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 1954.12Sec. 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 was established after the close of the prior tax year that the taxpayer did not have an unrestricted right to such item;15 and
- The amount of such deduction exceeds $3,000.16
Relationship of the Clawback Provisions of Proposed Rule 10D-1 to Sec. 1341
Clawbacks under proposed Rule 10D-1 are likely to meet the requirements that an item had been included in gross income in a prior tax year, that a deduction be allowed in the year of repayment because it was established after the close of the prior tax year that the taxpayer did not have an unrestricted right to the item of income, and that the amount of the deduction exceed $3,000.17 What is less clear is whether amounts subject to clawback meet the claim-of-right requirement that they were included in gross income in a prior year because it appeared from all of the facts available in the year of inclusion that the taxpayer had an unrestricted right to the item of income. Much of the controversy and many of the limitations on the application of Sec. 1341 relate to this requirement.
Those interpretations have struggled with distinguishing whether "all the facts available in the year of inclusion" gave rise to the appearance of an unrestricted right to the item of income, in which case Sec. 1341 relief could be available, versus an absolute right to the income or no right to it at all (such as with stolen money), in neither of which case Sec. 1341 relief would be available. Interpretations are often based on the degree of responsibility that a taxpayer has for the occurrence of the facts that gave rise to the receipt of the income and, correspondingly, the subsequent repayment.
Proposed Rule 10D-1 requires clawback of executive officer compensation regardless of any fault on the part of the executive whose compensation is clawed back and regardless of the reasons giving rise to the accounting restatement. The question before the tax authorities and the courts is whether the facts available in the year that the incentive compensation was included in income give rise to no right to the income, an absolute right to the income, or the appearance of the unrestricted right to the income.
Clawbacks or Repayments of Compensation Due to Subsequent Events Involving Contractual Arrangements
The ruling and litigating position of the IRS on these issues has wavered. Initially, the Service adopted a subsequent-event test and took the position that "facts available in the year of inclusion" meant that if the determination that the taxpayer was not entitled to the income was based on an event that occurred in a year after the year of receipt, such as an accounting restatement, all of the facts available in the year of receipt gave rise to an absolute right to the income and not the appearance of the right.18 If the subsequent-event test were applied to clawbacks under proposed Rule 10D-1, Sec. 1341 relief would not be available because the subsequent event would be the accounting restatement, which was not a fact available in the year of inclusion. However, case law establishes a facts-in-existence test with which the IRS appears to agree, or at least has not announced disagreement.
In Van Cleave,19 the taxpayer, who was president and majority shareholder of his corporate employer, was required by corporate bylaw and agreement with the employer to repay to the corporation income the IRS determined to be excessive and so not deductible by the corporation as a business expense. The bylaw and the agreement antedated the year in which the compensation in question was paid to the taxpayer.20 The taxpayer sought the benefit of Sec. 1341 by claiming a credit on his return for the year of repayment based on the reduction in tax for the year of receipt computed without the amount repaid. The district court held that Sec. 1341 treatment was unavailable because the repayment was voluntary due to the taxpayer's control of the corporation.
On appeal, the government did not argue that the reason Sec. 1341 was inapplicable was that the payment was voluntary and did not even contend that the payment was voluntary. Instead, the government argued that in the year of receipt, the taxpayer had more than the appearance of the right to the income. According to the government, he had an absolute right to the income, contingent only on the happening of a subsequent event, i.e., the disallowance of the deduction by the IRS. The Sixth Circuit rejected this argument and held that Sec. 1341 did apply to the taxpayer. "The fact that his ultimate right to the compensation was not determined until the occurrence of a subsequent event does not mean that Mr. Van Cleave had, in the statutory sense, an unrestricted right to the compensation when he received it," the court said.21
In IRS Letter Ruling 9516002, the IRS seems to have changed its view of the meaning of "facts available in the year of inclusion" from a subsequent-events test to a facts-in-existence test. In Van Cleave, all of the facts necessary to determine the reasonableness (and therefore the deductibility by the employer) of the compensation in question were in existence in the year of payment. That the facts were ascertained in a subsequent year does not mean that they did not exist in the earlier year in which the payment was received.
Proposed Rule 10D-1 requires issuers to adopt clawback policies, thus making them employment-related arrangements. Based on the strength of the Van Cleave decision and the apparent acceptance of it by the IRS, Sec. 1341 should, in general, apply to clawbacks under proposed Rule 10D-1. Under the facts-in-existence test, the facts available in the year of inclusion are the correct financial results. That they are ascertained in a subsequent year does not mean that they did not exist in the year of inclusion. The facts available in the year of inclusion do not establish an absolute right to the income. They only establish the appearance of the right because the income is subject to repayment in the event that the facts in existence in the year of inclusion are found to require clawback. Unless and until there is an accounting restatement, the executive officer has received income, claiming it to be his or hers, and without restriction on his or her right to use it.
