Appropriate a Book of Business, Capital or Ordinary Gain?

If an investment advisor is terminated by the bank he works for and the bank keeps the advisors book of business, is the bank compensating the investment advisor for the sale of his book of business or is it paying compensation for services? One would seem to produce capital gain and the other ordinary gain. The court addressed this in Connell v. Commissioner, T.C. Memo. 2018-213.

Facts & Procedural History

The taxpayer was an investment advisor who had amassed a sizeable book of business. He moved to a new bank and, as is common in the bank and brokerage industry, the new bank paid him by making a loan. The loan payment was not subject to Federal income tax.

The loan was to be extinguished over time by the investment advisor’s earnings. This results in the investment advisor recognizing income tax on the cancelled debt as the debt is extinguished.

A review of the administrative disputes shows that it is also common in the bank and brokerage business for the larger firms to concoct reasons to terminate new investment advisors, to take steps to damage the investment advisor’s reputation, and to appropriate the investment advisor’s book of business.

The taxpayer in this case made these claims against his employer. These claims were made in response to the new bank initiating claims against the taxpayer with Financial Industry Regulatory Authority (FINRA).

FINRA is the administrative agency that financial advisors agree to allow to hear some disputes. It operates like a private arbitrator, but is not independent and does not follow the normal formalities required to protect one’s interests like a court.

FINRA agreed with the taxpayer. It concluded that the taxpayer did not have to repay his loan and it made an award to the taxpayer. To add insult to injury, the bank issued a Form 1099-C to the IRS to report the discharge of debt income for the taxpayer.

Given the Form 1099-C and how it was reported on the taxpayer’s income tax return, the IRS audited the taxpayer’s return. The question for the court was whether the debt that was forgiven was capital or ordinary in nature. This mattered as the taxpayer had a sizable capital loss that could offset capital gains, but not ordinary gains.

Capital or Ordinary Gain

The taxpayer asserted that the cancellation of debt was payment from the bank for its appropriation of his book of business. A book of business is generally a capital asset and the transfer of the asset would trigger capital gain. And there was no dispute that the bank in this case kept the taxpayer’s book of business.

The IRS asserted that the cancellation of debt was compensation taxed as ordinary income. This position is supported by the general law that cancellation of debt income is ordinary, particularly when it originates from an employee-employer relationship.

The Dispute & Award Documents

The court applied the normal process for analyzing settlement awards. This involves analyzing the underlying claims and related documents for the dispute to determine what the payments was received for.

This process is frequently used for disputes that are handled by courts and neutral third parties. The idea is that each party will zealously represent their own interests in the underlying dispute, so the claim and claim documents present an accurate picture of the nature of the dispute.

The FINRA Dispute Process

But FINRA disputes initiated by banks and brokerage firms are not like proceedings before the courts or other neutral arbitrators. Investment advisors are often at a disadvantage in the FINRA dispute process.

Many of the banks and brokerage firms that bring claims have attorneys on staff who handle these issues. They also have the advantage of time, as they can build their case over time and then decide when to bring the claim when it is convenient for them.

Investment advisers on the other hand often have to scramble to meet short deadlines just to defend themselves once they are notified of the FINRA action. This requires the investment adviser to find and secure legal counsel, gather evidence, etc. during the short time frames allowed by the FINRA rules.

Given the process and timelines, many investment advisers are barely able to put forth defenses. They cannot fully develop any offensive claims for wrongs perpetuated by the banks or brokerage firms.

This problem is often exacerbated by the circumstances. The investment advisers are thrust into a situation where they have to try to salvage their business and protect their reputations against allegations that have not been proven up in court, all while having little or no income to pay for their personal expenses or their legal defense.

Close Call: Who Bears the Burden?

The court did not address these issues in this case. It reviewed the underlying FINRA documents.

The court even noted that the underlying documents supported the taxpayer’s contention that the cancellation of debt was for the bank appropriating his book of business:

Admittedly, the filings heavily emphasize Mr. Connell’s argument that Merrill Lynch lured Mr. Connell to Merrill Lynch in order to acquire his book of business and that thereafter it set out to ruin his professional reputation so as to keep him from working at a competing financial services firm.

The court then noted that the taxpayer raised other arguments in the FINRA dispute, including how the bank had breached the terms of its contract.

Given the varied arguments the taxpayer made and that the FINRA award did not specify what the forgiveness of debt was for, the court concluded that the taxpayer had the burden to establish the character of the gain and he did not meet it.