Financial Adviser Seeks Reversal of Cancelled Debt Income Decision

ROBERT A. CONNELL,
Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.

In the
United States Court of Appeals
For the Third Circuit

On Appeal from a Final Decision of the United States Tax Court

BRIEF FOR PETITIONER-APPELLANT,
ROBERT A. CONNELL
AND
JOINT APPENDIX — Volume 1 of 9 (JA1-JA40)

JOHN C. CONNELL
Counsel of Record
Archer & Greiner, P.C.
One Centennial Square
P.O. Box 3000
Haddonfield, NJ 08033
(856) 795-2121
jconnell@archerlaw.com
Counsel for Petitioner-Appellant,
Robert A. Connell

CORPORATE DISCLOSURE STATEMENT

Pursuant to FRAP 26.2(a), no such disclosure statement is required inasmuch as Petitioner-Appellant, Robert A. Connell, is an individual, not a nongovernmental corporate entity.

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TABLE OF CONTENTS

CORPORATE DISCLOSURE STATEMENT

TABLE OF CONTENTS

TABLE OF AUTHORITIES

JURISDICTIONAL STATEMENT

STATEMENT OF THE ISSUES PRESENTED FOR APPEAL

STATEMENT OF RELATED CASES AND PROCEEDINGS

STATEMENT OF THE CASE

SUMMARY OF ARGUMENT

ARGUMENT

CONCLUSION

CERTIFICATE OF BAR MEMBERSHIP

CERTIFICATE OF COMPLIANCE WITH F.R.A.P. 32(a)(7)(C)

CERTIFICATE OF CONFORMITY WITH ELECTRONICALLY-FILED BRIEF

CERTIFICATE OF VIRUS CHECK

CERTIFICATE OF SERVICE

JOINT APPENDIX — Volume 1 of 9 (JA1-JA40)

TABLE OF AUTHORITIES

Federal Cases

Abbott v. Perez, 138 S.Ct. 2305 (2018)

ABKCO Indus., Inc. v. Comm'r, 482 F.2d 150 (3d Cir. 1973)

B.B. Rider Corp. v. Comm'r, 725 F.2d 945 (3d Cir. 1984)

Boagni v. Comm'r of Internal Revenue, 59 T.C. 708 (1973)

Bose Corp. v. Consumers Union of United States, Inc., 466 U.S. 485 (1984)

Bross Trucking, Inc. v. Commissioner, 107 T.C.M. (CCH) 1528 (2014), 2014 WL 2535094

Burch v. Reading Co., 240 F.2d 574 (3d Cir. 1957)

Butler v. Commissioner, 46 T.C. 280 (1966)

Caporella v. Commissioner, 817 F.2d 706 (11th Cir.1987)

Carr Staley, Inc. v. United States, 496 F.2d 1366 (5th Cir.1974), cert. den., 420 U.S. 963 (1975)

Dye v. United States, 121 F.3d 1399 (10th Cir. 1997)

Estate of Masquelette v. Commissioner, 239 F.2d 322 (5th Cir. 1956)

Gail v. United States, 58 F.3d 580 (10th Cir. 1995)

Gidwitz Family Tr. v. Commissioner, 61 T.C. 664 (1974)

Highmark Inc. v. Allcare Health Management System, Inc., 134 S.Ct. 1744 (2014)

Holof v. C.I.R., 872 F.2d 50 (3d Cir. 1989)

Keller St. Dev. Co. v. Comm'r, 688 F.2d 675 (9th Cir. 1982)

Kenney v. Commissioner, 37 T.C. 1161 (1962), acq. 1965 WL 91396, 1965-2 C.B. 3

Kinsey v. Commissioner, 859 F.2d 1361 (9th Cir. 1988)

Lawson v. Comm'r, 110 T.C.M. (CCH) 424 (T.C. 2015)

Martin Ice Cream Company v. Commissioner, 110 T.C. 189 (1998)

McMunn v. Babcock & Wilcox Power Generation Grp., Inc., 869 F.3d 246 (3d Cir. 2017), cert. den., 138 S.Ct. 1012 (2018)

Newark Morning Ledger Co. v. United States, 416 F.Supp. 689 (D.N.J. 1975), aff'd, 539 F.2d 929 (3d Cir. 1976)

Norwalk v. Commissioner, 76 T.C.M. (CCH) 208, 1998 WL 430084 (T.C. 1998)

Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944), aff'g 1 T.C. 952 (1943)

Rees v. United States, 187 F.Supp. 924 (D.Or. 1960), aff'd, 295 F.2d 817 (9th Cir. 1961)

Sager Glove Corp. v. Commissioner, 36 T.C. 1173 (1961), aff'd, 311 F.2d 210 (7th Cir. 1962)

Spartan Petroleum Co., 437 F.Supp. 733 (D.S.C. 1977)

State Fish Corp. v. Commissioner, 48 T.C. 465, mod. by 49 T.C. 13 (1967)

U.S. Bank N.A. v. Village at Lakeridge, LLC, 138 S.Ct. 960 (2018)

Union Planters National Bank v. United States, 426 F.2d 115, 117 (6th Cir.), cert. den., 400 U.S. 827 (1970)

United States v. Gilmore, 372 U.S. 39 (1963)

Universal Minerals, Inc. v. C.A. Hughes & Co., 669 F.2d 98 (3d Cir.1981)

Virgin Islands Labor Union v. Caribe Const. Co., 343 F.2d 364 (3d Cir. 1965)

Wagner v. Comm'r of Internal Revenue, 78 T.C. 910 (1982)

Watson v. Commissioner, 35 T.C. 203 (1960), nonacq. 1964 WL 71988, 1964-2 C.B. 3

Woodward v. Commissioner, 397 U.S. 572 (1969)

Wyler v. Commissioner, 14 T.C. 1251 (1950) acq. 1959 WL 65582, 1959-2 C.B. 3

Federal Statutes

26 U.S.C. §7482(a)

IRC §61(a)(12)

Other Authorities

Amounts Received on Retirement or Resignation, U.S. Tax Rep., 615.112, 2019 WL 227155 (2019)

Damages to Business and Profits, 5 Mertens Law of Fed. Income Tax'n §24A:14 (2019)

Discharge of Debt, 2 Mertens Law of Fed. Income Tax'n §11:7 (2019)

Gross Income Arbitration Awards Ordinary Income v. Capital Gain Cancellation of Indebtedness Income, Jan. 4, 2019 RIA Fed. Tax Update, 2019 WL 102340 (2019)

2 Kenneth S. Brown, McCormick on Evidence §339 (7th ed. 2013)

Story, Partnerships §99

Taxability of the Discharge or Cancellation of Indebtedness, Fed. Tax Coordinator, Second Edition, ¶J-7001

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JURISDICTIONAL STATEMENT

Following the conclusion of an IRS examination and administrative appeal, the IRS issued a Notice of Deficiency to Petitioner-Appellant with respect to his 2011 federal income tax return. After trial, the United States Tax Court issued a Memorandum Opinion on Dec. 26, 2018, JA4, followed by an Apr. 18, 2019 Final Decision. JA6. On July 15, 2019, Petitioner-Appellant filed a Notice of Appeal from the Final Decision of the Tax Court. JA1.

