Loan Financial Adviser Found Not Liable to Repay in FINRA Action Treated as Ordinary Income

In the case of Connell v. Commissioner, TC Memo 2018-213, the taxpayer (who was employed by Merrill Lynch) attempted to classify the amount of a loan that was forgiven as part of a Financial Industry Regulatory Authority’s (FINRA) decision in a dispute he had with Merrill Lynch as a capital gain.

The taxpayer had been a financial adviser since 1974.  In 2009 when he discovered that Smith Barney, with whom he was then associated, was going to be acquired by Morgan Stanley, he decided to look for other employment opportunities.  The best offer he received was from Merrill Lynch which he accepted.

As part of that offer, Merrill Lynch provided he was to be paid $42,980.07 per month from October 2009 to June 2017 in “transition compensation.”  At the same time, Merrill Lynch provided him with a loan of $3,637,217 which he was to repay at $42,980.07 per month from October 2009 to June 2017.  As you might suspect, the perfect overlap was not a coincidence.

As the opinion noted:

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.”

However, there was a falling out between Mr. Connell and Merrill Lynch.  As the opinion notes:

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 counsel to accompany him to a followup interview.

While Merrill Lynch’s outside counsel recommended that Mr. Connell be reprimanded only and the issue end there. Merrill Lynch moved to force Mr. Connell’s resignation shortly before his one year anniversary, a date on which he would have been eligible to receive a bonus.

As well, Merrill Lynch first delayed filing a Form U5, Uniform Termination Notice for Securities Industry Registration with FINRA and then later filed one that explained his reason for leaving as “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.”  Other financial services were unwilling to work with Mr. Connell during the period in which the U5 was not filed, and continued to be unwilling to work with him once the U5 with Merrill’s statement was filed.

In the interim, Merrill Lynch kept all of Mr. Connell’s staff as employees and had them contact his customers to convince them to stay with Merrill Lynch.  They also sought to collect the balance due on the loan to Mr. Connell.

Mr. Connell filed an arbitration action with FINRA regarding Merrill Lynch’s actions, seeking to find that he was not liable for repayment of the loan among other issues.  Mr. Connell claimed that Merrill Lynch had breached its employment agreement with him by acting in bad faith, and had intentionally set out to gain access to his high-value client base while ensuring that he would be unable to offer those clients services on his own.  Thus, Merrill Lynch was extremely likely to be able to keep these customers that were formerly Mr. Connell’s long-term clients as its own.

FINRA did rule that Mr. Connell was not to be required to repay the loan to Merrill Lynch.  But now the question was what the nature of the taxable income was.

The FINRA arbitration did not go into detail regarding the exact reasoning for the ruling that the loan did not need to be repaid.  The taxpayer argued that the loan was payment for his client lists and relationships, an intangible asset that would generate capital gain income from this sale.  The IRS argued that the taxpayer had advanced a number of theories, including that Merrill Lynch had violated the employment agreement, that would lead to any award being taxable as ordinary income.

The Tax Court, noting that the FINRA decision did not provide a clear answer to why the debt had been forgiven, agreed that the pleadings of the taxpayer would control.

The Court summarized the taxpayer’s arguments as follows:

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.

But the Tax Court noted that while he had raised that issue with FINRA, he had also raised the other justifications for this payment.

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 [*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.

And, as the Tax Court notes, the burden is on the taxpayer to show why the IRS’s view of the payment as representing ordinary income is not the correct view:

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.