We Want You

One of the most challenging problems facing a business is how to attract, and then retain, qualified employees.[i] The competition among businesses can be fierce and, in order to succeed, businesses have, over the years, developed a number of compensation alternatives. Some of these have become “standard” options,[ii] thereby forcing businesses to devise more tailored arrangements for certain prospective employees. In almost all cases, however, both parties have recognized the impact of taxes – in terms of the amount of compensation and the timing of its recognition – on the net economic benefit of a particular compensation package.

Transition Loan/Compensation

In the financial services industry, it has long been the practice for a firm to loan a new key employee a significant sum of money (so-called “transition compensation”) in order to entice them to join the firm. In exchange, the employee executes a promissory note to evidence the amount they owe to the firm, along with an employment agreement pursuant to which the firm “pays” the employee a monthly amount, which is then immediately applied toward the amount owing to the firm for that month under the note. This arrangement allows the employee to receive the full amount of their transition compensation upfront, while recognizing income only as each monthly payment comes due. No moneys change hands with respect to each monthly “repayment” of the loan.

If the loan is consistently treated as such by the parties, it will likely withstand IRS scrutiny and be respected as a loan.[iii] Consequently, the monthly payments will be included in the employee’s gross income and will be deductible by the firm, provided the total compensation paid by the firm to the employee is reasonable for the services to be rendered.[iv]

Of course, circumstances may arise that cause the key employee and the firm to go their separate ways. In that case, depending upon the particular facts, the amount of the “transition compensation loan” that remains outstanding may become due immediately.[v]

The U.S. Tax Court recently considered a complicated version of this situation. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11848.

Welcome

Taxpayer was a very successful financial adviser and certified financial planner. He was employed by Firm A, where he developed a large book of business. To service those clients, he worked with a five-person team of brokers and assistants who, though they were employed by Firm A, worked exclusively for Taxpayer.

Taxpayer and his team subsequently joined Firm B. Upon his agreeing to work for Firm B, the firm lent him approximately $3.6 million. To evidence the loan, Taxpayer signed a promissory note. He also signed an employment agreement, which, among other things, provided for a “monthly transition compensation payment” in an amount equal to the amount due and payable each month by Taxpayer pursuant to the terms of the note. In order to facilitate the repayment of the loan, this amount – which was taxable to Taxpayer as compensation – was deducted from Taxpayer’s compensation from Firm B.[vi]

The employment agreement provided that Taxpayer would cease to be entitled to transition compensation upon the termination of his employment with Firm B for any reason. However, if his termination was other than for “cause,”[vii] Firm B would pay Taxpayer a lump sum equal to the remaining transition compensation payments through a specified date, less any outstanding debts Taxpayer owed Firm B. In the event Taxpayer resigned or his employment was terminated by Firm B for cause, Taxpayer would not receive these payments.

The loan became immediately repayable if Taxpayer’s employment with Firm B was terminated for any reason.

Taxpayer was offered this high level of compensation in anticipation of his clients’ moving with him and his team to Firm B. His efforts to contact his clients and persuade them to leave Firm A and join him at Firm B were governed by an protocol entered into by participating financial services firms, to which Firms A and B were parties, and which set forth the specific types of information which a financial adviser, such as Taxpayer, could take with them when they left one financial services firm to join another.

Seeking to bring his clients to Firm B, Taxpayer consulted with Firm B’s attorneys to interpret the protocol, and then relied on their interpretation of the protocol when he brought his client information with him to Firm B and used it to contact the clients, inform them of the move, and invite them to change financial services firms.[viii]

Taxpayer brought his entire team to Firm B. As part of the transition, Taxpayer also brought various spreadsheets and documents with client information used by his group at Firm A, which he had developed over his years of work. These documents and spreadsheets were treated as Taxpayer’s personal property at Firm A.