This Court exercises exclusive jurisdiction over this matter as an appeal from a final decision of the U.S. Tax Court. 26 U.S.C. §7482(a).

STATEMENT OF THE ISSUES PRESENTED FOR APPEAL

This matter involves the characterization of income realized by Robert A. Connell (“Connell”), a professional financial advisor, as a result of a Financial Industry Regulatory Authority, Inc. (“FINRA”) award resolving a dispute relating to the taking of Connell's book of business by Connell's former employer, Merrill Lynch Pierce Fenner and Smith (“Merrill”). The issues presented for appeal are as follows.

First, whether the Tax Court incorrectly applied the origin of the claim test by limiting its focus to the wording and terms used in Connell's filings with FINRA rather than looking to the economic realities of the dispute between Connell and Merrill.

Second, whether the Tax Court incorrectly interpreted Connell's Employment Agreement with Merrill and a Promissory Note he issued to Merrill when the Tax Court concluded that a breach of that Employment Agreement would relieve Connell of his obligation to repay the balance of the Note.

Lastly, whether the Tax Court incorrectly imposed on Connell a burden to prove by more than a preponderance of the evidence that the income realized on the extinguishment of his obligations under the Note constituted a capital gain.

STATEMENT OF RELATED CASES AND PROCEEDINGS

This case or proceeding has not been before this Court previously, and Petitioner-Appellant is not aware of any other case or proceeding that is in any way related, completed, pending, or about to be presented before this Court or any other court or agency, State or federal.

STATEMENT OF THE CASE

I. Relevant Facts

A. June 2009: Employment

As of the spring of 2009, Connell had worked as a professional financial advisor for some 29 years, most recently at Smith Barney. T19:19-T21:4. He had developed a large client base of approximately 200 clients, T23:8-9; T34:2-4, having assets under management at Smith Barney of about $350,000,000.00, which produced revenues to Smith Barney in excess of $3,150,000.00 annually.¹ T23:2-7; T66:8-25; JA796 ¶34; JA1024; JA1029. In 2009, and in the years leading up to 2009, Connell was one of Smith Barney's top financial advisors based on the size of his book of business: number 1 in his office, number 1 in the North Atlantic Region, and top 20 nationally. T23:10-T24:2; T293:1-6.

1. Employment Agreement with Merrill

On June 26, 2009, Connell left the employ of Smith Barney and joined Merrill, with whom he entered into an Employment Agreement. JA608 ¶4; JA636 (“Agreement”). Several provisions are pertinent, as follows.

Monthly Transition Compensation. In addition to other compensation, the Agreement provided that Connell was to be paid monthly transition compensation, each month's payment in the amount of $42,980.07, from Oct. 2009 through June 2017, entitlement to which ceased upon the termination of Connell's employment, including by resignation. JA637 ¶i.

Proprietary Client Information. As a general proposition, “all customer information . . . is confidential and proprietary to Merrill Lynch”, including after termination. JA645 ¶5. But there were two significant exceptions to this clause, as follows.

Protocol for Broker Recruiting. In the securities industry, the Protocol for Broker Recruiting, JA1619, is an agreement entered into by participating financial services firms to secure their clients' interests in privacy and freedom of choice related to the movement of their Registered Representatives (“RRs”) between firms. Thus, when RRs move from one firm to another and both firms are signatories to the Protocol, the RRs may take only the following account information: client name, address, phone number, email address, and account title of the clients that they serviced while at the firm (“protocol-compliant client information”); and are prohibited from taking any other documents or information. JA612 ¶25; JA1619; T56:22-T57:16; T101:9-25; T133:17-T134:14; JA760; JA173.

The Agreement permitted Connell, who was an RR, this customary right in the profession: “if Connell terminates his employment and joins a firm that is part of the Protocol for Broker Recruiting ('Protocol') and Merrill is part of the Protocol at the time, Connell will be entitled to follow the Protocol.” JA645 ¶6.

Connell's Book of Business and The Smith Barney Client Information. Significantly, the Agreement permitted Connell another unique and important right: on the front end, upon Connell's joining Merrill, the Agreement allowed Connell to bring to Merrill information pertaining to the clients he serviced at Smith Barney (“Smith Barney client information”), JA636 ¶3b; on the back end, upon Connell's departure from Merrill, the Agreement imposed a one year covenant not to solicit, except for “clients whom Connell served as a registered agent at his prior employer who become clients of Merrill Lynch within one year after he begins employment with Merrill Lynch.” JA645 ¶6. In other words, Connell had the rights to (1) bring the Smith Barney client information with him to Merrill, (2) take that same Smith Barney client information with him from Merrill upon his departure, and (3) use that Smith Barney client information if he left Merrill so that he could retain his book of business.

This book of business that Connell brought from Smith Barney to Merrill was the product of some 29 years of Connell's efforts as a professional financial advisor before joining Merrill. The information about Connell's clients — whom he serviced at Smith Barney and who collectively constituted Connell's book of business — was far more detailed and comprehensive than the basic protocol-compliant client information. As the Tax Court found,

[a]s 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. Although the standard Smith Barney employment agreement stated that all 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.

JA15 & n.9 (emphasis added). Connell did not have a covenant not to compete or a non-solicitation agreement with Smith Barney, so Smith Barney did nothing to prevent Connell from moving his book of business to Merrill. T35:1-23 (Smith Barney “didn't object”); T42:18-25; T72:11-21; T320:15-T321:4; T136:14-20; T138:4-8. In fact, Connell successfully transitioned virtually all of his book of business to Merrill, T32:22-24 (“99 percent”), which is not disputed. JA1986 ¶28.

Merrill unequivocally acknowledged these rights — to move his book of business to Merrill, to take it with him when he left Merrill, and to solicit them after he left Merrill in order to retain his book of business — vested in Connell. T320:6-T321:4 (“we are viewing it as those are Mr. Connell's clients. . . . So we're agreeing that he can take those [Smith Barney clients he brought from Smith Barney to Merrill] with him, in the event that he leaves” (emphasis added)). Nor does the Commissioner of Internal Revenue (“CIR”) dispute this. JA2018 ¶218.

