Clawbacks

1
Clawbacks Tax Treatment and Tax Issues
DC Bar Luncheon Program December 16, 2010

• Rosina B. Barker
• Ivins, Phillips Barker
• 1700 Pennsylvania Ave., N.W.
• Washington, DC 20006
• [phone]
• rbarker_at_ipbtax.com

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.
2
Whats a Clawback?

• Recoupment of compensation, traditionally upon
  violation of law, contract or company policy
• Sarbanes-Oxley Clawbacks
• CEO or CFO returns incentive-based compensation
  upon financial restatement caused by misconduct
  of the issuer
• No personal fault by CEO or CFO required
• Dodd-Frank Clawbacks
• Material financial restatement of issuer
• Recover from every current and former executive
  officer incentive compensation paid in three
  years preceding restatement
• Repayment measured as compensation not payable
  absent misstatement
• No-fault basis

3
What Do I Have to Think About?

• The basics
• Retroactive clawbacks
• Bad boy clawbacks
• 409A issues
• Other former employee issues
• Employer stock
• FICA

4
Repaying Compensation in the Same Year - Easy

• Repayment in same year as payment treated as
  if never paid
• Example
• 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

5
Repaying Compensation in Later Year - Hard

• Original payment
• Included in income in year of original payment
  claim of right doctrine
• Employee does not amend return for year of
  original payment
• Repayment tax treatment does not depend on
  repayment mode
• If held back from other compensation, reported on
  W-2 as wages and income
• Example
• 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

6
Minimizing Tax on Repaid Compensation

• Our example
• Employee receives 10 bonus in 2010, subject to
  income tax
• Employee repays 10 bonus in 2012, from after-tax
  income OR
• 10 withhold from employees 2010 compensation,
  reported on W-2 as wages and income
• Miscellaneous itemized deduction under section
  162 or 165(c)(1) in connection with employees
  trade or business of being an employee
• 2 floor
• Alternative minimum tax (AMT)
• Section 1341 claim of right deduction/credit
• No 2 floor
• No AMT

7
Minimizing Tax on Repaid Compensation Take 2

• Possible alternative approach
• 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

8
Section 1341 The Basics

• Section 1341 allows make-whole treatment of
  paid back amount
• Taxpayer gets better of
• Deduction for year of repayment (without 2 floor
  or AMT) or
• Credit equal to additional tax in year of payment
• Statute
• 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

9
Section 1341 IRS

• IRS old position subsequent events test
• Before Van Cleave v. US (Sixth Circuit, 1983)
• IRS new position facts-in-existence test
• 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 (taxpayers right only
  apparent)
• Problems with facts in existence test
• 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

10
Section 1341 Case Law

• Dominion Resources v. U.S., 219 F.3d 359 (4th
  Cir. 2000)
• 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
• Retroactive clawbacks
• Clawbacks triggered by breach of non-compete
  agreement

11
Retroactive Clawbacks Special Issues

• Some employers apply clawback policy to payments
  first made before policy put in place
• Deductible under section 162 or section
  165(c)(1)?
• Under unreasonable compensation cases
  possibly no
• Better answer these cases are distinguishable
• Section 1341 available?
• Under IRS facts-in-existence test, unclear
• Under Dominion Resources theory, probably yes

12
Bad Boy Clawbacks Special Issues

• Section 1341 available?
• IRS facts-in-existence test unclear
• Dominion Resources theory probably yes
• Claim of Wrong doctrine
• Applied only rarely, in egregious circumstances

13
409A and Other Former Employee Issues

• Repayments by former employees deductible?
• Yes
• Section 409A substitution rule
• Treasury Regulation 1.409A-3(j)(4)(xiii) - 5,000
  cap on acceleration of payment in satisfaction
  of debt of the service provider
• Example
• 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

14
FICA

• Claim of right doctrine does not apply
• Employer and employee can recoup FICA taxes
  withheld and paid (within three year statute of
  limitations)
• Use procedures under Code section 6413 for
  erroneous overpayments
• Use Form 941-x