The Securities and Exchange Commission (“SEC”) released a proposed rule on July 14, 2015 that will require publicly traded companies to create and enforce a clawback policy (called a “recovery policy” by the SEC) to recover incentive-based compensation (“IBC”) paid to executives for specific metrics for which the company has to issue revised financial statements because those metrics were overstated. While the rule is discussed in more length in a previous post, this blog post discusses two tax issues that companies and executives should be aware of when creating a clawback policy. The first issue arises if a company’s recovery policy were to provide for clawback from nonqualified deferred compensation before it becomes payable, which could result in a significant tax penalty on an affected executive under Section 409A of the Internal Revenue Code. The second issue arises when an executive has already paid taxes on the IBC, as the rule requires the clawback be equal to the bonus amount pre-tax, not the amount that the executive netted from the bonus.

Section 409A generally does not allow the payment of deferred compensation at times other than upon certain events specified in the statute (separation from service, disability, or death) or on a fixed date. Acceleration of payment is generally prohibited. Under the existing Section 409A guidance, the ability of a company to clawback IBC from deferred compensation that is not yet payable generally would violate the anti-acceleration rule of Section 409A, potentially triggering severe tax consequences for affected executives. Companies should draft their recovery policies so that clawback will come from sources other than deferred compensation subject to the anti-acceleration rule of Section 409A.

The second issue arises when the executive has already paid taxes on IBC, but the amount to be recovered is on a pre-tax basis. The executive generally should be able to claim the clawback repayment as a miscellaneous itemized deduction in the year of the repayment. However, there will be instances where the tax benefit from this deduction will not completely offset the amount of additional taxes incurred in the year the IBC was received (e.g., when the executive’s tax rate is different in the year of receipt of the IBC than the year the clawback takes place and due to limitations on miscellaneous itemized deductions). While Section 1341 generally provides relief in the situation where the deduction in the year of repayment does not fully compensate a taxpayer for the additional taxes previously paid on such repaid amount, tax practitioners are skeptical that Section 1341 will always be available to executives in these situations. This issue likely will not affect how companies draft their policies; rather, it will inform how executives make financial and tax decisions, particularly given that executives will generally have to make the clawback repayment of (and therefore will generally be “out of pocket” for) the full pre-tax amount of the bonus before realizing any tax benefits from the repayment.