Purdy v. Comm'r ( 2010 )

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.
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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.
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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.
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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
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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.
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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.
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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
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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
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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
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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.