Court Opinion

ID: 4338017
Source: CourtListenerOpinion
Date Created: 2018-11-14 03:40:22.276592+00
Date Added: 2024-06-11T13:29:37.882601
License: Public Domain

T.C. Summary Opinion 2010-26

                      UNITED STATES TAX COURT

          JAMES L. AND BARBARA B. PURDY, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

     Docket No. 26679-08S.              Filed March 8, 2010.

     James L. Purdy and Barbara S. Purdy, pro se.

     Matthew A. Houtsma, for respondent.

     KROUPA, Judge:   This case was heard pursuant to the

provisions of section 74631 of the Internal Revenue Code in

effect when the petition was filed.   Pursuant to section 7463(b),

the decision to be entered is not reviewable by any other court,

     1
      All section references are to the Internal Revenue Code
(Code), and all Rule references are to the Tax Court Rules of
Practice and Procedure, unless otherwise indicated.
                               - 2 -

and this opinion shall not be treated as precedent for any other

case.

     Respondent determined a $42,000 deficiency in petitioners’

Federal income tax for 2003.   The sole issue before this Court is

whether legal expenses incurred by petitioner James Purdy (Mr.

Purdy) are deductible as business expenses on Schedule C, Profit

or Loss From Business, or as unreimbursed employee business

expenses on Schedule A, Itemized Deductions.    We find the legal

fees are deductible as unreimbursed employee business expenses on

Schedule A.

                             Background

     Some of the facts have been stipulated and are so found.

The stipulations of fact and settled issues and their

accompanying exhibits are incorporated by this reference.

Petitioners resided in Montana at the time they filed the

petition.

     Mr. Purdy is a financial adviser.    Mr. Purdy began his

career at D.A. Davidson & Company (D.A. Davidson), a regional

financial consulting firm.   Mr. Purdy was the top-producing

broker for D.A. Davidson, establishing a substantial number of

clients with assets worth approximately $70 million.    Mr. Purdy’s

success led to a job offer from top-tier financial firm Merrill

Lynch (Merrill).   Mr. Purdy left D.A. Davidson to work for

Merrill in 2000.
                               - 3 -

     Julie McHenry (Ms. McHenry) joined Mr. Purdy in his move to

Merrill.   Ms. McHenry had worked as an administrative assistant

to Mr. Purdy while at D.A. Davidson, though she had also assisted

other brokers at the firm.   Ms. McHenry accepted a registered

client associate position at Merrill shortly after passing her

“series seven” stockbroker examination.   Ms. McHenry never acted

as a financial adviser at either D.A. Davidson or Merrill.

     Mr. Purdy and Merrill entered into two different agreements,

both of which explicitly referred to his employment with Merrill.

Merrill provided Mr. Purdy health and life insurance, as well as

a 401(k) retirement plan, and withheld Federal, State, and FICA

taxes from his pay.   Merrill paid him a salary and issued Forms

W-2, Wage and Tax Statement, to him for 2000, 2001, 2002, and

2003.   Mr. Purdy reported the wages from Merrill and never filed

a Schedule C nor paid self-employment taxes related to his income

from Merrill.   In addition, Mr. Purdy claimed unreimbursed

employee business expenses on returns for the three years before

the year at issue as a financial adviser for Merrill.

     Merrill consistently treated Mr. Purdy as an employee.

Merrill provided him office space, furniture, clerical staff,

training, and computer systems.   Merrill had the right to review

and conduct performance evaluations of Mr. Purdy’s work.   Merrill

also retained the right to fire Mr. Purdy.   Mr. Purdy had a

Merrill email account and was featured on the company’s Web site.
                               - 4 -

Mr. Purdy held himself out to others as employed by Merrill and

used the company’s name to market himself to clients.

     Ms. McHenry received benefits similar to Mr. Purdy’s.    Both

D.A. Davidson and Merrill paid her wages and treated her as an

employee.   Ms. McHenry received a salary that included a certain

percentage of commissions from Mr. Purdy and other brokers.

Merrill and D.A. Davidson also retained the right to fire her.

     Mr. Purdy became disenchanted with Merrill after working for

the firm for three years.   Mr. Purdy claimed Merrill failed to

provide him with the fees and facilities promised in the initial

employment agreement.   Mr. Purdy hired an attorney and filed a

personal claim for arbitration against Merrill with the National

Association of Securities Dealers, Inc. (NASD) Dispute Resolution

Group.   The claim alleged Merrill had fraudulently induced Mr.

