Clawbacks – Tax Treatment and Tax Issues
DC Bar Luncheon Program
December 16, 2010
IRS Circular 230 Disclosure: IRS regulations require us to
advise you that any tax advice contained herein was not
intended or written to be used and cannot be used for the
purpose of avoiding federal tax penalties.
Rosina B. Barker
Ivins, Phillips & Barker
1700 Pennsylvania Ave., N.W.
Washington, DC 20006
(202) 662-3420
[email protected]
What’s a Clawback?
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Recoupment of compensation, traditionally upon violation of law, contract or company policy
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Sarbanes-Oxley Clawbacks
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CEO or CFO returns incentive-based compensation upon financial restatement caused by misconduct of
the issuer
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No personal fault by CEO or CFO required
Dodd-Frank Clawbacks
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Material financial restatement of issuer
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Recover from every current and former “executive officer” incentive compensation paid in three years
preceding restatement
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Repayment measured as compensation not payable absent misstatement
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“No-fault” basis
Rosina B. Barker
December 16, 2010
2
What Do I Have to Think About?
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The basics
Retroactive clawbacks
“Bad boy” clawbacks
409A issues
Other former employee issues
Employer stock
FICA
Rosina B. Barker
December 16, 2010
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Repaying Compensation in the Same Year - Easy
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Repayment in same year as payment – treated as if never paid
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Example
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$100 bonus - $10 held back = $90 reported as wages and income on W-2
Couch v. Commissioner, Russel v. Commissioner
Revenue Ruling 79-311
Same tax treatment when repayment made directly by check
Rosina B. Barker
December 16, 2010
4
Repaying Compensation in Later Year - Hard
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Original payment
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Repayment – tax treatment does not depend on repayment mode
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Included in income in year of original payment – “claim of right” doctrine
Employee does not amend return for year of original payment
If held back from other compensation, reported on W-2 as wages and income
Example:
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$10 clawback held back from $100 compensation otherwise payable
Paycheck after holdback = $90
W-2 income and wages = $100
Tax treatment same as if employer pays $100 salary, employee pays clawback
by writing $10 check to employer
Rosina B. Barker
December 16, 2010
5
Minimizing Tax on Repaid Compensation
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Our example:
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Miscellaneous itemized deduction under section 162 or 165(c)(1) in
connection with employee’s “trade or business” of being an employee
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Employee receives $10 bonus in 2010, subject to income tax
Employee repays $10 bonus in 2012, from after-tax income OR
$10 withhold from employee’s 2010 compensation, reported on W-2 as wages
and income
2% floor
Alternative minimum tax (AMT)
Section 1341 “claim of right” deduction/credit
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No 2% floor
No AMT
Minimizing Tax on Repaid Compensation – Take 2
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Possible alternative approach
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Repayment via hold back is excludable from wages income
Arguable theoretical support in section 162 “unreasonable compensation”
cases
See also Revenue Ruling 2002-84
But see PLR 9103031
Issues under doctrine of consistency
Risk is on employer – possible under-withholding
Section 1341 – The Basics
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Section 1341 allows “make-whole” treatment of paid back amount
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Taxpayer gets “better of”
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Deduction for year of repayment (without 2% floor or AMT) or
Credit equal to additional tax in year of payment
Statute
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Repayment over $3,000
Deductible under another Code section
It appeared that taxpayer had unrestricted right to payment in year of payment
Established after the close of the year that taxpayer did not have right to
payment
Section 1341 – IRS
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IRS old position: subsequent events test
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IRS new position: facts-in-existence test
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Before Van Cleave v. US (Sixth Circuit, 1983)
Section 1341 applies if, under facts in existence at time of payment, taxpayer
had no right to payment – even if facts not known until later date
Difference between “actual” and “apparent” right
Example: section 1341 should apply to Dodd-Frank clawbacks of bonuses first
paid after clawback policy in place (taxpayer’s right only “apparent”)
Problems with facts in existence test
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“Retroactive” clawbacks (applied to amounts paid before policy in place)?
Clawbacks triggered by breach of non-compete agreement
In both cases, IRS might say right to original payment was “actual” - section
1341 does not apply
Section 1341 – Case Law
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Dominion Resources v. U.S., 219 F.3d 359 (4th Cir. 2000)
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Rejects IRS distinction between “real” and “apparent” right to income
Both are apparent – an “actual” right includes an “appearance that happens to
be true”
Section 1341 applies to a repayment arising from the “circumstances, terms
and conditions of the original payment”
That is, section 1341 applies if original payment made because of specified
conditions or assumptions, repayment made because assumptions and
conditions not satisfied
Should allow section 1341 for clawbacks when IRS facts-in-existence test
raises doubts
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Retroactive clawbacks
Clawbacks triggered by breach of non-compete agreement
Retroactive Clawbacks – Special Issues
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Some employers apply clawback policy to payments first made before
policy put in place
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Deductible under section 162 or section 165(c)(1)?
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Under “unreasonable compensation” cases – possibly no
Better answer: these cases are distinguishable
Section 1341 available?
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Under IRS facts-in-existence test, unclear
Under Dominion Resources theory, probably yes
Bad Boy Clawbacks – Special Issues
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Section 1341 available?
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IRS facts-in-existence test – unclear
Dominion Resources theory – probably yes
“Claim of Wrong” doctrine
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Applied only rarely, in egregious circumstances
409A and Other Former Employee Issues
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Repayments by former employees deductible?
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Section 409A – substitution rule
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Yes
Treasury Regulation 1.409A-3(j)(4)(xiii) - $5,000 cap on acceleration of
“payment” in satisfaction of debt of the service provider
Example:
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$100,000 bonus – subject to clawback
$500,000 parachute payment that is nonqualified deferred compensation
Employee pays only $400,000, holds back $100,000 as clawback of bonus
Permitted under section 409A because entire $500,000 included in income and
wages under Revenue Ruling 79-311
FICA
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Claim of right doctrine does not apply
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Employer and employee can recoup FICA taxes withheld and paid (within
three year statute of limitations)
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Use procedures under Code section 6413 for erroneous overpayments
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Use Form 941-x