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INSIGHT: Extinguishment of ‘Forgivable’ Merrill Lynch Loan Produces Ordinary Income for Financial Adviser

Jan. 8, 2019, 2:04 PM

Merrill Lynch & Co.’s extinguishment of the $3.24 million balance on a “forgivable” loan to a financial adviser—upon order of an industry arbitration panel—resulted in ordinary income for the adviser rather than capital gain.

Robert Connell argued that the extinguished amount was compensation for Merrill Lynch’s taking of his “book of business” upon his forced departure from the firm. The Internal Revenue Service determined that it was ordinary income, and the U.S. Tax Court agreed in Connell v. Commissioner, T.C. Memo. 2018-213.

Connell has been a financial adviser since 1974. In 1980, Connell joined Smith Barney, remaining there until 2009. By 2009, Connell and his team had assets under management exceeding $350 million. The size of Connell’s book of business made Connell one of Smith Barney’s top financial advisers. However, in light of Morgan Stanley’s pending acquisition of Smith Barney, Connell decided to seek new employment.

On June 26, 2009, Connell signed an employment agreement with Merrill Lynch. The agreement provided that Connell would be entitled to monthly transition compensation payments of $42,980 from October 2009 through June 2017. In the event that Connell’s employment was terminated other than for cause, he would no longer be entitled to the monthly payments. Instead Merrill Lynch would pay Connell or his estate a lump sum payment equal to the remaining payments less any outstanding debts Connell owed to Merrill Lynch.

Upon his agreeing to work for Merrill Lynch, the firm lent Connell $3.64 million. Connell signed a promissory note on June 26, 2009. Pursuant to the note’s terms, $42,980 was due and payable each month by Connell. This arrangement allowed 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. All principal and accrued but unpaid interest on the note would become due and payable if Connell’s employment with Merrill Lynch 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 Merrill Lynch. Connell brought his client information with him to Merrill Lynch and used it to contact his clients, inform them of the move, and invite them to change financial services firms.

Departure From Merrill Lynch

Less than one year after Connell joined Merrill Lynch, the relationship collapsed. Merrill Lynch launched an investigation with respect to how Connell brought his team’s Smith Barney clients to Merrill Lynch. On July 27, 2010, Connell was told by his manager that he “was going to be resigning.“ As soon as Connell resigned, Merrill Lynch froze his account and took legal action against him. On Aug. 9, 2010, Merrill Lynch initiated an arbitration proceeding before the Financial Industry Regulatory Authority (FINRA) Dispute Resolution Panel. Merrill Lynch was the claimant and Connell was the respondent.

Merrill Lynch did not immediately file the Form U5 with respect to his leaving. (Form U5 is ordinarily filed within a week of an adviser’s departure). Without such a filing, no reputable financial services firm would have entertained Connell’s employment application. Consequently, for a time after he left Merrill Lynch, Connell could not service his clients. Merrill Lynch actively solicited Connell’s clients. Nearly a month after Connell’s resignation, Merrill Lynch filed the U5, which was disparaging of Connell.

The Arbitration

On Aug. 9, 2010, Merrill Lynch filed an amended statement of claim wherein it sought repayment of the loan, damages, injunctive relief, and legal fees and costs. On Sept. 16, 2010, Connell filed a counterclaim. In his counterclaim, Connell requested that he be awarded transition compensation, first year back end compensation, and lost commission compensation.

The issue before the Tax Court involved the character of the balance of the upfront forgivable loan, which was extinguished as a result of the award determination of the FINRA panel. The court said it must determine whether that award constituted capital gain, as Connell contended, or ordinary income, as the IRS maintained.

“To resolve the characterization of the award, we focus on Mr. Connell’s arguments raised before the FINRA panel in his filings,” the court said. Connell asserted that if Merrill Lynch were permitted to collect the balance of the upfront forgivable loan, then Merrill Lynch would have benefited from the revenue generated from Connell’s entire book of business without having provided to Connell any compensation for that book of business.

On May 5, 2011, the FINRA panel rendered its decision. The panel stated Merrill Lynch’s “claims are denied in their entirety.“ The panel declined to order Connell to pay the balance owning under the promissory note. Connell was also awarded compensatory damages of $476,500. Connell was further awarded attorney’s fees and costs. The order did not prevent Merrill Lynch from retaining the substantive client information. Merrill Lynch issued Connell a Form 1099-C, reporting debt cancellation income. On Oct. 10, 2013, Connell filed an amended 2011 income tax return. In essence, in connection with that return, Connell recast the extinguishment of the balance of the loan from ordinary income to capital gain.

Origin of the Claim

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. When a solvent debtor’s fixed obligation is reduced or canceled, the amount of the reduction or cancellation constitutes gross income under tax code Section 61(a)(12).

“The 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. … The nature of the litigation is determined by the origin and character of the claim which gave rise to the litigation. … Thus, to the extent that amounts received for injury or damages to capital 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. … In deciding the issue before us the question we must answer is ‘in lieu of what were the damages awarded?’” the court said.

The FINRA panel did not explain the basis of its award. In similar cases, the court said, “we have looked to the pleadings to determine the nature of the taxpayers’ claims.” The nature of the recovery is determined from the claims made in the pleadings or complaint.

Connell argued that his filings with the FINRA Panel made it abundantly clear that the award was to compensate him for “the taking of his book of business” and hence should be taxed as capital gain. The court disagreed. Admittedly, it acknowledged, the filings “heavily emphasize” Connell’s argument that Merrill Lynch lured 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 Connell presented to the FINRA panel.

Connell’s filings forcefully argued that the FINRA panel should reject Merrill Lynch’s position and conclude that 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” causing Connell to suffer damages, the court said. This argument, by itself, would relieve Connell of his obligation to pay the outstanding balance of the promissory note to Merrill Lynch.

The court noted that the record did not reveal the specific argument the FINRA panel found most persuasive when it extinguished the balance of the upfront forgivable loan. The court concluded that Connell had not met his burden to conclusively establish that the amount at issue was solely for the acquisition of Connell’s book of business. Consequently, the court sustained the IRS’s determination that the extinguishment of Connell’s debt constituted cancellation of debt income and that the amount of the extinguishment is taxable as ordinary income.

In short, the FINRA panel’s failure to state the actual basis of recovery redounded to the detriment of Connell—without that information, it became impossible for Connell to conclusively demonstrate, to the court’s satisfaction, that the settlement proceeds were designed to compensate him for the taking of his book of business. Thus, the court was forced to conclude that the award fell into the “compensation for lost profits” category, and, accordingly, gave rise to ordinary income.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

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