Tax relief for executive compensation clawbacks under proposed Dodd-Frank rules.

• Author: Casten, David B.

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Sec. 1341 is designed to be a relief provision that allows a taxpayer who receives income in one year and repays or refunds it in a later year to be in the same income tax position as having not received the income at all. Since Sec. 1341 became a part of the Code in 1954, its application has been subject to numerous limitations as a result of administrative and judicial interpretation.

On July 1, 2015, the SEC issued proposed rules directing national securities exchanges and associations to establish listing standards requiring companies to adopt policies that require executive officers to pay back incentive-based compensation that the companies awarded those officers erroneously. (1) These are generally referred to as clawback policies. The proposed rules are required under Section 10D of the Securities Exchange Act of 1934, "Recovery of Erroneously Awarded Compensation Policy," and are among those required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). (2)

This article explores the extent to which Sec. 1341 relief may be available to the executive officer whose compensation is clawed back under the proposed regulations. The article includes an in-depth discussion of the difficult tax problems faced by executive officers whose compensation is clawed back and the limited availability of relief under Sec. 1341.

Proposed Regulations Under Section 10D of the Securities Exchange Act of 1934

Under SEC proposed Rule 10D-1, (3) incentive-based compensation received by an executive officer is subject to clawback when there is an accounting restatement. The amount subject to clawback is the amount received by the executive officer in the three fiscal years prior to the date the company is required to issue the restatement, to the extent that the compensation exceeds what the executive would have received based on the restated financial results. The clawback occurs irrespective of fault and is based on the pretax amount received by the executive. (4)

Proposed Rule 10D-1 defines incentive-based compensation as "any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure." (5) It defines the term "executive officer" broadly to include a president; principal financial officer; principal accounting officer (and, if none, the controller); any vice president in charge of a principal business unit, division, or function; and any officer who performs a policymaking function or any other person who performs a similar function. (6) An accounting restatement is defined as a required revision of a previously issued set of financial statements to reflect correction of one or more errors that are material to those financial statements. (7) Thus, Rule 10D-1 enlarges the number of individuals whose compensation is subject to clawback by expanding the definition of "executive officer" and eliminating any requirement of fault as a condition of clawback.

The Whipsaw; Clawed-Back Compensation and Tax on Phantom Income

After the injury of having had compensation clawed back, the executive officer must face the insult of having tax on phantom income. When he or she receives the compensation, the executive will have taxable income and will pay tax primarily through withholding. When the company claws back the pretax compensation, how does the taxpayer recover the tax previously paid?

Example 1: Executive officer E receives a pretax incentive compensation payment of $1 million, with federal income tax withheld at 39.6%; E will have $604,000 remaining. If the incentive compensation is clawed back, E must repay to the employer the pretax amount of $1 million. If E cannot recover the $396,000 of tax withheld, he will be $396,000 poorer than if he had not received the incentive compensation at all. (8)

In North American Oil Consolidated v. Burnet, (9) the Supreme Court articulated the "claim of right doctrine" as a rule for the timing of the recognition of income when someone other than the taxpayer also claimed ownership of that income. The underlying principle of the claim-of-right doctrine is that income and tax are computed based on the tax year, and the government cannot be expected to wait until every contingency regarding the taxpayer's right to the income is resolved. In dicta, the Supreme Court suggested that if the taxpayer who was required to include the income item later had to relinquish it, a deduction might be available in the later year. In subsequent decisions involving the claim-of-right doctrine as a rule of inclusion, the Supreme Court confirmed that a deduction for the repayment (if such a deduction were otherwise allowable) in the year of repayment was the only recourse for the taxpayer. (10) According to the Supreme Court, the year of receipt of the payment could not be reopened.