Sorry It Didn’t Work Out

Less than a year after Taxpayer joined Firm B, their relationship soured. Firm B launched an investigation with respect to how Taxpayer brought his clients from Firm A to Firm B and whether he violated the protocol and/or his employment agreement.

At that point, Taxpayer voluntarily resigned and began seeking employment at another financial services firm. He was stymied, however, because Firm B did not immediately submit the requisite form to FINRA[ix] with details regarding the termination of his employment, without which no reputable would hire him. Consequently, for a time after he left Firm B, Taxpayer could not service his clients.

In the meantime, Firm B actively solicited Taxpayer’s clients. It had Taxpayer’s former team members[x] contact each client in an attempt to persuade them to abandon Taxpayer and remain with Firm B. It also retained Taxpayer’s documents and spreadsheets, which the team members continued to use to service clients.

About a month after Taxpayer’s resignation, Firm B made the requisite filing, but under the form included an explanation that Taxpayer was permitted to resign on account of “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.”

Firm B then brought a proceeding against Taxpayer before a FINRA panel in which it sought repayment of the outstanding balance of Taxpayer’s loan, asserting that the terms of the promissory note called for such repayment upon termination of Taxpayer’s employment.[xi]

In response, Taxpayer requested that the panel award him (i.e., forgive) the “unpaid” transition compensation (approximately $3.2 million) “loaned” to him when he joined Firm B. He also requested that Firm B release to his documents and spreadsheets.

The Panel’s Decision

Taxpayer stated that the panel should reject Firm B’s demand that he repay the outstanding balance of the upfront forgivable loan because if Firm B were allowed to collect the amount allegedly remaining due under such loan,[xii] after having induced Taxpayer to transfer his entire book of business to Firm B and then effectively forcing his resignation less than one year later, the firm would have been permitted to freeze Taxpayer out of the financial services industry, thus receiving the entire benefit of his substantial book of business, including the revenues generated from such book of business, all without having to provide any compensation to Taxpayer for that book of business.[xiii]

According to Taxpayer, these same facts supported his contention that Firm B had essentially converted his book of business and misappropriated his trade secrets (in the form of the client-documents and spreadsheets) via a plan whereby it: (1) lured Taxpayer to join the firm with a large compensation package (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 [Taxpayer] * * * [would] not be able to find comparable employment in the financial services industry, thereby allowing [Firm B] to continue to service [Taxpayer’s] clients almost entirely free from competition.”

Taxpayer stressed the fact that, unlike the scenario wherein a hypothetical financial planner leaves one firm to work at another with an outstanding balance remaining on a forgivable loan, when Taxpayer resigned from Firm B, he did not join a competitor. Instead, having effectively sidelined Taxpayer, Firm B was able to solicit his entire book of business free from competition, while in the several months since his resignation, Taxpayer had only managed to acquire a handful of clients.

The panel declined to order Taxpayer to pay the remaining balance of the upfront forgivable loan owing to Firm B under the promissory note, and ruled that Taxpayer was entitled to retain such balance.

The panel also ordered Firm B to deliver to Taxpayer the templates for his documents and spreadsheets, but expressly stated that the templates were to be delivered to him without any data. Upon delivery, Firm B was ordered to certify that it had removed these materials from its own computer systems. However, the order did not prevent Firm B from retaining the substantive client information.

Taxpayer’s Federal Income Tax Return

Firm B issued Taxpayer an IRS Form 1099-C, Cancellation of Debt, reporting debt cancellation income of approximately $3.2 million.[xiv]

Taxpayer timely filed his Federal income tax return, wherein he reported an overall loss and claimed a refund. He reported the 1099-C cancellation of indebtedness income as “deferred compensation.”[xv] He offset this amount with certain ordinary loss items, including a “Firm A Deferred Compensation Loss” of $2.5 million.

The IRS examined Taxpayer’s tax return and determined that the Firm A deferred compensation loss was actually a capital loss from the sale of stock, and could not be used to offset ordinary income.