2. Loan and Promissory Note

On June 26, 2009, Merrill also made a loan to Connell in the amount of $3,637,217.00 to induce Connell to transfer his entire book of business from Smith Barney to Merrill.² As Merrill testified, making such a loan is consistent with industry practice, where “we are looking to bring a financial advisor who has proven their ability to develop and grow a book of business at their current firm, and we're really looking to bring that person and their talents to Merrill.” T306:21-25. The dollar amount loaned is based on “the book that they would currently manage . . . to gauge their success.” T307:5-8. The amount of the loan was directly tied to the value of Connell's client base — as noted above, estimated at $350,000,000.00 in money under management, generating approximately $3.15 million in annual gross revenue. There is no dispute about the amount of the Promissory Note or that the Promissory Note was based on the value of the book of business that Connell brought to Merrill, which book was a capital asset.³

The loan was evidenced by a Promissory Note executed by Connell in favor of Merrill on June 26, 2009. JA608 ¶5; JA649 (“Note”). The Note provided that upon the termination of Connell's employment “for any reason . . . all outstanding principal and accrued but unpaid interest on this Note shall become due and immediately payable”. JA650 ¶2. Significantly, there is no provision in the Promissory Note that entitles Connell to be relieved of his obligation to repay the Note under any circumstances, contrary to the Tax Court's conclusion.

The Note called for the loan to be repaid in monthly payments of $42,980.07. JA649 ¶1. Essentially, each monthly transition compensation payment of $42,980.07 was an accounting transaction that on paper reflected wages paid to Connell; on paper, he in turn was treated as having paid a corresponding amount in satisfaction of his monthly Note obligation (reducing the balance of the $3,637,217.00 loan on a monthly basis). That is, for the convenience of both Merrill and Connell, Connell's monthly loan repayment obligation was offset entirely by Merrill's obligation to make monthly transition compensation payments to Connell in the same amount. JA649 ¶1. In essence, no monies changed hands in terms of Connell's obligation to make monthly payments on the loan or Merrill's obligation to pay monthly transition compensation. T47:17-T48:10; T159:8-17. These types of loans are commonplace in the recruitment of financial advisors. T137:13-15; T206:7-T207:24.

For each of the taxable years 2009 and 2010, Merrill included on Connell's W-2 the aggregate amount of each year's $42,980.07 monthly transition compensation payments. Connell reported such amounts as wages on his 2009 and 2010 federal income tax returns. JA608 ¶6.

B. 2010: Internal Investigation of Connell

In 2010, Merrill initiated an internal investigation of Connell for alleged violations of the industry's Protocol for Broker Recruiting related to Connell's transfer of his Smith Barney client information to Merrill. Connell strongly disagreed with the allegations, yet he cooperated fully in the investigation by Merrill's independent outside counsel, explaining that he did not violate the Protocol and that Merrill personnel had either explicitly approved what he and his team had done or voiced no prior concerns about what they had done. T60:14-T62:7; JA766 & JA785-786; JA1491-92. Ultimately, Merrill's counsel recommended that nothing more than a written reprimand be issued.

Nonetheless, Merrill management disregarded that advice and — just days before his one-year anniversary at Merrill (upon which he was to receive a bonus of several hundred thousand dollars) — Connell was “basically told that . . . [he] was going to be resigning.” JA17; T62:8-T63:7; T71:6-9. Connell was well aware that if Merrill fired him, it would have to report that fact on his Uniform Termination Notice for Securities Industry Registration Form U5 (“Form U5”)⁴, which reporting would prevent him from gaining employment at any other reputable financial services company; if that happened, there would be no realistic chance of saving the very significant, profitable book of business he had developed over his career. But if Merrill were to prepare the Form U5 showing simply that Connell resigned, other reputable firms would be willing to hire him, and that in turn would give him the opportunity to retain his book of business. T139:7-25.

C. July 2010: Termination of Employment

On July 27, 2010, by tender of resignation letter, Connell left the employ of Merrill. JA608 ¶7; JA653 (“Letter”). This event triggered, among other things, (1) the cessation of Connell's monthly transition compensation payments from Merrill, JA637 ¶i, (2) Connell's obligation to remit to Merrill the balance then due on the loan, JA649-650 ¶¶1 & 2, and (3) Connell's possessory rights in the Smith Barney client information as provided in ¶6 of Connell's Agreement. JA645 ¶6.

However, in violation of the Agreement, Merrill refused to provide Connell with “access to [his Smith Barney] client contact information”, which access was “vital” if Connell were to have any chance of retaining his book of business. T65:13-T66:3.

D. Aug. 2010: Merrill's Actions against Connell

Subsequent to Connell's resignation, Merrill undertook a series of actions against Connell which were designed to ensure that Merrill would end up with Connell's book of business (including his team) and Connell would not be in a position to be hired by a Protocol-compliant firm (which was necessary in order for him to pursue his book of business).

Federal Court Injunction. On Aug. 3, 2010, Merrill commenced an action in the Eastern District of Pennsylvania, JA654 (“Complaint”), T124:17-T125:23, seeking an emergency injunction against Connell. JA609 ¶¶8-9; JA667 & JA672. The outcome was a Consent Order, JA609 ¶10; JA689-691 (“Consent Order”) ¶¶1-3, requiring Connell to return to Merrill all records of Merrill customer information, but permitting Connell to solicit Merrill clients pursuant to the Protocol and Smith Barney clients pursuant to ¶6 of Connell's Agreement (to the extent he could solicit without having the actual client information). JA645 ¶6. By its terms, that Consent Order remained in effect pending a decision of Merrill's request for a permanent injunction by a FINRA arbitration panel, to which the court directed the parties. JA691-692 ¶¶4-5. During the court proceedings, Merrill was using its resources to contact Connell's clients for the express purpose of trying to convince them to keep their accounts at Merrill. T64:16-T65:12; T140:8-22.

In the meantime, Connell was effectively barred from access to any client information, and therefore, he was not able to communicate with his clients at a time when Merrill was doing all it could to secure their business.

Delayed Filing of Form U5. Although a Form U5 is typically filed within a week of an advisor's departure, Merrill delayed filing Connell's for 22 days after he resigned, thereby preventing him from taking immediate employment with another financial services firm to which he could transition his book of business. T69:18-T70:24; JA610 ¶12; T131:20-T132:2; T140:1-7; T141:8-13; JA764-766 §XIV & JA786-787 §VI; JA798 ¶¶49-50 & JA801 ¶64; JA857-858; JA1064-65 & JA1076. This is not contested. JA1995 ¶86. “[W]hen [Connell] is not employed, he cannot solicit clients, because it becomes a regulatory problem if he did.” T144:8-14.

At the same time, Merrill was actively soliciting Connell's entire book of business, JA764-766 §XIV & JA786; JA1064-65, by having Connell's team (each of whom (i) knew, and had worked with, Connell's clients, and (ii) stayed with Merrill) contact Connell's clients to solicit their continued business at Merrill, see JA801 ¶64, and tell those clients that Connell no longer worked for Merrill, the reason for his leaving could not be discussed, and no one had Connell's contact information. T64:16-T65:4; T68:11-16; T140:12-16; JA788; JA1028 & JA1056-58 (including exhibits). “If Merrill Lynch is able to keep [Connell] out for 30 days, which is the Form U5, and then not give [Connell] his protocol spreadsheet for a period of time, Merrill Lynch secures all the relationships at that point.” T144:14-18.

