Neil F. MacLean v. Commissioner of Revenue (February 21, 2014)

COMMONWEALTH OF MASSACHUSETTS

APPELLATE TAX BOARD


NEAL F. MACLEAN 	      v.       COMMISSIONER OF REVENUE 
 							 	   
Docket No. C299505		          Promulgated:			    
				   			February 21, 2014


This is an appeal filed under the formal procedure pursuant to G.L. c. 58A, § 7 and G.L. c. 62C, § 39(c) from the refusal of the appellee, Commissioner of Revenue ("Commissioner" or "appellee"), to grant an abatement of personal income tax assessed to the appellant, Neal F. MacLean ("appellant"), for the yearly tax period ending December 31, 2007 ("tax year at issue").
Chairman Hammond heard this appeal and was joined by Commissioners Scharaffa, Rose, Mulhern and Chmielinski in a decision for the appellee.  
These findings of fact and report are made pursuant to a request by the appellee under G.L. c. 58A, § 13 and 831 CMR 1.32.  


Kevin J. Kilduff, Esq. for the appellant.

Julie A. Flynn, Esq. and Brett M. Goldberg, Esq. for the appellee.	



FINDINGS OF FACT AND REPORT
On the basis of an Agreed Statement of Facts and the testimony and exhibits offered into evidence at the hearing of this appeal, the Appellate Tax Board ("Board") made the following findings of fact.
At all relevant times, the appellant was a resident of Massachusetts.  On September 10, 2008, the appellant filed a Massachusetts Income Tax Return for the tax year at issue.  On November 26, 2008, the Commissioner received the appellant's Application for Abatement and Amended Return for the tax year at issue.  By a notice dated February 16, 2009, the Commissioner denied the appellant's abatement application.  The appellant filed a Petition Under Formal Procedure with the Appellate Tax Board ("Board") by first class mail in an envelope postmarked April 17, 2009 and received by the Board on April 21, 2009.  On the basis of the foregoing facts, the Board found that it had jurisdiction to hear and decide the instant appeal.
The issue raised in this appeal is whether the appellant may deduct liquidated damages that he was required to pay for breaching a covenant not to compete.  The facts pertinent to the appeal are as follows. 
The appellant started working as an employee at Thomas Weisel Partners Group, LLC ("TWPG LLC" or "the LLC") in 1999 as a salesman in its Boston office.  In December of 2000, after serving as a salesman for almost two years, the appellant was invited to become a member of TWPG LLC by making a capital contribution and receiving in exchange a 0.5% interest in the LLC.  Over the course of the next few years, the appellant made additional capital contributions in exchange for greater interests in the LLC.  
TWPG LLC was operated as an LLC from its inception in 1998 through 2006, when its executive committee voted to convert the LLC into a publicly traded company.  In anticipation of the plan for an initial public offering (the "IPO"), a new corporation, Thomas Weisel Partners Group, Inc. ("TWPG, Inc." or "the corporation") was formed.  On February 7, 2006, the LLC merged into TWPG, Inc., and the LLC was thereby dissolved.  Immediately thereafter, TWPG, Inc. made its IPO of corporate stock.  
On February 7, 2006, the date of the merger and dissolution, the appellant's membership interest in TWPG LLC was converted into 152,816 fully vested shares of TWPG, Inc.  While the appellant's day-to-day job duties did not change as a result of the merger, the appellant, as of the date of the merger, began to receive W-2 wages consisting of a base salary and annual bonus.  In addition, he became eligible to participate in all employee retirement and benefit plans offered by TWPG, Inc. to its employees, including health and dental plans, 401(k), and short and long-term disability insurance.  
Also on February 7, 2006, and in connection with the merger and dissolution, the appellant signed three documents:  a Partners Equity Agreement (the "Non-Compete Agreement"); an Employment Agreement; and the Pledge Agreement.  All three agreements were signed by individuals who had been members of the LLC.  The Board found that the agreements were signed by TWPG, Inc. as the "Firm" and the former members in their individual capacity as employees and shareholders of TWPG, Inc., as demonstrated by the following language from the Non-Compete Agreement:  
In view of each Shareholder's importance to the Firm, each Shareholder hereby agrees that the Firm would likely suffer significant harm from such Shareholder's competing with the Firm during such Shareholder's Employment period (as defined in the Employment Agreement) and for some period of time thereafter.

