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.

NY’s Tax Jurisdiction

Last week we considered New York’s “statutory residence” rule pursuant to which an individual domiciled outside of New York may nevertheless be taxed by New York as to all of their income for a taxable year – including their business income – regardless of its source, by virtue of maintaining a permanent place of abode in the State for substantially all of the taxable year, and spending more than 183 days of the taxable year in New York.

Of course, New York’s taxing jurisdiction extends beyond those individuals who are domiciled or resident in New York, and covers nonresidents who have New York source income. Thus, a nonresident will be subject to New York personal income tax with respect to their income from:

  • real or tangible personal property located in the State, (including certain gains or losses from the sale or exchange of an interest in an entity that owns real property in New York State);
  • services performed in New York;
  • a business, trade, profession, or occupation carried on in New York;
  • their distributive share of New York partnership income or gain;
  • any income received related to a business, trade, profession, or occupation previously carried on in the State, including, but not limited to, covenants not to compete and termination agreements; and
  • a New York S corporation in which they are a shareholder, including, for example, any gain recognized on the deemed asset sale for federal income tax purposes where the S corporation has made an election under IRC section 338(h)(10).

Although the foregoing list encompasses a great many items of income, there are limits to the State’s reach; for example, New York income does not include a nonresident’s income:

  • from interest, dividends, or gains from the sale or exchange of intangible personal property, unless they are part of the income they received from carrying on a business, trade, profession, or occupation in New York State; and
  • as a shareholder of a corporation that is a New York C corporation.

A recent series of decisions, culminating in an opinion from the Third Department, considered one taxpayer’s futile attempt to fit within, or expand upon, these excluded items.

Income from “Intangibles”?

Spouse was a member of LLC, a company that was treated as a partnership for income tax purposes and that did business in New York. He assigned his entire 18.75% ownership interest in LLC to Taxpayer. Spouse and Taxpayer were residents of New Jersey[ii] during the periods at issue.

This assignment was challenged by other members of LLC, which resulted in litigation, and in a ruling that the assignment was valid.

Litigation and Settlement

Taxpayer then commenced an action against LLC seeking a valuation of her interest in LLC, including her share of its profits. After receiving an accounting report from a court-appointed referee, the trial court determined that Taxpayer was entitled to an award of approximately $600,000 for her ownership interest in LLC and a profit distribution of approximately $1 million, together with both pre- and post-judgment interest.

Shortly thereafter, Taxpayer settled her claim against LLC for just over $2 million, and the parties agreed that approximately $600,000 of that amount would be allocated as payment for her interest in LLC and “not as ordinary income.”  

Tax Audit and Aftermath

Taxpayer and Spouse, being New Jersey residents,[iii] reported a capital gain of almost $600,000 and “other income” in the amount of almost $1.5 million on their federal return (IRS Form 1040), but none of the settlement was allocated to New York on their nonresident return (NY Form IT-203).

An audit by New York’s Department of Taxation and Finance ensued, and a notice of deficiency was issued assessing taxes and interest based on the $1.5 million that Taxpayer had identified as “other income.” Taxpayer and Spouse challenged the notice, but it was upheld by an Administrative Law Judge who noted that the litigation commenced by Taxpayer sought, among other things, her distributive share of LLC’s profits as the assignee of Spouse’s membership interest. The ALJ’s finding was, in turn, upheld by the Tax Appeals Tribunal.

Taxpayer brought an Article 78 proceeding in the Appellate Division of the Third Department to challenge the Tribunal’s decision upholding the deficiency.[iv]

The crux of Taxpayer’s challenge was that the “other income” was not taxable to them as nonresidents because it was a “return on an intangible asset” and not a distributive share of profits from a partnership doing business in New York.

Taxpayer’s Appeal

The Court began by explaining that New York may tax a nonresident only on income that is “derived from or connected with New York sources.”[v] New York source income, the Court continued, includes a taxpayer’s “distributive share of partnership income, gain, loss and deduction.”

