Clawbacks’ Tax HeadachesBy
Clawbacks are designed to serve justice to unethical senior executives, but the tax implications can be complicated.
Clawback provisions are special contract clauses designed to ensure that company executives don’t manipulate financial information to hit certain earnings targets linked to their compensation payments. Typically, clawbacks require executives to pay back bonuses they received if the incentive was based on a performance benchmark that later turned out to be an incorrect number. Voluntary clawbacks are adopted on a company-by-company basis and have significant tax implications. To see some of the potential issues, consider the hypothetical example of Morris Maxwell, the CEO of publicly traded Carp Corp., who received a bonus due to higher-than-expected reported earnings in the last quarter.
The bonus consisted of a cash payment, a stock award, and options with a total value of $1 million. Unfortunately, it turns out that Maxwell or others at the company used several accounting tricks or manipulations to achieve this reported result. The auditors didn’t discover this initially, but Carp Corp. had to restate its financials a year later.
If the company included a clawback provision in its executives’ contracts, then Maxwell might be required to repay all or some of the $1 million bonus payment. Several practical questions about the tax effects arise:
- If Carp Corp. deducted the bonus as a business expense on its corporate tax return in the year when the bonus was paid in cash, should the company claim the reimbursement as income in the year when it activated the clawback? Similarly, if Maxwell included the bonus as income on his personal tax return in the year he received the bonus, does he deduct it from his taxable income when he repaid the bonus to Carp Corp.?
- If the tax rates changed from the year when the company initially paid Maxwell the bonus to the year when it recouped the bonus, is there any opportunity for tax planning?
- If the bonus was awarded in shares or stock options, does Maxwell give the shares or stock options back to Carp Corp., or should he repay the current value of the equity in cash?
- If Maxwell sold the bonus shares at a profit before the clawback was activated and he needs to repay the bonus shares plus the profit he made on them, how much of the profit was illegally gained from manipulating the company’s financials and how much was legitimate?
TAX TREATMENT OF BONUSES
Bonuses paid in cash are taxable income for the executive and deductible compensation expenses for the corporation up to the $1 million limitation under IRC §162(m). Bonuses paid in shares are taxable for the executive at the market price at the time of the award. Stock-option bonuses (which are likely nonqualified options) are considered income equal to the intrinsic value of the option when the employee exercises it. Per IRC §83(b), if certain requirements are met, the executive may elect to report the value of the options (valued at the grant date) as income when the options were received.
When the executive repays the bonus, the repayment may be deducted under IRC §1341 based on the “claim of right” doctrine. This rule allows taxpayers to deduct an amount that was previously included in income as long as it’s more than $3,000 and shouldn’t have been included in the income calculation because the taxpayer actually didn’t have the right to it.
The IRS’s interpretation of IRC §1341 has evolved over the past 50 years and has been subject to various limitations, such as only allowing the use of IRC §1341 when no other deduction is available. Furthermore, past IRS and court rulings have been inconsistent in determining whether to allow taxpayers to use IRC §1341 in situations similar to a clawback repayment. After the elimination of the miscellaneous itemized deduction, most individuals have no possible deduction currently available other than IRC §1341.
REPAYMENTS IN DIFFERENT TAX YEARS
Discovering that financial statements were manipulated takes time. When any company activates a clawback, it’s likely occurring in a different tax year than when the bonus was paid, which means that different tax rates may apply to both the executive and the corporation. IRC §1341 takes the possibility of a tax-rate change into account and allows taxpayers to reduce their tax liability in the year when the bonus was repaid by a credit in the amount of the tax difference. It’s calculated as the larger of:
- The tax paid in the bonus year with the bonus payment minus the tax paid in the bonus year without the bonus, or
- The tax paid in the current year without a deduction for the repayment minus the tax paid in the current year with a deduction for the repayment.
Maxwell got the $1 million bonus payment in 2017 and must repay it in 2018. Table 1 shows the tax consequences for both Maxwell and Carp Corp. The company will have to pay less in 2018 than the tax benefit it received in 2017.
REPAYING STOCK OPTIONS
When a bonus is paid in the form of stock or stock options, the company can require executives to repay any undisposed shares and unexercised options and take away unvested restricted stock and performance shares. For example, in the 2017 Wells Fargo clawback case, the board required the former CEO to forfeit more than $47 million of outstanding stock options and $19 million of unvested equity awards.
If the shares have been sold or the options exercised, the company can require executives to repay the proceeds by calculating the difference between the market value of the shares at the time of the sale or disposition and the exercise price. If Maxwell sold the stock that he was awarded, then repayment can be tricky. First, he may not have enough cash to make such a large repayment. Second, it may be difficult or impossible to determine how much of the change in Carp Corp.’s stock price was attributable to the manipulation of the financials.
Because of the uncertainties associated with the tax consequences of a bonus repayment, consider the practicality of clawback provisions before adopting them.
© 2019 A.P. Curatola