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Bonus Clawbacks: Tax and Financial Planning Issues

No one wants to face the possibility that their compensation may be clawed back. The complex tax aspects of the situation only serve to rub more salt in the wound.

The practice of “clawing back” compensation has drawn media attention several times in the past few years. In the wake of American International Group’s government bailout, many of its executives returned bonuses. The insurer subsequently adopted a new clawback policy, largely to counter the public perception that maintaining executive compensation at all costs was a top priority for the insurer.

One of the most prominent examples of clawbacks more recently was JPMorgan Chase’s reaction to the “London Whale” scandal, which caused the bank to suffer $6 billion in trading losses in 2012. The London-based employees who were responsible for the trading losses were fired and faced clawback of their compensation. In addition, the bank’s chief investment officer, Ina Drew, gave up two years of salary and ultimately chose to retire.

While few executives will have to face London Whale-sized fiascos in their careers, the legal landscape and public sentiment have pushed more companies toward including clawback provisions for their executives and other high-level officers.

The Regulatory And Legal Landscape

Following the Great Recession of 2008, extensive new financial regulations have come into play, including provisions related to clawbacks. These regulations are part of the reason that many more individuals may encounter clawback provisions in employment contracts or offers than was previously the case. Though the regulations generally apply only to public companies, many smaller, private companies have also instituted policies reflecting these new norms.

However, clawback policies have a legal history that extends well before 2008. An early manifestation of the trend appeared in the Sarbanes-Oxley Act, passed in 2002 in response to several accounting scandals that caused the collapse of major companies, the most prominent of which were Enron and Tyco. The law set new standards for corporate boards and and public accounting firms. One provision allows the Securities and Exchange Commission to force a public company’s chief executive officer or chief financial officer to disgorge executive compensation earned within a year of misconduct that was “deliberate” or “reckless.” While the SEC has only rarely attempted to use the ability to claw back executive compensation, the threat of expensive and time-consuming lawsuits has forced many companies to adopt tighter financial reporting standards.

Sarbanes-Oxley also set the stage for the Emergency Economic Stabilization Act of 2008. The law, better known as the government bailout of the financial system, was passed in response to the subprime mortgage collapse that triggered the global financial crisis that year. Companies that sold assets directly to the Treasury were explicitly given authority to claw back senior executive bonuses or incentive pay based on earnings or other data that later proved inaccurate.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in 2010, extended clawback provisions even further. Dodd-Frank forbade national stock exchanges from listing any publicly traded company that did not develop and adopt a clawback policy. Unlike Sarbanes-Oxley, Dodd-Frank did not confine its requirements to CEOs and CFOs, instead including “any current or former executive officer.” The law expanded SEC authority and extended the exposure period from one year to three.

In addition to this legislative framework, a variety of court cases have dealt directly with the complications clawback policies can create. Though clawbacks as we know them today were rare in the 1960s, they were not unheard of. Flagg Grain Co., Inc., included a provision in its contracts for officers and directors, stipulating that in the event the Internal Revenue Service determined that any of their salaries were excessive, officers would pay the difference back to the corporation. This is precisely what happened in 1963. George Blanton, the company’s secretary treasurer, then tried to claim a deduction on his income tax for the $3,600 he repaid. In Blanton v. Commissioner, the Tax Court found that he could not claim such a deduction under Section 1341 of the tax code. Blanton v. Commissioner also serves as a reminder that not all clawbacks result from misconduct.

A 1983 case, Van Cleave v. United States, further dealt with the tax treatment of returned compensation. Eugene Van Cleave, the president of the Van-Mark Corporation, honored a requirement in his company’s by-laws that he pay back any portion of his compensation that the IRS found excessive. Again, the IRS initially disallowed an attempt to use Section 1341 in computing tax liability. Though the district court characterized Van Cleave’s payback as “voluntary,” meaning he would be ineligible for relief under section, the appellate court did not agree and held that Section 1341 was applicable in Van Cleave’s situation. Van Cleave, unlike Blanton, received a deduction for the amount he repaid.

The IRS’ position in Revenue Ruling 79-311 has weighed heavily on later cases involving returned compensation. The ruling centered around two employees (designated in ruling as “A” and “B”) who received advances for unearned commissions. Employee A resigned before the end of the tax year and repaid all of his unearned advances by December 31 (“Year 1.”) Employee B resigned shortly after the end of Year 1. Employee B repaid the compensation received in Year 1 during Year 2. The IRS ruled that Employee A was able to exclude the commissions from his gross income, and thus would not be subject to taxes on the returned amount. However, Employee B had to include the advances in his income in Year 1 and then had to claim a deduction for the amount he repaid on his tax return in Year 2. This situation created a disadvantage for Employee B because he could only receive a benefit if he had itemized deductions, and because his deduction could be limited.

As the above cases illustrate, clawbacks are not new. They are, however, newly popular. Where does that leave the employee who must deal with the financial implications of repaying compensation?

Tax and Financial Planning Considerations for Clawed-Back Compensation

In the worst-case scenario, where compensation must be returned or relinquished, you should keep several aspects of the transaction in mind.