In the meantime, Connell remained barred from access to client information.

FINRA Proceedings. About Aug. 9, 2010, Merrill commenced an arbitration proceeding against Connell before FINRA. JA609 ¶11; JA694 (“Merrill Am. Statement of Claim”); T124:15-16; T126:12-18. In pertinent part, Merrill sought an order that Connell

pay the balance due under the Note, JA609 ¶11; JA703-704 ¶¶43-50 (Facts and Claims) & JA707-708 ¶¶75-80 (Counts VII and VIII) & JA710 ¶3 (Prayer for Relief); T126:1-4, as well as

be barred from using any client information, including the Smith Barney client information. JA609 ¶11; JA699-701 ¶¶32-37 (Facts and Claims) & JA704-706 ¶¶53, 58-68 (Counts I-IV) & JA709-710 ¶1 (Prayer for Relief).

Connell filed an Answer, JA747, with defenses and counterclaimed, seeking, among other things, retention of the balance due on the Note (approximately $3.2 million). JA789; JA610 ¶13; JA1082; JA1535. Thereafter, the parties exchanged extensive briefing. JA611 ¶¶17-20; JA986 (“Merrill Prehearing Brief”); JA1024 (“Connell Prehearing Brief”); JA1491 (“Connell Response to Merrill Prehearing Brief”).

In the meantime, Connell was still barred from access to any client information.

Filing of Form U5. On August 18, 2010, Merrill finally filed Connell's FormU5. JA610 ¶12; JA741 (“Form U5”). That form falsely indicated that Connell was “permitted to resign” (rather than simply “resigned”), JA742; T131:10-14, and explained the termination 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.” JA742; T71:19-24; JA764-766 §XIV; JA799 ¶51.⁵ As Connell's attorney testified, “[t]hat's the kiss of death. Because no firm would want to hire Bob Connell with that type of a U5.” T139:19-25. In fact, after reading Connell's Form U5, a prospective employer told Connell, “I can't hire you”. T72:22-T74:4. Merrill's false Form U5 forever precluded Connell from obtaining employment at a reputable financial services firm, which in turn made it virtually impossible for Connell to retain his book of business. T72:22-T74:4; T74:16-20; T142:14-20; T253:8-10; T253:22-T254:2; T254:9-15; JA764-766 §XIV & JA787; JA1027-1029 & JA1066. The CIR conceded this unrebutted testimony. JA1995 ¶87.

In the meantime, Connell continued to be barred from access to any client information.

Compelled Disclosure of Protocol-Compliant Client Information. On August 26, 2010, the Panel entered a Permanent Injunction based on the court's Preliminary Injunction. Nonetheless, Merrill continued to purposely withhold all client information from Connell, notwithstanding the fact that Connell was entitled to it under the terms of both the Protocol and the Agreement, as well as the court and FINRA Injunctions. T65:13-24; L. 2; JA862-863; JA952-955. Merrill had “every intention of keeping the book of business, because it generated millions of dollars in revenue.” T135:6-T136:2.

Consequently, on Oct. 7, 2010, Connell filed an Emergency Motion with FINRA, JA667 (“Motion”), to compel Merrill's release of a full protocol-compliant client list. JA610 ¶14; JA848. It was not until after November 22, 2010 — four months after Merrill forced Connell to resign and long after Merrill had successfully solicited and secured Connell's clients — that Merrill finally gave Connell the protocol-compliant client information, but that was done only under FINRA compulsion. JA848 & JA902 & JA943; T67:18-T68:10; T106:14-20; T132:17-23; T142:22-T144:7.

However, the Smith Barney client information was still not released by Merrill to Connell.

Connell's Personal Accounts. Knowing there was a dispute concerning repayment of the loan, and even before the parties had the opportunity to present their cases to the FINRA Panel, Merrill froze the personal accounts Connell maintained at Merrill (which had total assets of almost $5,600,000.00 — well in excess of the $3.2 million balance due on the Note) and bounced several checks he had written against one of those accounts. T195:10-T196:23; T197:15-25; JA767 & JA788-789 & JA802-803 ¶¶72-75; JA859-860; JA964-968; JA1063-64 & JA1077-78. This put Connell in a difficult cash flow position, as he had significant on-going costs which had to be paid, such as legal bills to fight Merrill, support obligations, his mortgage, and his real estate taxes, to name a few. T197:15-25; JA788-789; JA866; JA964-968. As the Tax Court concluded, Merrill's actions “prevent[ed Connell] from paying for his livelihood.” JA17 & n.11.

E. May 2011: FINRA Arbitration

Claims. At the May 2011 FINRA hearing, the only claim repeatedly advanced on behalf of Connell by his attorney, Thomas Lewis, Esquire, with respect to the loan was that the unpaid loan amount represented monies Connell was entitled to retain because Merrill took his book of business. T129:21-T130:14; T131:5-T132:16; T136:14-T138:13; T140:16-19; T144:19-22; T146:14-T147:8; T160:12-16; JA776-779. This is not in dispute. JA1999 ¶¶110-111.

On the other hand, Merrill argued simply that the loan should be repaidbecause the Note called for the unpaid balance to be paid upon termination ofConnell's employment. T126:1-11; JA703-704 ¶¶43-50. Merrill never took theposition (1) that the loan should be repaid because the proceeds were intended tobe compensation in lieu of future services, T130:15-21, or (2) that the amount ofthe loan represented a bonus to Connell when he joined Merrill, T130:22-24, or (3)that the nature of the loan was anything other than an obligation which should berepaid. T130:25-T131:4.

Decision. On May 6, 2011, after days of testimony and documentary evidence, the FINRA Panel issued a unanimous decision, JA1597 (“FINRA Award”), which, among other things, ruled on Connell's claims as follows:

See JA1602-03; JA20-21 & JA32-33. Further, the Award denied in its entirety all relief sought by Merrill. JA1602; JA611 ¶21.

Most pertinent to this appeal, as the Tax Court noted, “[t]he FINRA order did not prevent Merrill Lynch from retaining the substantive client information”. JA33 (emphasis added). Specifically, the FINRA Award modified the FINRA Permanent Injunction by requiring Merrill to return to Connell his proprietary templates, personal computers, and portable electronic devices — but “with all data removed”. JA1602-03 ¶5 (emphasis added). That “data” was the Smith Barney client information, which was an integral part of the book of business that he had developed and compiled over some three decades, and which was thus effectively and permanently transferred to Merrill, robbing Connell of all the goodwill he had developed.