Taxpayer conceded this adjustment, and then amended his income tax return to recharacterize the extinguishment of the balance of the Firm B upfront forgivable loan from ordinary income to capital gain,[xvi] and again claimed a refund.

The IRS denied the refund claim, and Taxpayer petitioned the Court.

The issue before the Tax Court involved the character of the balance of the upfront forgivable loan which was extinguished as a result of the panel’s award determination. Specifically, the Court had to determine whether that award constituted capital gain resulting from Firm B’s taking of Taxpayer’s book of business, as Taxpayer maintained, or ordinary income resulting from the cancellation of indebtedness, as asserted by the IRS. To resolve the characterization of the award, the Court focused on Taxpayer’s arguments raised before the panel.

The Tax Court

It is axiomatic that a taxpayer’s gross income includes all income realized by the taxpayer, from whatever source it is derived, unless it is specifically excluded by statute. Thus, proceeds “received” pursuant to a judgment arising from a dispute – including the amount of the reduction or cancellation of a debtor’s obligation[xvii] – constitutes taxable income unless the taxpayer can establish that the proceeds come within the scope of a statutory exclusion.

Starting from this premise, the Court recognized 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.” The nature of the litigation, the Court continued, “is determined by reference to the origin and character of the claim which gave rise to the litigation.” Thus, to the extent that amounts received for injury or damage to capital assets exceed the basis of the property, such amounts are taxable as capital gain, whereas amounts received for lost profits are taxable as ordinary income.

In deciding the character of the upfront forgivable loan that was extinguished as a result of the panel’s award, the Court asked: “In lieu of what were the damages awarded?”

The IRS argued that Taxpayer was bound by his employment agreement and promissory note. The promissory note was made as part of Taxpayer’s compensation package with Firm B (i.e., the monthly transition compensation). The note made no mention of Taxpayer’s book of business.

Moreover, Taxpayer treated the monthly transition compensation he received during his tenure at Firm B as ordinary income, which is consistent with the terms of the employment agreement and promissory note.

The IRS also pointed out that Taxpayer did not assert that the income was capital gain income until the IRS determined that his Firm A stock loss was a capital (rather than ordinary) loss.

The Court observed that the panel did not explain the basis of its award; hence, the Court was left to infer the panel’s reasoning. It explained that, in similar cases, it has looked to the claims made in the pleadings to determine the nature of the taxpayers’ claims.

Taxpayer argued that his filings with the FINRA panel made 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 Taxpayer’s claim before the panel was that he was entitled to retain the unpaid portion of the loan proceeds because they represented fair compensation for Firm B’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.

The Court disagreed.

It conceded that the filings heavily emphasized Taxpayer’s argument that Firm B lured him 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 Taxpayer presented to the panel. For example, Taxpayer’s filings emphasized that Firm B breached the terms of the employment contract, causing Taxpayer to suffer damages. This argument, by itself, would have relieved Taxpayer of his obligation to pay the outstanding balance of the promissory note to Firm B.

Unfortunately for Taxpayer, the record before the Court did not reveal the specific argument that the panel found most persuasive when it extinguished the balance of the upfront forgivable loan.

Taxpayer had the burden of answering the question “in lieu of what were the damages awarded?” On the basis of its examination of the record, the Court concluded that Taxpayer did not meet his burden to establish that the amount at issue was solely for the acquisition of Taxpayer’s book of business.

Consequently, the Court sustained the IRS’s determination that the extinguishment of Taxpayer’s debt to Firm B constituted cancellation of debt income, and that the amount of the extinguishment was taxable as ordinary income.

Takeaways?

It’s an old question: how to distinguish between being given the opportunity to provide services for which one receives compensation taxable as ordinary income, on the one hand, and the transfer of an asset that produces ordinary income, on the other.

