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Personal Income Tax Implications Of Compensation Clawbacks

When publics funds were used to provide emergency financing to major financial institutions and automobile manufacturers during the Great Recession, details about executive compensation packages were thrust into the national spotlight. Public pressure and subsequent legislation caused many companies to adopt clawback policies that require employees to repay incentive-based compensation under certain circumstances. As the enactment and enforcement of such policies has become more prevalent, it is important for individuals to understand how clawbacks could affect them from a tax perspective.

When compensation is received by an employee in Year 1, and then repaid to the employer in Year 2 pursuant to a contractual clawback provision, those two payments are treated as completely separate transactions for income tax purposes. The payment received by the employee in Year 1 is taxed as compensation. The “books are then closed” at the end of the year. The Year 1 tax returns of the employer and employee cannot be amended for the purpose of addressing the clawback payment in Year 2. The Supreme Court addressed this issue in United States v. Lewis, when it ruled that the tax deduction associated with the repayment of a bonus received in a prior year must be claimed in the year of repayment, not the year the bonus was originally received.

Instead of amending the Year 1 returns, a clawback payment in Year 2 is deductible as a trade or business expense for the employee under Section 162. It should be noted that the Section 162 deduction offsets Year 2 income, the year in which the repayment was made. This is important if the employee’s marginal tax rate was greater in Year 1 than Year 2. In that scenario, the deduction does not allow the employee to fully recoup the tax paid in Year 1. The employee’s ability to recover previously paid tax is further mitigated by the fact that a Section 162 deduction is an itemized deduction, making it subject to certain limitations and Alternative Minimum Tax issues. However, many of these problems can be avoided if the employee qualifies for Section 1341 treatment.

If the employee qualifies, Section 1341 allows an employee who receives compensation in Year 1 and repays it in Year 2 to reduce the Year 2 tax liability by either taking the deduction discussed above, or claiming a credit equal to the amount of tax paid during Year 1 on the portion of compensation that was later repaid in Year 2. This effectively eliminates any “unfair” tax treatment created by year-to-year rate differences, itemized deduction issues, or AMT issues. Under certain circumstances, the employer and employee share of employment taxes originally withheld can be recouped as well.

Determining whether a taxpayer qualifies for Section 1341 treatment can be difficult. The tax law in this area is complicated because case law and IRS guidance surrounding qualification for Section 1341 have evolved inconsistently over the last fifty years. GBQ professionals are available to assist taxpayers with determining whether they qualify for Section 1341 treatment and understanding other income tax implications of compensation clawback situations.

Article Written by:
Ryan Chesnut, JD, CPA
Tax Senior

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