As is typical in FINRA proceedings, the Panel gave no reason for its decision, nor was the recording of the proceeding reduced to written form. JA1597; T126:19-T127:20; T136:5-13.

II. Procedural History

A. 2011 Federal Income Tax Return

After the FINRA Award issued, Merrill sent Connell an Internal Revenue Service (“IRS”) Form 1099-C reporting cancellation of indebtedness income for the unpaid loan balance. JA612 ¶22; JA615. As Connell understood the rules for reporting amounts shown on a Form 1099-C, he reported the full amount shown thereon ($3,242,248.19) as ordinary income on his 2011 return. JA615. As stipulated, Connell timely filed his 2011 federal income tax return. JA607 ¶2; JA615.

However, Connell subsequently learned that he should have treated that amount as a long-term capital gain. JA46 ¶4E & JA54 ¶¶5TT-VV. Therefore, Connell filed an amended return for the taxable year 2011 that was received by the IRS on October 10, 2013. JA608 ¶3; JA627. In 2014, the IRS undertook an examination of Connell's 2011 tax return, and determined that there were errors in Connell's 2011 tax return. In 2015, Connell pursued an administrative appeal of these determinations. However, no settlement or resolution was achieved. On April 6, 2016, the IRS issued a Notice of Deficiency, setting forth a deficiency and an addition to tax for the year 2011. JA44-45 ¶¶2-3; JA94 ¶2-3 & JA103 (exhibit A); JA1622; JA613 ¶26.

B. June 2016: Pre-Trial Proceedings before United States Tax Court

Between June 30, 2016 and Jan. 22. 2018, various pre-trial proceedings occurred before the U.S. Tax Court. Initially, Connell filed a Petition, contesting the adjustments in the IRS Notice of Deficiency, JA44, to which the CIR responded, JA93, and Connell replied. JA114. Connell and the CIR were able to resolve all issues raised in the Petition, except for the issue relating to the character — i.e., ordinary income or capital gain — of the $3,242,248.19 of income in 2011 that arose as a result of the FINRA Award allowing Connell to retain the loan proceeds. JA601; T7:7-9.

C. Jan. 2018-Apr. 2018: Trial Proceedings before United States Tax Court

On Jan. 23, 2018, this matter was tried for one day before the Hon. Julian I. Jacobs, U.S.T.C.J. JA1633; JA1721; JA1821; JA1916 (hereinafter referenced as “T”). The dispositive issue was whether the loan forgiveness constituted ordinary income (the CIR's position) or capital gain (Connell's position). At that same time, the parties filed a Stipulation of Settled Issues, JA601, and a Stipulation of Facts with exhibits. JA606; JA614; JA1023; JA1490; JA148. Thereafter, the parties filed Apr. 26 & 27, 2018 Opening, JA1970; JA2065, and June 13 & 14, 2018 Reply Briefs, JA2133; JA2212.

D. Dec. 26, 2018: Opinion of the United States Tax Court

On Dec. 26, 2018, the Tax Court issued a Memorandum Opinion. JA6. The Tax Court noted that “[t]he issue before us involves the character of the balance of the Merrill Lynch upfront forgivable loan,” and, in order to address that issue, the Tax Court “focus[ed] on Mr. Connell's arguments raised before the FINRA Panel in his filings”, specifically his Answer, his Prehearing Brief, and his Response to the Merrill Prehearing Brief, JA21-22, as noted below.

1. Connell's FINRA Pleadings

With respect to Connell's Answer, the court first focused on two block quotes in the Answer where Connell explained that allowing Merrill to seek repayment of the loan without providing any compensation to Connell for the taking of his book of business would amount to unjust enrichment. Specifically,

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.

* * *

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.

JA22-23 (emphasis added).

Then the court looked at five of Connell's ten counterclaims, namely count I (breach of contract demanding repayment of transition compensation), count VI (quantum meruit, unjust enrichment, and conversion of client accounts), count VIII (tortious interference with contracts and/or business relationship), count IX (misappropriation of trade secrets), and count X (unfair competition). JA23-25. All of these counts related to Merrill's taking of Connell's book of business and proprietary spreadsheets, demanding repayment of the loan despite keeping the book of business, preventing Connell from retaining or even reaching out to his clients, and preventing Connell from even competing for those clients' business, all while Merrill was doing everything in its power to secure the exclusive benefit of the book of business for itself and generate revenue therefrom.

Regarding Connell's Prehearing Brief, the court listed three block quotes and seven arguments by Connell. The three block quotes stated the following:

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 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.

* * *

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.

* * *

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.

JA25-27 (emphasis added).

The seven arguments were as follows:

1. Connell's breach of contract claim should be granted because, if Merrill “is Permitted to Obtain the Return of [the balance of the Note,] 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”. Further:

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 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;

2. Merrill breached the covenant of good faith and fair dealing “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”;

3. Merrill engaged in fraud “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”;

4. Merrill “converted Connell's book of business” without “Paying any Remuneration to Mr. Connell” via a plan that would allow Merrill “to continue to service Mr. Connell's clients almost entirely free from competition”;

5. Merrill tortiously interfered with Connell's relationship with his clients by “convert[ing] Mr. Connell's book of business”;

6. Merrill misappropriated Connell's trade secrets by keeping the spreadsheets that were a part of his book of business; and

7. Merrill violated FINRA rule 2010 and engaged in unfair competition 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.”

JA27-31 (emphasis added).

Finally, as to Connell's Response to Merrill's Prehearing Brief, the court noted that Connell reiterated that Merrill's arguments were meritless and further argued that “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”. JA31-32 (emphasis added).

2. Tax Court's Reasoning

InitsrulingagainstConnell,theTaxCourt“sustain[ed]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.” JA39.

In support of its decision, the Tax Court invoked the origin of the claim doctrine (which Connell agrees is the appropriate theory to apply). Specifically, the court explained 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), and that “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. 664, 673 (1974). JA36. The court then noted that the primary question to be answered is “in lieu of what were the damages awarded?” State Fish Corp. v. Commissioner, 48 T.C. 465, 472 (quoting Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944), aff'g 1 T.C. 952 (1943)), mod. by 49 T.C. 13 (1967)). JA37. Lastly, the court stated that, in situations like this one, where there is no explanation for the basis of the litigation or settlement proceeds, “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. JA38.

Moving on to Connell's arguments, the court recognized that his 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.” JA38 (emphasis added). However, the court found that Connell had made other arguments to the FINRA panel. JA38-39. Specifically, the court found 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.

JA39 (emphasis added). The Tax Court then noted that the FINRA panel did not explain its reasoning or which of the two arguments — i.e., that Merrill converted his book of business, or that Merrill breached the employment contract, which would have the effect of cancelling Connell's obligation to pay the outstanding balance of the promissory note — FINRA found to be persuasive. JA39. The Tax Court did not specify the authority for the second argument. Yet, on this basis, the court found that Connell did not meet his “burden to establish that the amount at issue was solely for the acquisition of Mr. Connell's book of business.” JA39 (emphasis added).