Further, the Court continued, “only the portion [of source income] derived from or connected with New York sources of such partner’s distributive share of items of partnership income . . . entering into [her] federal adjusted gross income”. . . is included as the source income of a partner or limited liability company member.[vi] The Court noted that this includes income “derived from or connected with . . . a business . . . carried on in this state.”[vii]

However, Taxpayer contended that the Tribunal was incorrect in upholding the assessment because she was neither a “partner” nor a member of LLC, and she did not receive a distributive share of profits from LLC. According to Taxpayer, her assignee interest did not allow her to participate in the management and affairs of LLC, or to exercise any rights or powers of a member. Thus, Taxpayer argued, she should not be subject to tax as a member of LLC.

Taxpayer also asserted that her assignee interest in LLC was an intangible asset, and that income from such an asset should not be considered New York source income.

The Court disagreed, stating that the “membership interest” assigned to Taxpayer included “the member’s right to a share of the profits and losses of the [LLC]”. As the assignee of a membership interest, Taxpayer was not automatically entitled to participate in the management or affairs of LLC, but she was entitled “to receive . . . the distributions and allocations of profits and losses to which the assignor would be entitled.”[viii] Considering these provisions, the fact that Taxpayer was not a member of LLC had no bearing on whether the profit distribution to her was taxable. Further, it was undisputed that LLC “carried on” business in New York.

Origin of the Claim?

According to the Court, to determine the taxable status of a sum reached by settlement of the litigating parties, it is generally necessary to consider “[i]n lieu of what were the damages awarded?”[ix] The record showed that the settlement payment was made in consideration of Taxpayer withdrawing the causes of action in her complaint seeking her share of LLC profits. The parties, through counsel, expressly allocated approximately $600,000 of the total settlement as payment for Taxpayer’s ownership interest in LLC and “not as ordinary income,” without further characterization.

Consistently therewith, Taxpayer and Spouse reported the balance of almost $1.5 million as “other income” on their tax returns.[x] Pointing to the award in the underlying litigation, they also claimed that a portion of the settlement was attributed to interest and, therefore, not taxable in New York.

The Court pointed out that while interest income is generally not taxable as nonresident personal income, it was Taxpayer’s burden to establish that the assessment was erroneous. However, no portion of the settlement payment was expressly attributed to interest.

The Court then observed that the litigation was resolved by settlement, not court order. Given this structure, the Court continued, the Tribunal reasonably concluded that $1.5 million of the settlement was for lost profits. As such, the Court declined to disturb the Tribunal’s finding in this regard.

Having found that the Tribunal’s determination had a rational basis and was consistent with the statutory language, and that Taxpayer’s interpretation was not the “only logical construction” of the relevant provisions,[xi] the Court decided to defer to the Tribunal’s construction, and concluded that the determination by the Department of Taxation to issue the notice of deficiency was reasonable and supported by substantial evidence.

“Other Income”


Did Taxpayer actually believe that the income at issue was not taxable to a nonresident? The settlement payment was clearly attributable to Taxpayer’s interest in LLC’s profits, which were generated by the business that LLC conducted in New York. Accordingly, the “other income” was derived from New York sources and, as such, was taxable.

Yet Taxpayer stuck by her position through the audit, through the proceeding before the ALJ, through the Tax Appeals Tribunal, and through the Appellate Division.[xii]

The fact that the income at issue was not specifically addressed in the settlement, that is was paid “in exchange for” Taxpayer’s claims for her share of LLC profits, that Taxpayer labeled it as “other income” on her tax returns, and that she treated it as ordinary income for federal purposes, sealed the matter and forced Taxpayer to defend her position with fairly desperate arguments, like the one based upon her assignee status, described above.

Now, don’t get me wrong. There are times when perseverance in the face of many challenges may be commendable. There are also times, however, when advisers have to be blunt with their clients, when they cannot continue to stoke their hopes for a miracle, when no amount of legal creativity will save the day, when they simply have to throw in the proverbial towel.[xiii]

The moment for structuring a plausible argument for not taxing the settlement proceeds began when Taxpayer filed her first cause of action; it passed when the settlement was executed. Having failed to establish a basis for exclusion of the proceeds at that time, Taxpayer should have saved herself the additional interest, penalties and legal fees; she should have known “when to walk away.”[xiv]


[i] Apologies to Kenny Rogers, The Gambler.

