Giving Back Bonuses: Easy; Getting Tax Deductions ...

1 Giving back bonuses : Easy; Getting Tax Deductions : PricelessBy Robert W. WoodThe newspapers are full of stories about executivesrepaying bonuses . In fact, there are so many of themunder discussion today that it is difficult to know who isrepaying what and why. There are calls for supertaxationof bonuses , new caps on bonuses , mandatory bonusrepayments, voluntary bonus repayments, and variouscombinations of those things. In a climate of near (butunderstandable) hysteria, few seem to be discussing taxlaw, which seems downright feel-good news came when New York s Attor-ney General, Andrew Cuomo, announced that 15 of thetop 20 recipients of AIG retention bonuses (about $50million worth in all) have agreed to give back press coverage isn t clear on howvoluntary or compulsory that was, Cuomo s commentssuggest that the givebacks were entirely voluntary.

2 Inter-estingly,The Wall Street Journalnoted that in making thedecision whether to remit, some of those individualswere concerned about the potential tax implications ofreturning money practitioners won t findthat fact, what is surprising is that amid all the hubbub,there s been so little mention of this issue. After all, muchof the brouhaha started with the payment of bonuses thateveryone knows are tax deductible. The biggest catalystfor the bonus repayment mess was the discovery thatmany companies on the receiving end of enormousgovernment bailouts were, at around the same time,paying out bonuses to some of the same people whocaused the problems requiring the bailout.

3 Of course, thebailout money was all tax were even tax rules released by the IRS on theheels of the bailouts. The IRS issued rules (incrediblyquickly, mind you, which is no mean feat for the IRS)addressing how bailed-out companies would be treatedfor purposes of net operating losses on the receipt ofbailout money. And much of the focus on how to preventthis sort of thing from ever happening again has beencentered on the tax code. We turn to the tax code, itseems, to change this considerable focus on the tax law, it seems alittle strange that few appear to be considering exactlywhat happens from a federal income tax perspectivewhen someone returns compensation they received.

4 Likeso much else in the tax law, it is a far more complexproblem than one might think. Dollars in and dollars outsounds simple, but untangling the mess for the execu-tives who return money is going to be a PaybackWhatever the factual setting, a repayment of cashcompensation raises interesting and fundamental taxquestions. For example, does the code allow the undoingof a prior transaction? If so, how does that square withannual accounting, which is one of the underpinnings ofour tax system? If you give back compensation (volun-tarily or not), can you be made whole via a tax deduc-tion? If a deduction is warranted, what is its timing andcharacter?

5 Suppose an executive received a $10 million cashbonus in 2008, on which state and federal income taxeshave been withheld, along with Social Security and otherpayroll taxes. Suppose the executive gives it back in 2009,either voluntarily or under some kind of program. Doeshe just give back his net check after all those Deductions ?That might seem a reasonable approach if the execu-tive were repaying compensation, because that is all hereceived. But withheld income taxes were credited to hisaccount with the IRS. If a court or administrative orderdirects the repayment or even if a repayment provision ina contract is triggered, the true payment to the executivewas $10 million. However, the payment was more thanthat when you consider the employer s portion of payrolltaxes.

6 The taxes withheld are credited to the executive sincome tax obligations and Social Security account, and itmay be his problem to get them back . The company mayoffset tax amounts, but it is probably not obligated easiest scenario to address is one in which thecash bonus and the giveback occur in the same year. Thatseems rare, however. The majority of bonus repaymentsdo not occur in the year of payment. That means therepaying executive, whether he must return the entirebonus or only some net number after Deductions , has a1 SeeRappaport and Pleven, AIG Employees Will ReturnAbout $50 Million of bonuses , The Wall Street Journal, Mar. 24,2009, p. W.

7 Wood practices law with Wood & Porterin San Francisco ( ). He isthe author ofTaxation of Damage Awards and SettlementPayments(3d ed. 2008) andQualified Settlement Fundsand Section 468B(2009), both published by the TaxInstitute and available at discussion is not intended as legal advice, andcannot be relied on for any purpose without theservices of a qualified 2009 Robert W. rights notes TAX PRACTICETAX NOTES, April 13, 2009185(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party problem. He has previously included in income(probably as wages) an amount he is now returning andwants to is probably necessary to know whether the repay-ment is voluntary.

8 As we shall see, a repayment moti-vated by altruism, shame, or patriotism may be moreadmirable, but it may yield a bleaker tax outlook. Anexecutive who gives back a bonus when a law, courtorder, or administrative decree requires it runs an easiertax gantlet, although even that does not guarantee a rosy(or even just) tax posture. For the most part, we ll assumethe executive can make a case that hehadto give back abonus, although that may not be a reasonable assump-tion in some of Right IssuesIn considering the tax ramifications of paying backcompensation, there are several possibilities. It may bepossible for the payer to claim a deduction under section1341 for restoring an amount held under claim of claim of right doctrine requires a taxpayer to pay taxon an item of income in the year in which he received itunder a claim of right, even if it is later determined thathis right to the item was not absolute and that he isrequired to return rule is based on the propositionthat because the taxpayer has the free and unfettered useof funds from the time of receipt, the tax year in whichthat receipt occurs is the appropriate time to fix the taxliability.

9 That is a manifestation of the annual accountingprinciple on which our tax system is claim of right doctrine allows the taxpayer todeduct the repayment amount from his income in theyear of repayment (as opposed to deducting the amountin a prior year). That result was mandated by theSupreme Court, because income and Deductions aredetermined on an annual course, annual ac-counting often results in a mismatch. The taxpayer maybenefit less from the deduction in the year of repaymentthan if he had been able to deduct the amount repaid inthe year of receipt. That may be the case when thetaxpayer was in a higher tax bracket in the year of receiptthan in the year of , that sounds quite nice, but section 1341is not simple.

10 Under it, a taxpayer who previouslyreported income under a claim of right may be able tolater deduct the repayment in a subsequent year (butonly if the amount restored is greater than $3,000). Asection 1341 deduction usually provides a better resultthan a deduction under other code sections because itattempts to place the taxpayer in the position he wouldhave been in had he never received the income. Fre-quently, other Deductions can be subject to limitations,phaseouts, floors, and so must meet several requirements to obtain adeduction under section 1341. First, the taxpayer musthave included the item in gross income in the prior yearbecause he had an unrestricted right to the item.