In so ruling, the Tax Court did not reference the extensive and unrebutted trial testimony of Thomas Lewis, Esquire, or the Petitioner's considerable filings before FINRA, which unquestionably assert that Connell should not have to repay the loan since Merrill converted his book of business. Most notably, the Tax Court ignored Connell's claims that the book of business was a capital asset and that, based on the underlying series of events, the extinguishment of the loan obligations in consideration for Connell's book of business would result in a long term capital gain rather than ordinary income. JA2121-31.

Subsequently, on Apr. 10, 2019 the parties submitted an Agreed Computation for Entry of Decision, JA2292, with the Tax Court's Final Decision filed on Apr. 18, 2019. JA4.

E. July 2019: Appeal to Third Circuit

On July 15, 2019, Connell filed a Notice of Appeal from the Final Decision of the Tax Court. JA1.

III. Rulings Presented for Review

1. To determine the tax character of the proceeds of a lawsuit, where the underlying ruling body does not make the character clear, requires the application of the origin of the claim doctrine. However, the Tax Court ruled that, in the absence of any explanation of the FINRA Award, “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.” JA38.⁶

2. As to whether the extinguishment of the $3,242,248.19 loan obligation, which was extinguished as a result of the FINRA Award, generated income which is taxable as ordinary income as opposed to capital gain, the Tax Court noted that, while Connell emphatically argued that so much of the Award which extinguished his obligations under the Promissory Note was in exchange for Merrill's conversion of Connell's book of business, Connell asserted other arguments as well. In particular, the Tax Court relied on the unsupported observation that Merrill's breach of the terms of the Employment Agreement “by itself, would relieve Mr. Connell of his obligation to pay the outstanding balance of the promissory note to Merrill Lynch.” JA39.

3. The record does not reveal the argument that the FINRA Panel found most persuasive in extinguishing the loan obligations. JA39. Therefore, the Tax Court concluded that “the 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.” JA39 (emphasis added).

SUMMARY OF ARGUMENT

In its analysis, the Tax Court committed three legal errors. First, the court wrongly applied the origin of the claim test when it relied solely upon the claims made in the pleadings or complaint, as opposed to the economic realities of the underlying transaction. Second, the court misinterpreted the contract documents when it found that a breach by Merrill would relieve Connell of his obligation to repay the loan. Third, the court misapplied the applicable burden of proof. Any one of these legal errors is ground for reversal.

ARGUMENT

I. Scope and Standard of Review

“The United States Courts of Appeals (other than the United States Court of Appeals for the Federal Circuit) shall have exclusive jurisdiction to review the decisions of the Tax Court . . . in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury”. 26 U.S.C. §7482(a). See Holof v. C.I.R., 872 F.2d 50, 52 (3d Cir. 1989).

Questions of law are subject to plenary review. Holof, 872 F.2d at 52 (citing Universal Minerals, Inc. v. C.A. Hughes & Co., 669 F.2d 98, 101–02 (3d Cir.1981) (review of choice, application, and interpretation of legal precepts is plenary). Cf. Caporella v. Commissioner, 817 F.2d 706, 708 (11th Cir.1987) (Tax Court's interpretation of tax forms by comparison of two forms was issue of law subject to de novo review); Kinsey v. Commissioner, 859 F.2d 1361, 1362 (9^th Cir. 1988) (decision involving how and when Form 872–A waiver is terminated and the scope of waiver is subject to de novo review).

Accordingly, “the Tax Court's definition and application of the 'origin of the claim' test” is a question of law. Keller St. Dev. Co. v. Comm'r, 688 F.2d 675, 678 (9th Cir. 1982). Furthermore, “the legal characterization, for federal income tax purposes, of the transactions between the parties [to a contract] . . . is not a question of fact, but rather one of law.” ABKCO Indus., Inc. v. Comm'r, 482 F.2d 150, 155 (3d Cir. 1973) (quoting Union Planters National Bank v. United States, 426 F.2d 115, 117 (6th Cir.), cert. den., 400 U.S. 827 (1970)). Similarly, the “interpretation and construction of a contract is a question of law” and thus “the determination of the tax consequences of [a] contract presents a legal issue.” Id. Likewise, “whether the court applied the correct burden of proof is a question of law subject to plenary review . . . [a]nd when a finding of fact is based on the application of an incorrect burden of proof, the finding cannot stand.” Abbott v. Perez, 138 S.Ct. 2305, 2326 (2018) (citing U.S. Bank N.A. v. Village at Lakeridge, LLC, 138 S.Ct. 960, 965 (2018); Highmark Inc. v. Allcare Health Management System, Inc., 134 S.Ct. 1744, 1748 (2014); Bose Corp. v. Consumers Union of United States, Inc., 466 U.S. 485, 501 (1984)).

Finally, the Third Circuit will “review the tax court's factual findings and inferences from fact for clear error only.” B.B. Rider Corp. v. Comm'r, 725 F.2d 945, 948 (3d Cir. 1984).

A. The Court Erred as a Matter of Law by Incorrectly Applying the Origin of the Claim Test.

“Whether litigation proceeds are properly characterized as 'ordinary income' or 'capital income' is governed by the 'origin of the claim' test.” Dye v. United States, 121 F.3d 1399, 1404 (10th Cir. 1997) (quoting Woodward v. Commissioner, 397 U.S. 572, 577 (1969)). The origin of the claim test was first articulated by the Supreme Court in United States v. Gilmore, 372 U.S. 39 (1963). In Gilmore, the taxpayer claimed that the litigation expenses for his divorce were deductible as a business expense because, depending on the outcome of the divorce, the taxpayer could “los[e] his controlling stock interests,” which “might well cost him the loss of his corporate positions, his principal means of livelihood.” Id. at 42. The Court disagreed, finding that “the characterization, as 'business' or 'personal,' of the litigation costs of resisting a claim depends on whether or not the claim arises in connection with the taxpayer's profit-seeking activities.” Id. at 48 (emphasis added). Therefore, “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was business or personal.” Id. at 49 (emphasis added).

The Supreme Court further explained the origin of the claim test in Woodward v. Commissioner, 397 U.S. 572 (1969). There, the taxpayer sought to deduct his litigation expenses in connection with a suit to appraise the value of a minority stock interest on the basis that the “primary purpose” of the suit “did not directly involve the question of title to the minority stock”, but was instead “concerned solely with the value of that stock.” Id. at 576-77. Relying on Gilmore, the Court rejected the “primary purpose” test (because that would require an examination into the claimant's subjective intent) in favor of the “origin of the claim”, and found that neither “the consequences of the litigation” nor “the taxpayer's motives or purposes in undertaking defense of the litigation” are factors to consider when deciding the origin of the claim. Id. at 578.