Section 3.02(a), Non-Compete Agreement (emphasis added).  Under Section 3.08 of the Non-Compete Agreement, breaching the covenant would require the Shareholder to pay liquidated damages to the Firm.  Thus, "[a]s security for the timely payment of the Liquidated Damages," the appellant entered into a Pledge Agreement, whereby he pledged his shares of TWPG, Inc. as collateral for his potential obligation to pay liquidated damages pursuant to the Non-Compete Agreement.  Pursuant to the Pledge Agreement at B.1.(b), appellant had the option to pledge other collateral acceptable to the Board of Directors of TWPG, Inc., but he chose to pledge his shares of TWPG, Inc. stock.  
On April 9, 2007, after working for TWPG, Inc. for about fourteen months, the appellant gave notice to TWPG, Inc. that he would be terminating his employment.  On this same day, TWPG, Inc. sent a notice to the appellant acknowledging its receipt of his "termination of employment" and further reminding him of his continuing contractual obligations to TWPG, Inc. pursuant to the Employment Agreement, the Non-Compete Agreement and the Pledge Agreement.  The appellant's official date of termination was July 6, 2007.  
On July 9, 2007, the appellant began his employment at Deutsche Bank Securities, Inc. ("Deutsche Bank"), which was a "Competitive Enterprise" under the Non-Compete Agreement.  Therefore, the parties agreed, and the Board found, that the appellant breached the Non-Compete Agreement on July 9, 2007.  On that same date, TWPG, Inc. issued to the appellant a Liquidated Damages Calculation and Enforcement Notice ("Notice"), informing the appellant that liquidated damages in the amount of $1,146,120 were due and that payment of these damages would be satisfied by TWPG, Inc.'s sale of 66,804 pledged shares.  The Notice further informed the appellant that he would be receiving a federal tax Form 1099 showing the taxable capital gain on the forfeiture of these shares of stock and that the appellant would be responsible for paying the taxes on that capital gain.
On his original federal tax return, the appellant reported $1,131,748 as capital gain on the disposition of the forfeited shares of TWPG, Inc. stock, and he claimed a liquidated damages payment of $1,146,120 as a miscellaneous itemized "below the line" employee deduction subject to limitations in the Internal Revenue Code ("Code").  Accordingly, on his original Massachusetts return, the appellant claimed no deduction for the liquidated damages.  Thereafter, on his federal amended return, the appellant claimed that the damages payment was an ordinary and necessary business expense, an "above the line" deduction not subject to the limitations in the Code.  Accordingly, on his amended Massachusetts return, the appellant claimed that the payment of damages was a "trade or business expense of a partner."  Also on his amended return, the appellant now claimed that the liquidated damages were paid to TWPG LLC, not to TWPG, Inc., as he had reported on his original return.  When cross-examined at the hearing of this appeal, the appellant conceded that he had paid the $1,146,120 damages expense to TWPG, Inc., as TWPG LLC was no longer in existence on the date of his breach of the Non-Compete Agreement:  
Q:  Now, for the record, I want to identify what we are looking at is the abatement application/amended return for Massachusetts for the 2007 year.
Mr. MacLean, this document says liquidated damages was paid to the former partnership; that is not correct, isn't that true?
A:  If it was paid back at the time of the breach, it was after we had gone public.  So.
Q:  Just to clarify, that is incorrect?
A:  It appears to be.
Q: You paid liquidated damages to [TWPG] Incorporated?
A:   Yes.  That's correct.