The Court did not expressly address the issue, nor did it have to. There were just too many indicia of ordinary income: the industry practice of the forgivable loan as a substitute for immediately taxable compensation, the fact that Taxpayer (as the purported “seller”) rather than Firm B (as the purported buyer) gave a promissory note, Taxpayer’s reporting of the transition payments as ordinary income, Taxpayer’s having negotiated the right in his employment agreement to solicit the customers he brought to Firm B in the event he left the firm, and the fact that he first reported the forgiven loan as ordinary before amending his tax return in response to the IRS’s adjustment of the Firm A stock loss.

That being said, there were also some factors that may have supported capital gain (i.e. sale) treatment under different circumstances. For example, Firm A treated Taxpayer’s spreadsheets and other documents as his personal property, his team remained with Firm B after Taxpayer’s departure, and Taxpayer was effectively precluded from taking his clients with him when he resigned from Firm B. If Taxpayer had not been an employee of Firm A prior to moving his team and clients to Firm B, an argument might have been made that the relationship among Taxpayer, his team, and his clients was indicative of a going concern and of personal goodwill, which together represented an asset, the sale of which generated capital gain.[xviii]

Of course, if the parties had intended something other than a compensatory arrangement, they could have memorialized their agreement differently, and they could have reported their payments and receipts under this arrangement, for tax purposes, other than as they did; in other words, their chosen form would presumably have been consistent with the intended tax treatment.

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[i] Last week we considered this issue from the perspective of a tax-exempt organization, in light of the Tax Cuts and Jobs Act. https://www.taxlawforchb.com/2019/01/its-a-business-no-its-a-charity-wait-its-a-charity-that-is-treated-like-a-business/ .

[ii] At least within an industry.

[iii] I.e., a receipt of value that is nontaxable because it has to be repaid; there has been no accretion in value by the recipient.

[iv] IRC Sec. 162(a).

[v] Indeed, these upfront forgivable loan arrangements are often contingent upon the continued employment of the employee with the employer-lender.

[vi] Query why the IRS did not argue that this circular flow of funds caused the entire amount of the “loan” to be treated as compensation in the taxable year the proceeds were transferred to Taxpayer?

[vii] “Cause” was defined to include, among other things:

  1. violation of any rules or regulations of any regulatory or self-regulatory organization;
  2. violation, as reasonably determined by Firm B, of its rules, regulations, policies, practices, directions, and/or procedures; or
  3. a suspension, bar, or limitation on Taxpayer’s activities for Firm B by any regulatory or self-regulatory

organization.

[viii] Taxpayer’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 Firm A) if he should ever leave Firm B. Specifically, for a period of one year following the termination of Taxpayer’s employment with Firm B for any reason, he agreed not to solicit, or initiate contact or communication with, either directly or indirectly, any account, customer, client, customer lead, prospect, or referral whom Taxpayer served or whose name became known to him during his employment at Firm B. However, this restriction did not apply to clients whom Taxpayer served at his prior employer (Firm A) or who became clients of Firm B within one year after he began employment with Firm B.

[ix] Form U5. FINRA is a private corporation that acts as a self-regulatory organization. It is the successor to the NASD, and ultimately reports to the SEC.

[x] Whom Firm B had convinced to stay with the firm through various incentives.

[xi] Interestingly, none of Taxpayer’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 the team remained at Firm B servicing Taxpayer’s entire book of business. “Who’s your daddy?”

[xii] Which amount was directly tied to the amount of revenue his book of business generated the year before he joined Firm B.

[xiii] Taxpayer relied on these facts to support his claims against Firm B of unjust enrichment, fraudulent inducement, breach of contract, and breach of the implied covenant of good faith.

[xiv] The remaining balance of the upfront forgivable loan.

[xv] Ordinary income.

[xvi] So as to offset the capital loss resulting from the IRS’s adjustment.

[xvii] IRC Sec. 108, 61(a)(12).

[xviii] Much as a non-compete is an important element in ensuring the transfer of a seller’s goodwill to a buyer, so the acts allegedly taken by Firm B effectively secured for its benefit the asset represented by Taxpayer’s client base.