While courts agree that the origin of the claim doctrine is the proper test to apply to the taxability of litigation and settlement proceeds, the state of the law regarding the elements of that doctrine is murky at best. In particular, numerous Tax Court opinions, including the Tax Court's decision here, rely on cases that either predate Gilmore and Woodward or fail to even reference the origin of the claim test. For example, the Tax Court here cited State Fish Corp. v. Commissioner, 48 T.C. 465, mod. by 49 T.C. 13 (1967), for the proposition that, where there is no explanation of the basis for the litigation or settlement proceeds, “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.” 48 T.C. at 474. JA38. However, more recent decisions have recognized that “the pleadings and language” of the underlying action do not “control the characterization of a judgment for tax purposes” because “notice pleading under the rules of civil procedure and the tax code now emphasize function instead of form, and economic reality rather than labels.” Gail v. United States, 58 F.3d 580, 583 (10th Cir. 1995); see also Carr Staley, Inc. v. United States, 496 F.2d 1366, 1375 (5th Cir.1974) (“Taxation should be based on the economic realities of the particular commercial transaction involved” (emphasis added)), cert. den., 420 U.S. 963 (1975).

This governing principle — that the origin of the claim doctrine is premised on an examination of the economic realities of the underlying transaction — is illustrated in Newark Morning Ledger Co. v. United States, 416 F.Supp. 689 (D.N.J. 1975), aff'd, 539 F.2d 929 (3d Cir. 1976). In Newark, a newspaper company brought a number of suits against the trustees of certain pension funds for “siphoning off earnings of the newspapers to the funds and to themselves.” Id. at 692, 697. However, the plaintiff alleged a variety of claims in its complaints, including that the trustees were “making excessive contributions to the two pension funds, as well as making generous, long-term employment contracts and paying unwarranted bonuses.” Id. at 697. The court, in analyzing the origin and nature of the plaintiff's claims, found that, “[w]hile the structure to be dealt with involved trust and fiduciary concepts which led highly competent counsel to couch their allegations in legal terms suitable to the circumstances, the origin and nature of the claim is no different than a claim to recover sales revenues pocketed by a clerk from the cash register, or by falsifying expense accounts.” Id. In other words, the court correctly focused on the underlying events which gave rise to the plaintiff's claims, and in doing so, concluded that the origin of the claim was the recovery of corporate earnings which had been wrongfully converted by the defendants. Id. As the court succinctly stated,

[t]he teaching here is that labels do not control; the facts do. Calling a tail a leg will not give a cat 5 legs.

Id. at 695 (emphasis added).

A collateral source of confusion is the decision in Boagni v. Comm'r of Internal Revenue, 59 T.C. 708, 713 (1973). There, the court found that the origin of the claim test requires the court to examine “the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, the background of the litigation, and all facts pertaining to the controversy.” Id. at 713. While many Tax Court opinions, and some Circuit Courts, follow the Boagni factors, e.g., Wagner v. Comm'r of Internal Revenue, 78 T.C. 910, 912 (1982), the Ninth Circuit has criticized Boagni for failing to accurately state the origin of the claim test. Keller St. Dev. Co. v. Comm'r, 688 F.2d 675 (9th Cir. 1982). Specifically, Boagni's emphasis on “objectives” and “purpose” is improper because it goes to “the primary purpose of the litigation,” which, as Woodward made clear, is not the correct focus. Keller, 688 F.2d at 680. Rather, “the proper approach is first to determine the nature of the event or transaction that is the origin of the claim,” i.e., “the event that prompted [the taxpayer] to sue,” then examine how the litigation or settlement proceeds fit into that transaction. Id. at 681.

Characterization of a transaction for taxation is a two step process. The initial step is to discover the origin of the claim from which the tax dispute arose. This attribution determination is critical to proper tax characterization because of the inherently factual nature of taxation. Once a transaction is placed in its proper context, the nature of that transaction becomes discernible, and its tax character may be identified.

Id. at 678.

In Keller, the taxpayer sold a brewery to another company, but the taxpayer's minority shareholders brought a derivative suit, delaying the transaction for ten years. Id. at 677. The California court ultimately recharacterized the sale of the assets and awarded the taxpayer an additional “$2,432,175.45 to compensate [the taxpayer] for the fact that [the buyer] had held the assets and had benefited from their earning power during the ten years of litigation.” Id. at 677, 682. The taxpayer reported this as a change to the sale price of a capital asset (capital gain), but the government considered it to be ordinary income. Id. at 677. Applying the two-step process, the Ninth Circuit found that the origin of the shareholders' claim for rescission “clearly . . . originated in the sale of the brewery.” Id. at 681. However, while “the payment at issue here was a result of the sale of the brewery, that is, the sale of capital assets . . . the $2,432,175.45 is analogous either to interest paid to a seller to compensate for delay in the payment of a purchase price, or to rent paid for the temporary use of income producing property.” Id. at 681-82. Therefore, the payment was taxable as ordinary income. Ibid.

Here, the Tax Court's analysis constitutes legal error because it misapplied the origin of the claim doctrine. Specifically, the court placed undue emphasis on the language of State Fish Corp., namely that “the nature of the recovery is to be determined from the claims made in the pleadings or complaint filed in the prior action,” and seemingly focused on form over substance and the labels used in Connell's pleadings. The court gave no indication that it considered the economic reality of the underlying events. The Tax Court's statement that Connell argued that he did not have to pay back the loan is accurate, but the court focused on the legal theories asserted by Connell rather than looking to the origin of the claim warranting the remedy sought, namely Merrill having converted Connell's book of business for no consideration (if Connell were required to repay the loan). Similarly, the Tax Court's statement that Connell argued that Merrill breached the contract and caused him damage is also true, but it focuses on labels, namely “breach of contract,” instead of looking to the origin or basis for the claimed breach, which once again was Merrill having converted Connell's book of business.

A correct application of the origin of the claim test to the instant facts requires first determining the economic realities of the underlying transaction from which this dispute arose. Keller, 688 F.2d at 681-82. In this regard, it is patently clear that the seminal event in the underlying transaction was Merrill's conversion of Connell's book of business. Next, the Tax Court should have examined how the loan extinguishment fits into that event.