Purdy to leave his employment with D.A. Davidson.   Merrill

subsequently fired Mr. Purdy and Ms. McHenry.

     Mr. Purdy then filed another arbitration claim against

Merrill asserting wrongful termination and retaliatory discharge.

NASD awarded Mr. Purdy $393,165 for the first claim and dismissed

his second claim.   Merrill issued a W-2 for this payment, and Mr.

Purdy reported the entire award as wages on petitioners’ income
                                 - 5 -

tax return for 2003.   Mr. Purdy paid $120,000 of this amount to

his attorney during 2003.2

     After being terminated from Merrill, Mr. Purdy and Ms.

McHenry established Purdy-McHenry Investments, LLP (PMI), a

partnership providing financial advisory services.     Mr. Purdy and

Ms. McHenry signed a formal partnership agreement and filed a

partnership return on behalf of PMI.      Mr. Purdy had not filed a

tax return or any partnership before PMI’s inception in 2002.

     Petitioners deducted $120,000 in legal expenses incurred

from Mr. Purdy’s claim against Merrill and reported only $1,717

in gross receipts on Schedule C of their return for 2003.      The

gross receipts represent interest paid on the Merrill award.

Respondent disallowed the legal expenses deducted on Schedule C

but allowed a deduction on Schedule A for unreimbursed employee

business expenses subject to the 2 percent of adjusted gross

income floor under section 67.    Petitioners timely filed a

petition contesting the deficiency notice.

                             Discussion

     We must determine whether the legal fees Mr. Purdy paid to

successfully sue his former employer are deductible in full as

ordinary and necessary business expenses or whether they are

deductible as unreimbursed employee business expenses on Schedule

     2
      Had the payment been made after Oct. 22, 2004, the
effective date of sec. 62(a)(19), the payment might be deductible
from gross income in computing adjusted gross income.
                                - 6 -

A.   Schedule A expenses are subject to the 2 percent of adjusted

gross income floor and the alternative minimum tax.      Sec. 67.

     We begin with the burden of proof.    The Commissioner’s

determinations are generally presumed correct, and the taxpayer

bears the burden of proving otherwise.    Rule 142(a).    Section

7491(a) shifts the burden of proof to the Commissioner in certain

situations.   Petitioners do not argue that the burden of proof

shifts to respondent under section 7491(a) and have not shown

that the threshold requirements of section 7491(a) were met.        In

any event, we decide the issues involving whether petitioners may

deduct the legal expenses as business expenses on Schedule C on a

preponderance of the evidence standard, and the burden of proof

does not affect the outcome.

     We now focus on the deductibility of legal expenses.

Taxpayers may deduct all ordinary and necessary expenses paid or

incurred during the taxable year in carrying on a trade or

business.   Sec. 162(a).   Legal expenses paid as ordinary and

necessary expenses may be deductible on Schedule C when the

matter generating the expense arises from, or is proximately

related to, a business activity other than employment.      Test v.

Commissioner, T.C. Memo. 2000-362, affd. 49 Fed. Appx. 96 (9th

Cir. 2002); see Bagley v. Commissioner, 8 T.C. 130, 134 (1947).

A taxpayer generally must report on Schedule A legal expenses

attributable to the taxpayer’s service as an employee.      Sec.
                               - 7 -

62(a)(1); McKay v. Commissioner, 102 T.C. 465, 493 (1994),

vacated on other grounds 84 F.3d 433 (5th Cir. 1996); O’Malley v.

Commissioner 91 T.C. 352, 363-364 (1988); Test v. Commissioner,

supra.

     The question becomes whether Mr. Purdy was an employee of

Merrill.   Mr. Purdy contends that he was never an employee of

Merrill.   Instead, Mr. Purdy claims that he deducted the fees on

Schedule C because they resulted from a partnership with Ms.

McHenry.   Respondent counters that Mr. Purdy was an employee at

Merrill and that no partnership existed between Mr. Purdy and Ms.

McHenry during Mr. Purdy’s employment at Merrill.