The appellant further conceded that he did not receive a K-1 from TWPG LLC in 2007, and that the $1,146,120 was not his partner-share of TWPG LLC's losses.  Finally, the appellant testified that the only trade or business in which he was engaged during 2007 was his work as an employee of TWPG, Inc. and Deutsche Bank.  He stated that he was not in the trade or business of investing in partnerships or in any other trade or business during the tax year at issue.
The appellant argued that the Non-Compete Agreement was directly tied to his status as a member of TWPG LLC.  In support of this argument, the appellant pointed out that only LLC members were required to sign the Non-Compete Agreement, as it was specifically included in the Partners' Equity Agreement, not in the Employment Agreement that was signed by employees who had not been members of the LLC.  The appellant theorized that the loss of a former member of the LLC, who would be a key employee of the corporation, would potentially be damaging to the corporation and would thus decrease its value in the public marketplace, particularly if the former member joined a competing enterprise.  Therefore, the appellant contended, because the purpose of the Non-Compete Agreement was to preserve the value of the stock, he signed the Non-Compete Agreement in his capacity as a member of the LLC, rather than as an employee of the corporation.  The appellant further contended that the fact that the stock was pledged as security for a breach of the Non-Compete was evidence that the damages were incurred in connection with his status as a member of the LLC. Accordingly, he claimed that the liquidated damages that he paid pursuant to the breach of the Non-Compete Agreement were specifically tied to his status as a member of the LLC, rather than to his duties as an employee of the corporation, and therefore were expenses incurred in connection with his trade or business as a member of the LLC.      
The Commissioner countered that the liquidated-damages payment was attributable to the appellant being employed as a stockbroker of TWPG, Inc., because the Employment Agreement and the Non-Compete Agreement were both entered into on the date the LLC was dissolved and the appellant become an employee of TWPG, Inc.  Furthermore, while the Non-Compete was only included in the Partners' Equity Agreement, it was specifically tied to the so-called "Employment Period" with TWPG, Inc. and twelve months after the "Date of Termination" from TWPG, Inc.  Thus, the appellant's obligation to pay liquidated damages was triggered by his becoming an employee of Deutsche Bank during the twelve-month period from the Employment Period.  
On the basis of the evidence of record, the Board found that, on February 7, 2007, TWPG LLC was dissolved and no longer existed as of the moment immediately prior to the IPO.  Therefore, as of the IPO, when the appellant received the stock that he pledged as security for the damages at issue, the appellant was no longer a member of the LLC, because the LLC was no longer in existence.  Instead, on that date, the appellant became an employee of TWPG, Inc., as evidenced by his receipt of W-2 wages and his eligibility to participate in all employee retirement and welfare benefit plans.  
The Board further found that the appellant signed the Non-Compete Agreement - the breach of which triggered the obligation to pay liquidated damages - in his capacity as an employee of the new corporation, not as a member of the defunct LLC, and thus, his obligation not to compete was made to the new corporation, not to the LLC.  The appellant himself conceded that he did not receive a K-1 from TWPG LLC in 2007 and that the LLC was no longer in existence at the time of the breach.  Therefore, the Board found that the $1,146,120 was not the appellant's partner-share of TWPG LLC's losses.  Accordingly, the Board found and ruled that the liquidated damages were expenses paid in connection with the appellant's trade or business of being an employee of the corporation.
Based on its ruling that the liquidated damages were attributable to the appellant's employment with TWPG, Inc., the Board ruled that the appellant was prohibited from deducting them on his Massachusetts return pursuant to G.L. c. 62(a)(1).  Accordingly, the Board issued a decision for the appellee in the instant appeal.
OPINION
Massachusetts adjusted gross income includes some but not all of the deductions allowable under the Code.  G.L. c. 62, § 2(d).  Pursuant to G.L. c. 62, § 2(d)(1), a taxpayer may take "trade and business deductions," defined by Code § 62(a)(1) to include those deductions attributable to a trade or business conducted by the taxpayer, with the following caveat:  "if such trade or business does not consist of the performance of services by the Taxpayer as an employee." (emphasis added).  The only exception to the caveat for unreimbursed employee business expenses, G.L. c. 62, § 2(d)(2) provides that all federally deductible employee business expenses are deductible in Massachusetts by an employee "if such trade or business is to solicit, away from the employer's place of business, business for the employer."  This category of taxpayer is commonly referred to as an "outside salesperson."  Department of Revenue ("DOR") Directive 89-1 (citing Code § 162, Code § 67, and G.L. c. 62, § 2(d)(2)).  
The issue in this appeal is whether the liquidated damages were attributable to the appellant's trade or business of being a member in an LLC or to his performance of services as an employee.  Only if the expense were attributable to the appellant's business of being a member in the LLC would the expense be deductible.  See G.L. c. 62, § 2(d)(2).  In the absence of a finding that an employee is an outside salesperson engaged in solicitation while away from the employer's place of business, deductions for expenses incurred in connection with a taxpayer's employment are not permitted under § 2(d)(2).  See, e.g., Devine v. Commissioner, Mass. ATB Findings of Fact and Reports 2012-821, 835. 
It was undisputed that the appellant was an employee of TWPG, Inc. at the time that he was required to pay the liquidated damages.  The parties also agreed that the appellant paid the damages to TWPG, Inc., as the LLC was no longer in existence as of the date of the breach.  The parties, however, dispute the characterization of the appellant's receipt of the stock from which the liquidated damages originated, i.e., whether the appellant received the stock in connection with his status as a member of the former LLC or in connection with his performance of services as an employee of the corporation.  
In characterizing expenses, the United States Supreme Court has relied upon the "origin of the claim" test.  See, e.g., United States v. Gilmore, 372 U.S. 39, 48 (1963) (finding that the controlling test of whether an expense is "business" or "personal" is to consider the origin and character of the claim with respect to which an expense was incurred).  In reaching its determination that the appellant received stock as an employee of the corporation, the Board specifically relied on its findings that: (1) the LLC was no longer in existence as of the date when the appellant signed the agreements and the stock was issued to him; and (2) the appellant signed the agreements, including the Non-Compete Agreement, in his capacity as a shareholder of the new corporation.  Based on these findings, the Board ruled that the appellant received the stock in connection with his status as an employee.  Therefore, the liquidated-damages payment was properly considered an employee business expense which, pursuant to G.L. c. 62, § 2(d)(1), was not deductible on the appellant's Form 1 for the tax year at issue.  
Deductions are "a matter of legislative grace"; taxpayers thus have the burden of showing that they are entitled to any deduction claimed.  Indopco, Inc. v. Commissioner, 503 U.S. 89, 94 (1992).  Massachusetts allows only those itemized deductions of an employee who is an "outside salesperson."  G.L. c. 62, § 2(d)(2); Devine, Mass. ATB Findings of Fact and Reports at 2012-835; DOR Directive 89-1.  The appellant was not an outside salesperson, and therefore, his payment of liquidated damages is not an allowable deduction under § 2(d)(2).  Accordingly, the Board issued a decision for the appellee in this appeal.

 THE APPELLATE TAX BOARD



By:	_____	   ________________	       
 Thomas W. Hammond, Jr., Chairman 


A true copy,


Attest:				_____undefinedundefinedundefinedundefined___
	      Clerk of the Board

 See G.L. c. 58A, § 7 (when a petition is received by the Board after the specified time limit, the date of the postmark or other substantiating mark permitted by Rule of the Board shall be considered the relevant filing date).  

ATB 2014-51