Bonus Clawbacks Bring Complex Income Tax Consequences
Aug. 29, 2017
By Lisa M. Brooks, CPA, and Chan-Yu Wang, CPA
Paying off a bonus clawback for a new employee is not nearly as straightforward as it might seem, and can come with unexpected income tax consequences.
With the current consolidation environment in the financial services industry, many banks are in the process of creating new compensation arrangements. Increasingly, banks are pursuing individuals employed at other institutions who might be subject to bonus clawbacks. While the candidate may pay the clawback amount using personal funds, candidates often negotiate for their prospective employer to pay off the clawbacks. It can seem like a small price to pay for the bank in pursuit, but the income tax implications can significantly inflate the true cost.
Federal Income Tax Consequences to Employees
Departing employees might be required to pay back retention, signing, or other types of bonuses due to a clawback provision in their employment agreement. Unfortunately, it’s not as simple as merely writing a check to the former employer for the balance due, regardless of who actually pays. If the new employer writes a check, that amount is taxable to the employee. If the employee pays the clawback personally, the challenge is how to get a deduction for the repaid amount.
Say, for example, that an employee received a retention bonus in 2015. He or she would have paid income tax on the bonus that year, as well as Federal Insurance Contributions Act (FICA) withholding for Social Security and Medicare taxes. For this reason, the tax consequences become complicated for an employee who must pay a clawback, because the IRS does not allow a taxpayer to file an amended return to exclude the clawed-back bonus payment from the prior year tax return in which the original bonus amount was included in gross income. The employee typically cannot recover the taxes paid in the initial year, despite returning some of the income the taxes were paid on.
The Possible Scenarios and Their Tax Implications
Two tax scenarios can occur in these circumstances. In the first, the original bonus payment and the clawback repayment occur in the same calendar year. In this case, the payment is essentially treated as if it were never made. The repaid bonus is not considered income to the employee and therefore is not subject to tax reporting or withholding.
The more likely scenario, though, is that the bonus clawback repayment is made in a tax year subsequent to the original bonus payment, making the income tax consequences more complex.
The most likely outcome is that the repayment in a subsequent year will be deductible as a miscellaneous itemized deduction, subject to the 2 percent adjusted gross income (AGI) floor. To benefit from the deduction, the employee’s itemized deductions must exceed the standard deduction. If the employee can take only the standard deduction, he or she loses out on the deduction for the repayment. In addition, itemized deductions are subject to phase-out at higher income levels, and the repayment deduction cannot be considered when determining the employee’s alternative minimum tax (AMT) liability.
Some take the position that the claim of right doctrine of Internal Revenue Code (IRC) Section 1341 applies to the repayment in a subsequent year. Under the claim of right doctrine, the employee’s tax for the year of repayment is the lesser of either:
- The amount computed for the year of repayment with a deduction for the bonus repayment
- The tax for the year with no deduction for the repayment and a credit for the amount of tax paid on the bonus in the previous year
This option is only available if at the time and in the year that the employee included the bonus payment as income, the employee appeared to have an “unrestricted right” to it, but it is established in a later year that the right was not unrestricted after all. The IRS will apply a “facts and circumstances” test to determine whether the right to compensation appeared to be unrestricted. But it could be an uphill battle to assert the claim of right when an employee has signed a document saying, for example, that he or she would stay with the employer for a certain amount of time. The agreement to provide future services could be viewed as evidence that the employee did not have an unrestricted right to the compensation at the time it was received.
The following example can make the tax implications easier to understand:
An employee receives a $20,000 retention bonus in Year 1. The bonus must be paid back pro rata if the employee leaves the company before Year 5. The retention bonus was included on the employee’s Form W-2 and subject to all required withholdings (federal and state income tax and FICA) in the year of payment. The employee leaves at the beginning of Year 4 and must pay back $5,000.
If the employee directly repays the former company $5,000, the amount likely is deductible as an itemized deduction subject to the 2 percent of AGI floor. The employee can seek relief under the claim of right doctrine only if he or she establishes there was an unrestricted right to the retention bonus in the year of payment and, as described earlier, that may prove difficult.
If the new employer pays the $5,000 on his or her behalf (whether by paying the former employer directly or giving the employee the money to then pay his or her former employer) the treatment of the repayment is unchanged. However, the $5,000 will be included as income on the employee’s Form W-2 from the new company, and he or she will have to pay taxes on this amount on top of the taxes already paid back in Year 1 on the bonus he or she partially repaid.
Alternatively, the employee might ask the new employer to make him or her “whole” – requiring the employer to pay not only the $5,000 but also all related taxes so the employee is not out of pocket any cash. This scenario is particularly attractive to the employee. However, assuming the employee’s marginal federal and state income tax rate is 30 percent, increasing the payment to make the employee whole increases the employer’s cost from $5,000 to $7,000 – a 40 percent increase from the original amount. If FICA taxes also are factored in, the employer’s true cost can be even greater.
Proceed With Caution
When bonus clawbacks occur in a tax year subsequent to the original payment, the rules can be complex. In addition to income tax issues for the employee, new employers offering to fund the clawback directly must consider all related withholding taxes on the clawback amount. As a result, it’s imperative that employers know the full financial implications from the start.
In This Issue