     We now look to whether Mr. Purdy was an employee.    Whether

an employer-employee relationship exists is a factual question

determined by common law principles.   Nationwide Mut. Ins. Co. v.

Darden, 503 U.S. 318, 323 (1992); Weber v. Commissioner, 103 T.C.
378, 386 (1994), affd. 60 F.3d 1104 (4th Cir. 1995).    The Court

considers the degree of control exercised by the principal over

the details of the work, which party invests in the facilities

used in the work, the opportunity of the individual for profit

and loss, whether the principal has the right to discharge the

individual, whether the work is part of the principal’s regular

business, the permanency of the relationship, and the

relationship the parties believe they are creating.     Profl. &

Executive Leasing, Inc. v. Commissioner, 862 F.2d 751, 753 (9th
                                 - 8 -

Cir. 1988), affg. 89 T.C. 225 (1987); Shelley v. Commissioner,

T.C. Memo. 1994-432.

     We apply these factors to the facts of this case.    Merrill

had the right to review Mr. Purdy’s work as well as the right to

forbid Mr. Purdy from conducting any outside business without

prior approval.   Merrill also retained the right to discharge Mr.

Purdy and, in fact, did so.   Merrill invested in the facilities

in which Mr. Purdy worked as well as purchased furniture and

office supplies for Mr. Purdy’s use.     Mr. Purdy held himself out

as an employee of Merrill and was featured on the company’s Web

site.   The financial advising work Mr. Purdy conducted was part

of Merrill’s regular business.

     In addition, the parties treated Mr. Purdy as an employee.

The two agreements Mr. Purdy signed consistently mentioned his

employment with Merrill.   Merrill paid Mr. Purdy a salary,

withheld Federal and State taxes, and issued Mr. Purdy a W-2

every year.   Mr. Purdy received benefits of the kinds an employee

would receive, including health insurance and a retirement plan.

Mr. Purdy reported the wages he earned as an employee

consistently each year he was working at Merrill and even

reported the settlement award as wages despite having been fired.

At no time did he report any self-employment income from Merrill.

Moreover, he claimed unreimbursed employee business expenses

while he was working at Merrill.    Mr. Purdy’s tax returns during
                                 - 9 -

his tenure at Merrill never included a Schedule C related to his

financial adviser activities and instead included his expenses

related to his advising as unreimbursed employee business

expenses.    Further, Ms. McHenry testified that she and Mr. Purdy

were both employees of Merrill.    Accordingly, we find and the

record establishes that Mr. Purdy was an employee of Merrill.

     Moreover, we are unconvinced that any partnership existed

between Mr. Purdy and Ms. McHenry.       Petitioners argue that a

partnership existed because of the fee- and commission-splitting

arrangement between Mr. Purdy and Ms. McHenry.       We are not

persuaded.    Both Mr. Purdy and Ms. McHenry still received a

salary from Merrill, and Ms. McHenry also received commissions

from other financial advisers.    Mr. Purdy and Ms. McHenry did not

file a partnership return until after they had been fired from

Merrill.    The two agreements Mr. Purdy signed with Merrill did

not mention any partnership, and Ms. McHenry was not a party to

either agreement.    Further, Mr. Purdy made no mention of a

partnership in his claim for fraudulent inducement nor in his

claim for wrongful termination.    Mr. Purdy cannot now claim that

he was involved in a partnership so that he may deduct the legal

expenses in full rather than as a percentage of adjusted gross

income.    See Estate of Bean v. Commissioner, 268 F.3d 553 (8th

Cir. 2001), affg. T.C. Memo. 2000-355.       We find that Mr. Purdy
                             - 10 -

was not involved in a partnership with Ms. McHenry while he

worked at Merrill.

     We find that Mr. Purdy brought his claim as an employee of

Merrill and not in any trade or business other than his

employment or in a partnership with Ms. McHenry.   Accordingly, we

find that Mr. Purdy incurred these legal fees as an employee, not

as an independent contractor, sole proprietor, or partner.    We

therefore sustain respondent’s determination that the legal fees

are deductible as unreimbursed employee business expenses on

Schedule A.

     We have considered all arguments made in reaching our

decision, and, to the extent not mentioned, we conclude that they

are moot, irrelevant, or without merit.

     To reflect the foregoing,

                                          Decision will be entered

                                      for respondent.