain. The Tax Court ruled in the IRS's favor after applying the origin-of-the-claim test articulated in State Fish Corp. v. Comm'r, 48 T.C. 465 (1967). While noting that the FINRA panel did not explain the basis of its award, the court found that Connell failed to meet his burden of establishing that the amount at issue was solely for the acquisition of Connell's book of business. The court noted that Connell's arbitration filings emphasized that ML had breached the terms of the employment contract and the court found that this argument, by itself, would relieve Connell of his obligation to pay the outstanding balance of the promissory note to ML.

Connell appealed to the Third Circuit. He argued that the Tax Court misapplied the origin-of-the-claim test and should have relied on "more recent" decisions such as Gail v. U.S., 58 F.3d 580 (10th Cir. 1995), which he said emphasize "economic reality." According to Connell, the FINRA arbitration panel cancelled the debt to ML as compensation for his book of business, a capital asset, and therefore the cancellation of debt income should have be taxed as a capital gain. He argued that the Tax Court looked only to the legal theories and terms in his arbitration filings rather than the factual economics of his case.

Third Circuit's Analysis

The Third Circuit upheld the Tax Court after finding that it did not err in its articulation of the origin-of-the-claim test. The Third Circuit found that the Tax Court reviewed in depth Connell's recruitment to ML, the employment agreement and promissory note, the circumstances surrounding Connell's departure from ML, and the arbitration, including the filings and the award.

The court noted that neither Connell's employment agreement nor the promissory note stated or implied that Connell's compensation was the price paid for his book of business. Moreover, the court observed that Connell did not introduce evidence that would have shown that the value of his book of business was the same as the outstanding balance of the loan from ML. The court also found that the Tax Court was correct in interpreting Connell's filings before the arbitration panel which, in the view of the Tax Court, emphasized that ML breached the terms of Connell's employment contract. Although Connell argued that a breach by ML would not have relieved him of his repayment obligation, the Third Circuit rejected that argument, finding that upon a breach by ML other than for cause, Connell effectively would have been relieved of his obligation to repay the loan because he would have been entitled to up-front payment of the remainder of his monthly transition compensation - the loan balance and the up-front payment would have been the same amount and would have cancelled each other out. Thus, according to the Third Circuit, the Tax Court did not err in determining that a breach of contract by ML would relieve Connell of his obligation to pay the outstanding balance of the promissory note.

For a discussion of the taxability of discharge of indebtedness income, see Parker Tax ¶72,300.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com