James L. Purdy & Barbara B. Purdy, Petitioners

BSJ .T .C . Summary Opinion 2010-2 6

UNITED STATES TAX COURT

JAMES L . AND BARBARA B . PURDY, Petitioners v . COMMISSIONER OF INTERNAL REVENUE, Responden t 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 , '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 .

SERVED MAR - 8 2010

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 .

Backgroun d 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 regiona l 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 . Ns . 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 andlTax 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 dismisse d his second claim . Merrill issued a W-2 for this payment, and Mr .

Purdy reported the entire award as wages on petitioners' income 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 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 gros s 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 Schedul e 2Had .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 show n 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 .

. 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 (cid:127), 363-364 (1988 ) ; Test v . Commissioner , su ra .

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 facilitie s used in the work, . the opportunity of the individual for profi t and loss, whether the principal has the right to discharge the individual, whether the work is part of the principal's regula r business, the permanency of the relationship, and the relationship the part'ies'believe they are creating : Prof 1 . & Executive Leasing, Inc . v . Commissioner , 862`F .2d-751, 753 (9th 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 ii, 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 di d 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 entere d for respondent .