EXECUTIVE PAY CLAWBACKS AND THEIR TAXATION.

• Author: Walker, David I.

1. INTRODUCTION 524 II. CLAWBACK PROVISIONS: SOURCES, DESIGN, AND RATIONALES 529 A. Clawback Legislation 529 1. SOX. 530 2. TARP 530 3. Dodd-Frank 531 B. Employer-Initiated Clawbacks 532 C. Clawback Rationales 534 1. SOX. 534 2. Dodd-Frank 535 3. Employer-Initiated Clawbacks 538 III. OPTIMAL CLAWBACK TAXATION 539 A. Overview of Compensation Taxation: What's at Stake? 540 B. Clawback and Clawback Tax Incidence 544 C. The Optimal Tax Treatment of Clawed Back Compensation 546 1. Clawback Rationales and Tax 546 a. Prevention of Unjust Enrichment 546 b. Reducing Financial Misreporting and "Bad Boy" 548 Behaviors c. Mitigating Excess Risk-Taking Incentives 549 2. Fairness, Dynamics Responses, and Other Considerations 550 a. Fairness 551 b. Adoption and Implementation of Clawback Regimes 552 c. Impact on Compensation Design 554 3. The Impact of Tax Gross Ups on the Optimal 557 Tax Treatment of Clawbacks IV. ACTUAL TAX TREATMENT OF CLAWED BACK COMPENSATION 559 A. Deductibility under I.R.C. [section][section] 162/165 559 B. Tax Treatment of Clawbacks Under I.R.C. [section] 1341 563 1. Section 1341 Overview 563 2. Section 1341 Requirements 564 a. Underlying Deductibility 564 b. Apparent Unrestricted Right 567 3. Further [section] 1341 Asymmetries 572 V. HOW WELL DOES ACTUAL CLAWBACK TAX TREATMENT 574 ACHIEVE OPTIMAL TAX TREATMENT? A. Unjust Enrichment 574 B. Deterring Financial Misreporting 575 C. Mitigating Excess Risk-Taking Incentives 576 D. Fairness 577 E. Dynamic Responses 577 VI. OTHER RESPONSES TO LIMITED DEDUCTIBILITY OF 578 CLAWBACK PAYMENTS A. Clawbacks of Deferred Compensation and 578 I.R.C. [section] 409A B. Claw back Holdbacks 581 VII. CONCLUSION AND THE ROAD AHEAD 583 I. INTRODUCTION

   Executive pay clawback provisions require executives to forfeit previously received compensation under certain circumstances, most notably after a downward adjustment to the financial results upon which their incentive compensation was predicated. Clawback provisions are on the rise. Limited clawbacks were mandated under the Sarbanes-Oxley Act of 2002 (SOX). (1) The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) mandated a much more comprehensive no-fault clawback regime, (2) and the SEC is in the process of finalizing rules to implement the Dodd-Frank clawback. (3) Meanwhile, the fraction of S&P 1500 companies proactively adopting clawback provisions more expansive than those mandated by SOX increased from less than 1% in 2004 to 62% in 2013, (4) and a recent report indicates that more than 90% of the 1000 largest companies have disclosed that they have adopted clawback policies of one sort or another. (5)

   This Article focuses on the federal income tax consequences of clawbacks, specifically on the tax treatment of repayments by executives in cases in which the compensation repaid has been included in taxable income in a prior year. This is surprisingly under-explored terrain, (6) particularly given that individual taxes can consume as much as 50% of executive compensation.

   Imagine the following scenario. In 2019, Executive receives a $1 million cash bonus based on the Company's achievement of a certain earnings target. In 2020, the Company restates and reduces 2019 earnings. Based on the restated earnings, Executive would have been entitled to a $700,000 bonus for 2019, and under the Dodd-Frank claw-back regime, the Executive is required to repay $300,000 to her Company. Assuming that the Company was able to deduct the payment in 2019, it will be required to include the repaid amount in taxable income for 2020. Executive will have included and paid tax on $1 million of compensation in 2019. Should she receive a deduction in 2020 for the $300,000 repayment? Should the answer depend on whether Executive signed off on the 2019 earnings figure? On whether Executive "cooked the books" herself or enlisted an underling to do so? What if a deduction is allowed but, due to various limitations discussed below, fails to make Executive whole for the taxes incurred on the repaid compensation? Should additional relief be available?

