Compensation clawbacks, where employers recoup compensation, e.g., incentive bonuses, to rectify violations of rules or policies, have received much press since the Great Recession of 2008, and a number of well-publicized financial scandals, such as the J.P. Morgan “London Whale” incident. The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) (“Dodd-Frank”) dramatically increased the incidents of clawbacks, and, thus, the importance of their federal income tax treatment.
Under Dodd-Frank, as a condition to being listed on a U.S. stock exchange, every company must adopt a clawback policy. Such policy must provide that, in the event of any material restatement of financial statements, the company must recoup from every executive officer any performance-based compensation paid in the three-year period preceding the restatement, to the extent the compensation was based on erroneous data. These clawbacks must occur even in the absence of personal wrongdoing.
The basic rules are fairly straightforward.
- Recoupment in the Same Year as Payment Received. If the employer recoups compensation in the same year the compensation was paid, the original payment is completely disregarded, as if never paid. The amount of the recoupment is excluded from wages and gross income on IRS Form W-2. This exclusion applies regardless of whether the recoupment takes the form of a holdback from other compensation or a direct payment from the employee to the employer.
- Recoupment in a Year Subsequent to the Year of Payment. In this case, the IRS’ position is that the employee is not permitted to amend the prior year’s tax return to exclude the repaid amount from the prior year’s gross income. Neither may the employee net the repayment against the employee’s gross income for the year of repayment. According to the IRS, the employer must include the repaid amount in the employee’s gross income on Form W-2 for the year of repayment.
The employee may unwind the taxes already paid on the repaid compensation by claiming the repayment as an itemized deduction under Internal Revenue Code (IRC) Section 162 or 165(c)(1), subject, however, to the two percent (2%) floor for miscellaneous itemized deductions and the alternative minimum tax (as applied to the deduction). The two percent (2%) floor and the alternative minimum tax, though, may generally be avoided by claiming IRC Section 1341 (Claim of Right) treatment for the repayment, which is addressed further below. The treatment of holdback recoupments should be consistent with the treatment of direct repayments by the employee, but, somewhat surprisingly, there are conflicting precedents on this issue, as discussed below. Assuming the employer took a tax deduction for the original payment, the employer must report the repayment as income.
The tax analysis is more complicated in the following situations: (i) where clawbacks are enforced by being held back from payments of nonqualified deferred compensation; (ii) retroactive clawbacks are involved (i.e., clawbacks imposed on compensation paid before the clawback policy was adopted); (iii) clawbacks are imposed on former employees (for example, enforcement of a covenant not to compete); and (iv) clawbacks involve stock or other property compensation, which may have increased or decreased in value since the time of payment.
Two issues are currently receiving a lot of attention from tax practitioners and the IRS:
- IRC Section 1341 (Claim of Right). This is an important issue, because, as discussed above, this credit allows employees to avoid the two percent (2%) floor on miscellaneous itemized deductions, as well as the alternative minimum tax on the deduction. Section 1341 permits a taxpayer to claim a refundable credit on repayments in excess of $3,000 that are deductible under another IRC section if it “appeared” that the taxpayer had an unrestricted right to receive the payment, in the year of the payment. Revenue Ruling 68-153, 1968-1 C.B. 371, is pertinent in determining if the right to receive the payment was “apparent.” According to the Ruling, if there is uncertainty, as to the right to receive the payment, in the facts or in the law during the year of the payment, then the taxpayer “appeared” to have a right to the payment, and Section 1341 should apply; whereas, if the taxpayer was mistaken or if subsequent developments negated any apparent right to the payment, Section 1341 would not apply. Unless Section 1341 applies, the two percent (2%) floor and the alternative minimum tax apply. Accordingly, with the new prominence of clawbacks, under Dodd-Frank and well-publicized fraud cases, there is a real need for further guidance on the tax treatment of clawbacks, in general, and on the application of Section 1341 to various scenarios. In cases where clawbacks are imposed due to criminal misconduct, the “claim of wrong” doctrine may preclude Section 1341 treatment.
- Netting Clawbacks Against Compensation. When the recoupment occurs in a year subsequent to the year the compensation was received, there is a strong desire on the part of employees, in general, to net a clawback against compensation received in such subsequent year, reporting only the net amount on Form W-2. Again, the stakes are the two percent (2%) floor and the alternative minimum tax. Revenue Ruling 2002-84, 2002-2 C.B. 953 is supportive of a netting approach; whereas, General Counsel Memorandum 36851 and Private Letter Ruling 9103031 indicate that netting is not permitted. Clarification of the law is needed on this issue.