T.C. Memo. 201 8-213

SR

T.C. Memo. 201 8-213

UNITED STATES TAX COURT

ROBERT A. CONNELL AND ANN P. CONNELL, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

ROBERT A. CONNELL, Petitioner L

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.

¹The Court granted the parties' joint motion to consolidate docket numbers

14947-16 and 14948-16 on August 8, 2017.

SERVED Dec 26 2018

-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

Year

Deficiency

Penalty

sec. 6662(a)

2009

$169,552

$36,701

Docket No. 14948-16--Robert A. Connell

Year

Deficiency

Penalty

sec. 6662(a)

2010

2011

$147,198

1,312,943

$29,440

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.

2Pursuant 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.

3FINRA is a private corporation that acts as a self-regulatory organization.

-4[*4]

I.

FINDINGS OF FACT

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

4The record does not indicate whether Mr. Connell filed as a single

individual for 2010.

5Mr. 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.

6T12 is trailing revenue, i.e., fees paid to the firm for the financial adviser's

services over the preceding 12 months.

7In 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.

ii.

iii.

iv.

v.

vi.

vii.

viii.

ix.

violation of Federal securities laws, rules, or regulations;

violation of any rules or regulations of any regulatory or selfregulatory organization;

violation, as reasonably determined by Merrill Lynch

management, of Merrill Lynch's rules, regulations, policies,

practices, directions, and/or procedures;

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;

a suspension, bar, or limitation on Mr. Connell's activities for

Merrill Lynch by any regulatory or self-regulatory

organization;

violation of Merrill Lynch's policies against discrimination and

harassment;

failure to maintain licenses and required registrations;

dishonesty in connection with Mr. Connell's employment; or

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," 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.

2.

3.

4.

5.

client names;

client addresses;

client email addresses;

client telephone numbers; and

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:

"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

9Although 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 counsel¹° 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.

¹°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

firm" and took legal action against him. On August 3, 2010, the firm filed a

"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.

"(...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.

¹²The 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

¹³Mr. 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.

2.

3.

4.

5.

6.

7.

transition compensation of $3,200,000 paid when he joined

Merrill Lynch;

first year back end compensation of $950,000;

back end compensation for years 2 to 5 of $4,600,000;

lost commission compensation for 14 years of $26 million;

interest on the above mentioned amounts;

unspecified punitive damages; and

attomey'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

¹'The remaining counts were as follows: count II (breach of contract nonpayment 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 ¶l0. 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

- 23 [*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." h

Exhibit 10, Agreement at ¶l0.

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

¹sMr. Connell's employment agreement with Merrill Lynch was governed

by Pennsylvania law.

- 24 [*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."

- 25 [*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

- 26 [*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

- 27 [*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

- 28 [*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

- 29 [*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

¹6Merrill Lynch issued Mr. Connell a Form W-2, Wage and Tax Statement,

reporting the other awards made by the FINRA Panel.

¹7Respondent agrees that the amount listed on the Form 1099-C should be

decreased by $42,980.

- 30 [*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

- 31 [*31] from whatever source derived unless specifically excluded. Sec. 61(a);

Simpson v. Commissioner, 141 T.C. 331, 338 (2013), M, 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), M, 311 F.2d 210 (7th Cir. 1962); see also OKC

Corp. & Subs. v. Commissioner, 82 T.C. at 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. at

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. at 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), af[g 1

T.C. 952 (1943)), modified by 49 T.C. 13 (1967).¹ª

¹ªRespondent 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.

- 33 [*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. at 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

- 34 [*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.

- 35 [*35] To reflect the foregoing, and the concessions included in the joint

stipulation of settled issues,

Decisions will be entered

under Rule 155.