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
(202)
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. What’s 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
Rosina B. Barker
December 16, 2010

3. What Do I Have to Think About?
The basics
Retroactive clawbacks
“Bad boy” clawbacks
409A issues
Other former employee issues
Employer stock
FICA
Rosina B. Barker
December 16, 2010

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
Same tax treatment when repayment made directly by check
Rosina B. Barker
December 16, 2010

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
Rosina B. Barker
December 16, 2010

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 employee’s 2010 compensation, reported on W-2 as wages and income
Miscellaneous itemized deduction under section 162 or 165(c)(1) in connection with employee’s “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
But see PLR
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 (taxpayer’s 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

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