Last year, the Securities and Exchange Commission (SEC) released a proposed rule that would require public companies to establish “clawback” policies for recovering incentive-based compensation that was awarded erroneously. This proposal was mandated by the controversial Dodd-Frank Act. As we await a final rule, let’s review the potential tax consequences associated with clawbacks.

The Basics

Under the proposed rule, companies that restate their financials to correct certain material errors would be required to recover excess incentive-based compensation paid to current and former executive officers during a three-year period preceding the restatement.

Generally, the amount subject to clawback is the excess of:

1. The compensation an executive actually received, over
2. The compensation the executive would have received under the restated financials.

The recovered amount would be determined on a pre-tax basis. Unlike the clawback provision of the Sarbanes-Oxley Act, this SEC proposal would not require proof of misconduct.

Tax Consequences

The tax treatment for a clawback depends on whether the executive repays compensation during the tax year in which it was received. If that’s the case, the executive simply excludes the compensation from income as if the payment hadn’t been made.

In contrast, if an executive will be required to pay back compensation in a subsequent tax year, recovering overpaid taxes is more complicated. The IRS doesn’t permit taxpayers to amend prior years’ returns under these circumstances. Instead, there are two options:

1. Claim the returned compensation as a miscellaneous itemized deduction in the current year, or
2. Seek a deduction or credit under Internal Revenue Code (IRC) Section 1341, which provides relief for taxpayers who incur a tax liability based on an apparent unrestricted right to income that’s negated in a later tax year.

Unfortunately, neither option is ideal. Miscellaneous itemized deductions are subject to a 2% floor, are phased out at certain income levels and provide no benefit to taxpayers subject to alternative minimum tax. Sec. 1341 relief isn’t subject to these limitations, but is available only if an executive had an “apparent unrestricted right” to the compensation. That’s a factual question that neither the IRS nor the courts have answered in a consistent manner.

Watch Out for Sec. 409A

Can you satisfy a clawback obligation by reducing an executive’s future deferred compensation payments? This isn’t a good idea, because it would likely violate IRC Sec. 409A, which prohibits acceleration of deferred compensation. Doing so could potentially expose the executive to severe tax penalties.

Consult Your Advisors

Given the potential tax consequences and uncertainty surrounding the tax treatment of recovered compensation, executives faced with a clawback should consult their tax advisors. Once the SEC issues its final rule, our tax specialists can help your company draft an appropriate clawback policy.