Even if a deduction were allowed in the year of repayment, the taxpayer still might not be whole. In the year of repayment, the taxpayer might not have enough income or enough income of the proper character to recover all of the tax that he or she had paid in the year of inclusion. (11) Tax rates might be lower in the year of repayment than in the year of inclusion, making the tax reduction for the deduction worth less than the tax cost of having included the income in the earlier year. The taxpayer could not violate the principle that each tax year stands on its own regardless of the inequity. Since the Supreme Court refused to properly address this inequity, Congress had to remedy it by statute. The remedy took the form of Sec. 1341, which became part of the Internal Revenue Code of 1954. (12)

Sec. 1341: The Claim-of-Right Doctrine as a Relief Provision

When it applies, Sec. 1341 provides relief to taxpayers who have included an amount in income under a claim of right and later repay or relinquish it. However, its application is limited.

Sec. 1341 permits a taxpayer who has recognized income in one year and repays it in a later year to compute tax for the tax year of repayment by either (1) deducting the repayment in the year of repayment or (2) recomputing the tax for the year of inclusion without the amount of the repaid item and then reflecting the amount of the reduction in tax for the year of inclusion as a refundable credit of tax for the year of repayment (computed without deducting the repaid amount). (13) The taxpayer's tax for the year of repayment is the lesser of (1) or (2).

It is important to note that the tax return for the year in which the income was included is not amended or otherwise changed in any way. If the refundable credit results in the greater benefit to the taxpayer, it is reflected on the tax return in the year of repayment. The instructions for the 2015 Form 1040, U.S. Individual Income Tax Return (p. 71), provide: "If you are claiming a credit for repayment of amounts you included in your income in an earlier year because it appeared you had a right to the income, include the credit on line 73. Check box d and enter 'I.R.C. 1341' in the space next to that box." There is no specific form or other schedule for the taxpayer to provide. Nevertheless, given the complexity of the law in this area, as discussed below, taxpayers and preparers should consider accuracy-related penalties and the opportunities to avoid them through disclosure.

Examples Adapted From IRS Publication 525

Example 2: Assume that for 2014 a taxpayer filed a return and reported income on the cash method. In 2015, the taxpayer repaid $10,000 that had been included in his 2014 income under a claim of right. Assume a 35% flat rate of tax in 2014 and a 40% flat rate of tax in 2015. The taxpayer's income and tax for both years are shown in Exhibit 1.

The tax for 2015 is the lesser of A or [B-C], A = $36,000. B-C = $40,000-$3,500 = $36,500. In this example, Sec. 1341 did not help the taxpayer because the value of the deduction for repaying the disputed amount in 2015 was greater than the benefit determined by recomputing the tax for the year of receipt, because the tax rate in the year of receipt was lower.

Example 3: Now assume the same facts as in Example 2, except that there is a 40% flat rate of tax in 2014 and a 35% flat rate of tax in 2015. The taxpayer's income and tax for both years are shown in Exhibit 2.

Tax for 2015 is the lesser of A or [B-C], A = $31,500. B-C = $35,000-$4,000 = $31,000. In this example, the taxpayer was helped by the availability of Sec. 1341 because the value from recomputing the tax for the year of receipt was greater than the tax savings from deducting the amount of the repayment in the year of repayment. This is because the tax rate in the year of receipt was higher than in the year of repayment.

The application of Sec. 1341 puts taxpayers in the same tax position as if they had not included the disputed and repaid amount in taxable income. Sec. 1341 achieves this result without interfering with the concept of the tax year because it does not disturb the taxable income or tax for the year of inclusion. It merely permits the taxpayer to reduce tax for the year of repayment by the greater of the result obtained by deducting (if otherwise deductible) the amount repaid in that year or by recomputing the tax for the year of inclusion, leaving out the amount of disputed and repaid income, and claiming a refundable credit in the year of repayment for the reduction in tax so determined for the year of inclusion.

Application of Sec. 1341

To benefit from the application of Sec. 1341, a taxpayer must meet each of its three tests:

* An item was included in gross income in a prior tax year because it appeared that the taxpayer had an unrestricted right to the item; (14)

* A deduction is allowable for the tax year (i.e., year of repayment) because it...