[ii] I am told that people who live in New Jersey or who come from New Jersey are called New Jerseyites or New Jerseyans.

[iii] You may recall that last week’s post began with a review of the Tax Foundation’s State Business Tax Climate Index. You may also recall that NY did not fare too well with respect to individual income taxes, ranking 48th in the nation. Well, here’s some consolation: New Jersey ranked 50th.

[iv] Decisions rendered by the Tribunal are final and binding on the Department of Taxation and Finance, i.e., there is no appeal to the courts. Taxpayers who are not satisfied with the decision of the Tribunal have the right to appeal the Tribunal’s decision by instituting a proceeding pursuant to Article 78 of the Civil Practice Law and Rules to the Appellate Division Third Department of the State Supreme Court.

[v] Tax Law Sec. 631. https://codes.findlaw.com/ny/tax-law/tax-sect-631.html

[vi] Tax Law Sec. 632(a). https://codes.findlaw.com/ny/tax-law/tax-sect-632.html

[vii] Tax Law § 631(b)(1)(B). https://codes.findlaw.com/ny/tax-law/tax-sect-631.html

[viii] NY Limited Liability Company Law § 603. https://codes.findlaw.com/ny/limited-liability-company-law/llc-sect-603.html

[ix] What federal tax jurisprudence refers to as “the origin of the claim.”

[x] Indeed, they reported this amount as ordinary income on their federal tax return.

[xi] The Court was being kind.

[xii] “Please sir, may I have another?”

[xiii] Remember what happened to Apollo Creed in Rocky IV when the eponymous Rocky hesitated?

[xiv] As the refrain says:

You’ve got to know when to hold ’em
Know when to fold ’em
Know when to walk away
And know when to run

 

It Was the Worst of Times, Except . . .

It happens in most closely-held businesses: so long as the business is profitable and cash keeps flowing into the hands of the owners, everyone is happy. When the spigot slows, or is just plain turned off, however, the investor-owners (as distinguished from the management-owners) will have questions that they want answered, and quickly. When responses are not forthcoming, or are viewed as evasive, a lawsuit may not be far behind. iStock_000000181896XSmall11

In any litigation, there are few real winners. A lawsuit arises in the first place because someone was wronged, or believes to have been wronged, and there has certainly been an economic loss. Enter the attorneys, the accountants, perhaps, the “experts,” and rapidly-mounting costs.  Years may pass, and who knows what becomes of the business in the interim.

Sounds awful, right? But what if someone told you that, under the right circumstances, the costs may be cut by at least forty percent? You may say, “Tauric defecation.” (Any readers from Bronx Science out there?) “No,” I would reply, “it’s called tax savings.”

The Facts of a Recent PLR

Taxpayer was a shareholder in several closely-held corporations that owned and operated Business for many years. Taxpayer personally or jointly managed the finances of all the closely-held corporations that operated Business.

Taxpayer, E and F formed a closely-held corporation (“Corp.”), an S corporation, to operate Business in a new location. The shareholders agreed that Taxpayer was to manage Corp. and receive a management fee. The distribution of the remaining net profits was allocated among the shareholders based on their ownership percentages. For several years, E consistently received monthly distribution checks from Taxpayer. However, at some point the checks became less regular. After not receiving checks for several months, E made several inquiries of Taxpayer. There were several meetings and many letters and e-mails in which E asked Taxpayer for Corp.’s financial records. E eventually received some of the records, but they did not explain why Corp. was losing money. E filed a lawsuit against Taxpayer asserting causes of action that included fraud, breach of fiduciary duty, and breach of contract.

The jury found Taxpayer liable for breach of fiduciary duty and fraud. It also awarded E punitive damages. The court awarded costs to E. The final judgment against Taxpayer consisted of compensatory and punitive damages, prejudgment interest, costs, and post-judgment interest.

Taxpayer paid E the amounts ordered by the judgment of the trial court. In addition, Taxpayer paid legal fees to his accounting consultants and expert at trial, as well as to the attorneys he retained to defend him in the lawsuit at the trial court.