Initially, Connell received the upfront loan proceeds to induce Connell to transition his book of business and his supporting team to Merrill. After Connell resigned, Merrill did everything in its power to deny Connell access to his book of business and his supporting team. When the legal dispute with Merrill first arose, Connell sought the return of his templates, electronic devices, and client information, among other things. FINRA entered a Permanent Injunction on August 26, 2010, that allowed Merrill to retain all three items during the pendency of the litigation. Shortly thereafter, on September 16, 2010, Connell filed his Answer and Counterclaims, where his primary claim was that, if Merrill was permitted to retain his book of business and also seek repayment on the approximately $3.2 million balance due on the loan, then Merrill would be unjustly enriched. The economic reality of the FINRA Award fits directly into this dynamic, requiring Merrill to return everything to Connell other than the Smith Barney client information, but allowing Connell to retain the loan proceeds. In that way, the loan proceeds functioned as legal consideration in exchange for Connell's book of business, which is a capital asset giving rise to capital gain treatment.

However, the Tax Court did not examine the economic reality of these events, but merely focused on the labels attached to the arguments Connell made before FINRA. That, and the fact that FINRA did not provide a specific rationale for its Award, led the court to find that Connell did not meet his burden to show that the loan forgiveness was compensation for his book of business (a capital asset). For the Tax Court to implicitly find that the FINRA Award of loan forgiveness could have been for something other than Merrill's conversion of Connell's book of business, one must ignore the economic realities of the situation, which in turn flies in the face of basic common sense. This conclusion is reinforced by the fact that the net amount of the loan extinguished equaled the value of Connell's book of business, net of the $42,980.07 monthly transition compensation payments to that date. Thus, the loan extinguishment “fits” into the underlying transaction as compensation for Merrill's permanent conversion of Connell's book of business and, as such, is taxable as a long-term capital gain.⁷

Therefore, examining the origin of the claim in view of the economic realities of the underlying transaction reveals that the extinguishment of the loan obligations was compensation in exchange for Merrill's taking of a capital asset, namely Connell's book of business. However, by focusing solely on the legal terms and labels used in Connell's pleadings, the Tax Court committed legal error, causing it to find that there was a second possible origin of the claim based on some unspecified breach of the Employment Agreement by Merrill.

B. The Court Erred as a Matter of Law by Incorrectly Interpreting the Contract Documents At Issue.

Here, the Tax Court concluded that Connell had argued that Merrill breached the contract and that “[t]his argument, by itself, would relieve Mr. Connell of his obligation to pay the outstanding balance of the promissory note to Merrill Lynch.” However, neither the Agreement nor the Note provides that Connell shall be relieved from his obligations, or shall be entitled to retain any unpaid balance due, under the Note in the event of a breach of that Agreement by Merrill. Nor did the Tax Court cite any contract provision, or any authority, for this proposition. To the contrary, the Note explicitly states that “[n]otwithstanding anything to the contrary contained herein, all outstanding principal and accrued but unpaid interest on this Note shall become due and immediately payable if . . . the undersigned's employment with Merrill Lynch is terminated for any reason.” As such, the Tax Court's conclusion that a breach by Merrill would, by itself, relieve Connell of his duty to pay the outstanding balance of the loan is incorrect as a matter of law.

C. The Court Erred as a Matter of Law by Requiring Connell to Prove His Case to a Certainty.

“The Commissioner's determinations in a notice of deficiency are generally presumed to be correct, and the taxpayer bears the burden of proving by a preponderance of the evidence that the determinations are incorrect.” Lawson v. Comm'r, 110 T.C.M. (CCH) 424 (T.C. 2015). Proof by a preponderance of the evidence means that the plaintiff must convince the fact finder “that the facts asserted by the plaintiff are more probably true than false.” Burch v. Reading Co., 240 F.2d 574, 579 (3d Cir. 1957); see also 2 Kenneth S. Brown, McCormick on Evidence §339 (7th ed. 2013) (“The most acceptable meaning to be given to the expression, proof by a preponderance, seems to be proof which leads the jury to find that the existence of the contested fact is more probable than its nonexistence”); McMunn v. Babcock & Wilcox Power Generation Grp., Inc., 869 F.3d 246, 282-83 (3d Cir. 2017), cert. den., 138 S.Ct. 1012 (2018) (“courts have equated the 'more likely than not' element of this rule to a level of certainty greater than 50%”).

Most importantly, proof by a preponderance of the evidence does not require “complete certainty.” Virgin Islands Labor Union v. Caribe Const. Co., 343 F.2d 364, 367-68 (3d Cir. 1965). Rather, it “is a lesser burden than proof beyond a reasonable doubt, the well-known standard in criminal cases. It does not require proof to a moral certainty; for factual determination in civil cases rests not on certainty but on probability.” Id.; see also Burch, 240 F.2d at 579 (fact finders under a preponderance standard “are not required to find the facts to an absolute certainty or even beyond a reasonable doubt”).

Here, even assuming that the Tax Court's application of the origin of the claim test was correct, the court committed legal error by requiring Connell to prove to a certainty that the income he realized from the loan extinguishment was a capital gain. Specifically, the court concluded that, even though Connell's pleadings emphasized that Merrill converted his book of business, Connell asserted at least one other argument and, if FINRA extinguished the forgivable loan on the basis of that argument, then the extinguishment would result in ordinary income. Of course, this requires turning a deaf ear to the consistently repeated testimony of Thomas Lewis, Esquire, Connell's attorney, that “the only argument” he made was Connell's retention of the loan proceeds as compensation for Merrill's retention of the book of business. Yet, after concluding that there was at least one factual scenario under which the extinguishment would be ordinary income, which the Tax Court left unidentified, the Tax Court noted that “[t]he record herein does not reveal the specific argument the FINRA Panel found most persuasive when it extinguished the balance of the upfront forgivable loan.” JA39. Consequently, based on the Tax Court's examination of the record, “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.” JA39.⁸

Stated another way, the Tax Court's reasoning was as follows: there is more than one possible basis for the FINRA Award, and because FINRA did not explain its reasoning, we will never know, with certainty, what argument FINRA found to be persuasive. Thus, Connell cannot prove, with certainty, that FINRA found his argument that Merrill converted his book of business to be persuasive. As a result, Connell cannot prove, with certainty, that the loan extinguishment constitutes a capital gain.

On this basis, it is clear that the court held Connell to a far greater burden of proof than a preponderance of the evidence. The preponderance standard would simply require Connell to show that it is more likely than not that the basis for the FINRA Award was that Merrill converted his book of business. Instead, the Tax Court required Connell to disprove every other possible legal theory of recovery, thereby proving his case to a certainty. For this reason as well, the Tax Court committed legal error.

CONCLUSION

For all of the foregoing reasons, Petitioner-Appellant, Robert A. Connell, respectfully requests that the Final Decision of the United States Tax Court be reversed.

Respectfully submitted,

BY: JOHN C. CONNELL
(NJ I.D. 028631986)
Counsel of Record

Archer & Greiner, P.C.
One Centennial Square
P.O. Box 3000
Haddonfield, NJ 08033
(856) 795-2121
jconnell@archerlaw.com

Counsel for Petitioner-Appellant,
Robert A. Connell

Dated: January 15, 2020