Clawback Where the Executive Officer Has Responsibility for the Error Requiring an Accounting Restatement
Where an executive officer has responsibility for the facts giving rise to a restatement, the availability of relief under Sec. 1341 appears less likely.
In Rev. Rul. 68-153,the IRS held that where a railroad billed and received payment for shipping based on its own erroneous rate calculation and later refunded the amount erroneously charged, Sec. 1341 was unavailable to the railroad because all of the facts for computing a correct charge were available to the railroad in the year it received the income, but the railroad did not avail itself of those facts. If it had so availed itself, it would have known that it had no right to the amount that it was paid. Therefore, it had no right to the income and could not have had the appearance of an unrestricted right. Thus, the government's position appears to be that income received on the basis of erroneous facts or erroneous computations is not received with the appearance of an unrestricted right to it if the taxpayer receiving the income is responsible for the erroneous calculation or had access to facts that would have allowed the taxpayer to make a correct calculation.
Proposed Rule 10D-1 requires only that there be an error resulting in a financial restatement to trigger executive compensation clawback. In addition, proposed Rule 10D-1 expands the population of executive officers whose compensation is subject to clawback. Executive officers who are not responsible for, are not aware of, and do not have access to the actual facts but whose compensation is nevertheless clawed back should not be denied the relief of Sec. 1341. The facts available in the year that the compensation was paid were not available to those executives. While the facts in existence in the year the amounts were paid result in the conclusion that the nonresponsible executives must repay them, the executives should not be denied Sec. 1341 relief on the strength of Rev. Rul. 68-153.22
Following Rev. Rul. 68-153, the executive officer who is responsible for the employer's having to issue an accounting restatement may be charged with the knowledge of correct financial information. Under those circumstances, the facts available to the taxpayer (the executive officer) in the year the taxpayer receives the income might not create the appearance of an unrestricted right to it; rather, those circumstances may indicate that the executive had no right to the income in the year of receipt, making Sec. 1341 inapplicable. Under this analysis, it is possible that each executive officer whose compensation is clawed back may be put in the position of having to prove no responsibility for the error giving rise to the accounting restatement to obtain the benefits of Sec. 1341.
Rev. Rul. 68-153 deals with a "mere error" that was arithmetic and merely an error of fact. In such a case, there is no dispute as to fact or law and no need for a subsequent determination to ascertain the fact in existence in the year of inclusion. Where there is a bona fide dispute over a fact or application of law, it cannot be fairly said that the fact was available in the year of inclusion if only the taxpayer had looked for it. In those cases, the rulings and case law suggest that the facts available in the year of inclusion do not establish an absolute right to the income but only the appearance of such a right.
Bona Fide Disputes
When the "mere error" rises to the level of a bona fide dispute, the IRS and the Supreme Court have held that the recipient of the income can be considered to have received it with the appearance of an unrestricted right.23
In Lewis, the Supreme Court held that a taxpayer received a bonus under a claim of right where the employer computed the amount based on the its pretax profits and claimed that the bonus should have been computed on the basis of its after-tax profits.24 The dispute was litigated in state court, and a portion of the bonus was repaid to the employer. The Claims Court found as a fact that the employee, who was responsible for the computation of his own bonus, believed that he had computed it in accordance with his agreement with his employer, and the government took no exception to that finding. The employee filed a refund claim for the year that he received the bonus, and the Claims Court allowed the claim. The Supreme Court reversed, citing North American Oil Consolidated, and held that the subsequent repayment was deductible only in the year of repayment. Although Lewis antedated Sec. 1341, the IRS in Letter Ruling 9516002 cited Lewis with approval as a fact pattern to which Sec. 1341 would apply. Although in Lewis the taxpayer who repaid the bonus was the person responsible for the erroneous bonus calculation, he made the error in good faith and based on a disputed understanding of the manner in which the bonus was to be calculated.25
The Van Cleave decision and the apparent IRS acceptance of the facts-in-existence test appear to make Sec. 1341 relief available where an accounting restatement results from a bona fide factual or legal dispute, as compared to a mere error in the financial accounts. However, in the case of a bona fide dispute, the taxpayers whose compensation is clawed back and who have decision-making authority over the accounting treatment that is ultimately found to be in error may have to successfully prove their bona fidesto obtain relief under Sec. 1341. If the executive officer who made the decision regarding an accounting treatment that is later determined to be in error is found to be without bona fides in the decision-making, the IRS may argue that the executive had no right to the income and, therefore, it could not have appeared to him that he had a right to it, disallowing Sec. 1341 relief.
Where an error by the executive rises further, to the level of intentional wrongdoing, the executive would be denied the use of Sec. 1341 because he or she would be viewed as never having had any right to the income.