   These are very real, and with implementation of the mandatory, no-fault, Dodd-Frank clawback looming, likely soon to be very pressing issues. This Article considers these questions, focusing first on what the tax rules optimally should be. I conclude that optimally executives should be made whole for taxes paid on compensation that is subsequently repaid as a result of a clawback provision. This result is dictated most strongly if the underlying rationale for clawbacks is prevention of unjust enrichment and/or facilitating the management of executive risk-taking incentives. If the primary goal of clawbacks is to minimize the payoffs to and thus the amount of financial misreporting, one could argue that deductibility of clawback repayments is unnecessary and possibly even counterproductive. Even in this case, however, the risk of mistake and false positives weighs in favor of refunding previously paid tax. (7)

   But there are other reasons to prefer a clawback tax regime providing full recovery of tax paid on compensation that is subsequently returned. First, a full tax offset approach will provide consistent tax treatment of executives irrespective of their decision to defer compensation and tax and will avoid punishing innocent executives forced to repay compensation under no-fault clawback regimes. Second, executives and firms are less likely to voluntarily adopt comprehensive and meaningful clawback provisions, or to fairly enforce mandatory clawback obligations, if the tax treatment is asymmetric; that is, if taxes are not fully refunded when compensation is repaid, and to the extent that taxes are not fully refunded, we can expect that executives will demand to be compensated for the tax risk. (8) Third, whether mandated or voluntarily adopted, the existence of clawback provisions may distort the design of executive pay, and asymmetric tax treatment of repayments may amplify those distortions. When these additional effects are considered, the case for refunding becomes stronger, whatever the rationale for clawback adoption. (9)

   How does present tax law match up? It's complicated, but in a nutshell, repayment of clawed back compensation generally should be deductible by executives as ordinary and necessary business deductions under I.R.C. [section] 162 or as business losses under [section] 165. But basic deductibility is only one part of the equation. The [section][section] 162/165 deduction for clawed back compensation is a miscellaneous itemized deduction (MID). Prior to 2018, MIDs were deductible only to the extent that they exceeded 2% of AGI, were not deductible for purposes of the alternative minimum tax, and were, along with other itemized deductions, phased down for high income taxpayers under I.R.C. [section] 68. As a result, a deduction for compensation repaid was unlikely to make an executive whole for taxes paid on that compensation in prior years. The basic deductibility picture became clearer, but much worse, with the passage of the Tax Cuts and Jobs Act (TCJA). Under that legislation, MIDs are simply not deductible for tax years 2018 through 2025. So, as far as we have gone, there would be no effective deduction for compensation clawed back in any of the next several years. (10)

   But that brings us to I.R.C. [section] 1341, a provision that can make taxpayers whole for repayments of amounts received under a "claim of right" that are later repaid. When it applies, [section] 1341 provides a non-miscellaneous itemized deduction (still deductible under the TCJA) equal to the value of the current year deduction under [section][section] 162/165 or, if more valuable, a tax credit equal to the reduction in tax in prior years that would have occurred had the recouped compensation never been included in income in the first place. (11)

   The bottom line here is that [section] 1341 could be applied to executive pay clawbacks to get to the right result, or close to the right result, in most cases. However, there is a significant risk that it will be applied in such a way as to bar recovery in an excessive number of cases. Ideally, Congress or the Treasury would amend [section] 1341 or the regulations thereunder to make it clear that executives should be made whole for taxes paid on clawed back compensation, but this may be unlikely in the present environment. Moreover, there is a concern about optics. Allowing deductions for repaid compensation, particularly in cases in which the executive doing the repaying is at fault, looks like a tax subsidy for bad behavior. It isn't a subsidy, but if clawbacks become frequent and if executives succeed in employing [section] 1341 to recoup the tax paid on clawed back compensation, it would not be surprising if one or more members of Congress proposed legislation to bar such deductions. Perhaps the best we can hope for is that the courts will construe [section] 1341 liberally to allow deduction and that Congress and the Treasury will do nothing.

   The remainder of the Article is organized as follows. Part II provides an overview of clawback provisions, including existing and forthcoming legislatively mandated clawbacks as well as provisions that companies have voluntarily adopted. This Part highlights a shift from clawbacks apparently aimed at deterrence of financial misreporting to prevention of unjust enrichment. Part III considers from several perspectives how clawback payments should ideally be taxed and concludes that the optimal regime would allow executives full recovery of taxes previously paid on returned funds. Part IV explores the current taxation of clawed back compensation. It argues that full recovery of taxes previously paid on clawed back compensation should be available under I.R.C. [section] 1341 for executives who are not culpable, but that there is a great deal of uncertainty, including uncertainty resulting...