Executives required to repay compensation as a result of a compensation clawback regulation, provision or policy should be mindful of certain tax consequences to the executive as a result of the repayment. As described below, the tax consequences will be different when repayment occurs in a year subsequent to the year of the original payment versus when payment and repayment occur in the same year, and with respect to the former, there is more than one avenue of tax relief available to the executive stemming from the repayment.
When an executive repays compensation in the same calendar year as the year in which it was paid, the repaid compensation will not be considered income for that year, and therefore, will not be subject to tax reporting for the executive. Thus, to the extent repayment occurs in the same year as the initial payment, for tax purposes it is as though the payment was never made.
By contrast, when an executive is required to repay compensation in any year subsequent to the year in which it was originally paid, the tax consequences are more complex since the IRS generally disallows amending a prior year’s tax return to exclude a recouped amount. Further, when repayment occurs in a subsequent tax year, the compensation subject to repayment will have already been subject to ordinary income tax recognition in the year it was originally paid, even if the amount subject to clawback is determined on a pre-tax basis. An executive may seek relief by treating the amount repaid as a miscellaneous itemized deduction in the year of repayment. However, such a miscellaneous itemized deduction is limited to 2% of the executive’s adjusted gross income and subject to phase-out at higher income levels, and would not reduce income for purposes of determining the executive’s alternative minimum tax (“AMT”) exposure.
Instead, depending on the facts and circumstances, an executive may be better off seeking relief under the “claim of right” doctrine under Code Section 1341. Under this doctrine, a taxpayer is entitled to either (i) a deduction from income in the year of repayment equal to the gross amount repaid, or (ii) a refundable credit in the year of repayment for any additional tax liability incurred by the taxpayer as a result of including the payment in gross income in the prior year, in either case, without being subject to either the 2% floor or the AMT. Section 1341 relief is only available if the executive had an apparent unrestricted right to receive the compensation in the year of payment, and it’s established in a subsequent year that there was not an unrestricted right. Whether there is an unrestricted right to the compensation requires a facts and circumstances test, but IRS and court rulings have been inconsistent in this area. As a result, it is unclear whether Section 1341 relief will always be available to executives facing a clawback. Further, Section 1341 relief is only available where the amount subject to recoupment exceeds $3,000 and is otherwise deductible under another Internal Revenue Code section (e.g., Sections 162 or 165).
Due to complexities and uncertainties of the tax treatment of recouped compensation, an executive should consult his or her tax and/or legal advisors in the event that he or she becomes subject to a clawback, to the extent the compensation isn’t otherwise repaid in the same tax year as the original payment.