Clawbacks – Tax Treatment and Tax Issues

1. Clawbacks – Tax Treatment and Tax Issues Rosina B. Barker Ivins, Phillips & Barker 1700 Pennsylvania Ave., N.W. Washington, DC 20006 (202) 662-3420 rbarker@ipbtax.com DC Bar Luncheon Program December 16, 2010 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

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 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 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 (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 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