The Law

Section 162 of the Code provides a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The regulations promulgated under Sec. 162 provide that deductible expenses include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. The regulations under Section 263 of the Code provide that a taxpayer must capitalize an amount paid to another party to acquire any intangible from that party in a purchase or similar transaction. To qualify as a deduction  allowable under Sec. 162, an expenditure must satisfy a five part test: it must

(1) be paid or incurred during the taxable year,

(2) be for carrying on a trade or business,

(3) be an expense,

(4) be necessary, and

(5) be ordinary.

Thus, personal expenditures incurred outside of a taxpayer’s trade or business are not deductible under Sec. 162. In addition, capital expenditures under Sec. 263 are not deductible.

Once In A Lifetime

Even though a particular taxpayer may incur an expense only once in the lifetime of its business, the expense may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the “safety” of a business may happen only once in a lifetime. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The term “necessary,” under Sec. 162, imposes the requirement that the expense be appropriate and helpful for the taxpayer’s business. However, if litigation arises from a capital transaction (e.g., the sale of property) then the costs and legal fees associated with the litigation are characterized as acquisition costs and must be capitalized under Sec. 263.

The Origin of the Claim

A payment will be deductible under Sec. 162 as a trade or business expense only if it is not a personal expenditure or a capital expenditure. The controlling test to distinguish business expenses from personal or capital expenditures is the “origin of the claim.” Under this test, 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 test of whether the expense was “business” or “personal” and, hence, whether it is deductible or not. Similarly, the origin and character of the claim with respect to which a settlement is made, rather than its potential consequences on the business operation of the taxpayer, is the controlling test of whether a settlement payment constitutes a deductible expense or  a nondeductible capital outlay. It should be noted that the “origin-of-the-claim” test does not contemplate a mechanical search for the first in the chain of events that led to the litigation but, rather, requires an examination of all the facts. The inquiry is directed to ascertaining the “kind of transaction” out of which the litigation arose. One must consider the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, and all the facts pertaining to the controversy. Generally, amounts paid in settlement of lawsuits are currently deductible if the acts that gave rise to the litigation were performed in the ordinary conduct of a taxpayer’s business.

Similarly, amounts paid for legal expenses in connection with litigation are allowed as business expenses where such litigation is directly connected to, or proximately results from, the conduct of a taxpayer’s business.

The IRS Rules

The IRS determined that Taxpayer’s payments to satisfy the judgment awarded against him were ordinary and necessary expenditures. Under the origin of the claim test, E’s claims against Taxpayer had their origin in the conduct of Taxpayer’s trade or business – the management of Corp. Taxpayer’s activities that gave rise to the lawsuit did not result in the acquisition of a capital asset, did not perfect or defend title to an existing asset, and did not create a separate and distinct asset. Taxpayer did not receive a long-term benefit from the payments. An examination of all the facts indicated that the litigation payments were business expenses, and not personal or capital expenditures. Thus, the IRS concluded that the expenditures that Taxpayer paid, that resulted from the lawsuit by E against Taxpayer as the managing shareholder of Corp., were deductible under Sec. 162, provided that Taxpayer was not reimbursed for any of the payments by insurance or similar compensation.

Be Aware

In some cases, the deductibility of litigation-related expenses may not be relevant, as where the taxpayer’s costs are reimbursed by insurance.

In many other cases, however, the taxpayer and his or her attorneys ought to be aware of the opportunity for tax savings.

Although there is little that can be done about the facts when litigation has begun, a taxpayer should determine the kind of transaction out of which the litigation arose. He or she must consider the background of the litigation, its nature and its objectives. In turn, the defenses asserted may be framed in order to support the treatment of the litigation and settlement expenditures, as ordinary and necessary expenditures incurred in the conduct of the taxpayer‘s trade or business.

The goal in defending any litigation is damage-control, which includes the reduction of the economic cost of conducting and settling the litigation. The ability to reduce such cost through tax deductions can go a long way in making the economics of a deal easier to swallow.