One immediate concern, and one of the most complicated issues, is the way in which income tax is handled in a clawback situation. The extent to which you can recover taxes paid on income subject to a clawback provision varies based on the facts and circumstances of each taxpayer’s case. Some factors that make a difference include: whether the clawback occurs in the same year as the original compensation; whether the clawback is retroactive or applies to future compensation; whether the clawback is triggered by a breach of contract, financial restatements or other action; and whether the taxpayer is a current or former employee of the company. It also matters whether the clawback is due to a government process, such as a court order, and to what extent the IRS recognizes it as mandatory.

The simplest situation from the taxpayer’s point of view is when the clawback occurs in the same year as the original compensation was paid. As illustrated in Revenue Ruling 79-311 in the case of Employee A, the taxpayer should exclude the original payment from wages and gross income in this case, as if it were never paid. For clawbacks affecting future or deferred compensation, the treatment is also likely just as simple, since the employee never received the payments. However, these scenarios are relatively uncommon.

More often, compensation is clawed back from a previous year. In this case, it is likely the executive has already paid income tax on the compensation in question. The cleanest way to correct this issue would be to amend your return and exclude the amount that was repaid from income. However, you are only allowed to amend your return to correct mistakes, and the IRS does not generally recognize clawbacks as such. The accounting in our tax code is calendar based, and the IRS contends that items that happened in different tax years should not be used to offset one another. This feature of the tax code is codified in the legal concept called the “claim of right doctrine.”

The claim of right doctrine holds that taxpayers generally must report income in the year they obtain an unrestricted right it, even if there is a contingency that could require them to repay the income later. If they are required to repay the income, they can seek a deduction or credit at time of repayment. IRS Publication 525 outlines how repayments are treated for purposes of claiming a deduction or a credit. For amounts less than $3,000, the taxpayer can claim an itemized deduction. For amounts greater than $3,000, the taxpayer has the option of choosing a deduction for the repaid amount or a credit in the year of repayment, if the amount was included in income as a result of a claim of right. The latter approach is known as a Section 1341 deduction.

If the taxpayer in question is still an employee, the company will sometimes withhold the clawback from future compensation instead of requiring the employee to return past compensation. In these circumstances, the income’s tax treatment is not entirely consistent. The logical approach when the repayment is withheld from income paid in a year following the original year of compensation is to apply Revenue Ruling 79-311, and report the held-back income in wages. The employee can then claim a deduction for relief.

For example, assume Bob’s 2013 salary was $1 million, but he found himself subject to the clawback of a bonus from 2011 in the amount of $250,000. Bob will still report wages of $1 million in 2013, even though the company only pays him gross income of $750,000 after the clawback. In this case, Bob would need to try to claim a miscellaneous itemized deduction for the $250,000 difference in order to make sure he does not overpay his income tax.

However, in cases like Bob’s, the IRS and the courts have arrived at different conclusions in the past. In some circumstances, the taxpayer was not required to include the unpaid, clawed-back amount in income, because it was determined that, based on the facts and circumstances of the case, the taxpayer had no repayment liability. Excluding the clawback from income is preferable to claiming it as a deduction, since the deduction in this case is subject to the 2 percent floor and phaseouts, such as Pease limitations, which reduce itemized deductions when a taxpayer’s income exceeds certain thresholds. Also, taxpayers who are subject to the Alternative Minimum Tax (AMT) may receive no benefit from a miscellaneous itemized deduction. Claiming a deduction, rather than excluding the clawback from gross income in the first place, could leave the taxpayer less than whole.

In some cases, the IRS allows taxpayers to claim relief under Code Section 1341 for disparate tax outcomes caused by treatment of compensation repayments. Section 1341 provides relief in certain situations for years in which the deduction of repayment is worth less than the extra taxes originally paid, as well as in cases where the AMT means taxpayers would not receive the benefit of their miscellaneous itemized deductions. In cases where the taxpayer has culpability for the trigger that caused the clawback, such as willful wrongdoing or violation of a contract, it is less likely that the IRS or a court will support the use of Section 1341.

In addition to income tax, Federal Insurance Contributions Act (FICA) taxes may also be a concern for executives who must return compensation. Gross wages are subject to withholding for Social Security and Medicare taxes, which have a three-year statute of limitations. If the employee returns compensation originally paid as wages during that window, the company must presumably repay him or her for the employment tax overpayment. Alternately, the company might reduce future employment tax withholding instead, until it makes up the difference.

Recommendations

Executives should be aware of the increasing prevalence and reach of clawback policies as they consider and negotiate contracts for new positions. It is worth taking the time, at a minimum, to make sure you thoroughly understand the company’s position. To go further, consider requesting that the company reimburse any additional taxes incurred on clawed back compensation, such as income tax or FICA taxes. You may also want to stipulate that all clawbacks be demanded in writing, with language that makes it clear they are not voluntary (and thus unqualified for the benefits of Section 1341).

Should you find yourself subject to a clawback that is not as straightforward as repaying compensation in year of receipt, it may be wise to engage your accountant to prepare a tax opinion letter detailing how you have decided to handle the tax issues inherent in the situation and the justification in tax law for doing so.

Even after you receive a tax opinion letter, you may still find it advisable to seek a private letter ruling from the IRS. Taxpayers request these rulings in order to obtain approval for positions that they plan to take on their returns. While you have no guarantee that the IRS will issue a ruling to you, it can be worth the effort to try if the amount at stake is substantial.

No one wants to face a clawback, and most people will never need to. However, keeping in mind the variables at play can help you prepare for the worst-case scenario and keep the impact as contained as possible.

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