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E-MailDavid I. Walker is Professor of Law and Maurice Poch Faculty Research Scholar at Boston University School of Law. This post is based on his recent paper, forthcoming in the Florida Tax Review. Related research from the Program on Corporate Governance includes Rationalizing the Dodd-Frank Clawback by Jesse Fried (discussed on the Forum here).
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. The Dodd-Frank legislation, enacted in 2010, mandated a much more comprehensive no-fault clawback regime, and the SEC is in the process of finalizing rules to implement the Dodd-Frank clawback. Meanwhile, the fraction of S&P 1500 companies proactively adopting clawback provisions more expansive than those mandated by SOX has increased from less than 1% in 2004 to 62% in 2013.
This paper 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, 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 clawback 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 paper 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 counter-productive. Even in this case, however, the risk of mistake and false positives weighs in favor of refunding previously paid tax.
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. 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.
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 IRC §162 or as business losses under §165. But basic deductibility is only one part of the equation. The §§ 162/165 deduction for clawed back compensation is a miscellaneous itemized deduction (MID). Prior to 2018, MID’s 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 IRC § 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 five years.
But that brings us to IRC § 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, § 1341 provides a non-miscellaneous itemized deduction (still deductible under the TCJA) equal to the value of the current year deduction under §§ 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.
The bottom line here is that § 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 § 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 § 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 § 1341 liberally to allow deduction and that Congress and the Treasury will do nothing.
The complete paper is available for download here.