Judicial decisions and administrative pronouncements have considered the application of Sec. 1341 to repayments of income that a taxpayer has wrongly and intentionally obtained. In these situations, the courts have uniformly decided that a taxpayer has not obtained such income with the appearance of a claim of right. These decisions have concluded that the "appearance of an unrestricted right" means the subjective appearance to the recipient of the income and, therefore, it cannot appear to a wrongdoer that he or she had an unrestricted right to the income.26 This "claim of wrong" doctrine emanates from the Supreme Court's decision in James,27 which overruled Wilcox28 and held that illegally obtained income was taxable. In James, the Supreme Court created a new category of income that was taxable although the taxpayer charged with it had no right to it. The Supreme Court refused to say that such income was held under a claim of right, although the words used to describe why it was taxable sound very much the same as those used to describe income received under a claim of right.29 In any event, such income, because the taxpayer did not receive it under a claim of right, could not be the subject of Sec. 1341 when repaid.
The IRS and the courts have expanded this exclusion by creating the claim-of-wrong rule. Prior to the decision in James, illegally received income was generally not taxable because the taxpayer did not own it. This would have been the understanding of the definition of the word "income" at the time of the decision in North American Oil Consolidated. The claim-of-right doctrine as articulated in North American Oil Consolidated is based on the common law real property rule of adverse possession.30 This rule is all about appearances and how appearance gives rise to rights. It is grounded in the notion that after some period, the law will support the manner of dealing that exists among persons. If the adverse possessor appears to be the true owner and the true owner has not asserted a claim, then the law will settle the matter in accordance with the reality of facts established over a long period, regardless of the intent of the adverse possessor.31 Likewise, the claim-of-right doctrine as originally set forth requires that the taxpayer receive an item of income under a claim of right and not that the taxpayer has an actual right. That is, the taxpayer claims ownership. The tax law will then give credence to the taxpayer's claim and require the taxpayer to pay tax on the income. The appearance of ownership, as established by the taxpayer's or adverse possessor's behavior, is what matters.
Can it appear that a taxpayer has an unrestricted right to an item of income illegally earned or received, and, if so, to whom must such an appearance manifest itself? The recipient of illegal or fraudulently obtained income can behave with respect to it so that, to all the world (including the true owner who is unaware of the theft or fraud), it appears as if the income belongs to the wrongdoer. To avoid this problem, the courts have held that the appearance must be the subjective appearance to the wrongdoer. This makes the determination of the alleged wrongdoer's state of mind an essential element in a dispute over the application of Sec. 1341 clawbacks as based on acts of the taxpayer.
The claim-of-wrong doctrine applies where the taxpayer has received income through intentionally wrongful behavior even if it does not amount to criminal activity.32 The IRS has taken the position that the taxpayer must establish that he or she did not acquire the income through wrongful behavior, even where there has been no adjudication that the income in question was so acquired.33 In Wang,34 the Tax Court said in dicta:
We agree with respondent that with respect to embezzlement gains it is well established that section 1341 is not available. It does not necessarily follow, however, that taxpayers with illegal income, per se, are not entitled to use section 1341. With respect to each taxpayer it would be necessary to decide whether his circumstances meet the requirements of section 1341.
The Federal Circuit's recent decision in Nacchio underscores the government's continuing pursuit of a per se rule where the taxpayer's receipt of income is determined to be the result of criminal activity.35 Joseph Nacchio was the CEO of Qwest Communications International Inc. from 1997 to 2001. In 2007, he was convicted of insider trading. After appeals of his original sentencing, Nacchio was required to serve a prison term, pay a $19 million fine, and forfeit the proceeds of his insider trading of approximately $44 million. In 2009, Nacchio amended his 2007 income tax return and claimed a credit of approximately $18 million pursuant to Sec. 1341, representing the tax that he paid on the income from insider trading in 2001. The IRS disallowed Nacchio's claim on the grounds that the amount repaid was a fine or other penalty and not deductible.
In 2012, Nacchio sued for a refund in the Court of Federal Claims.36 The government argued that, as a matter of law, Nacchio was not entitled to relief under Sec. 1341 because the amount that he repaid was in the nature of a fine or other penalty under Sec. 162(f) and therefore not deductible under either Sec. 162 or Sec. 165. The government further argued that even if the amount repaid was deductible, Nacchio's criminal conviction was conclusive as to his state of mind regarding an unrestricted right to the forfeited income and that he was therefore barred from arguing his state of mind in a tax refund case.
The Court of Federal Claims held that the amount repaid was a deductible loss under Sec. 165 (but not an ordinary and necessary business expense under Sec. 162). Furthermore, the court found that the question of Nacchio's subjective belief about his right to the income received in 2001 was not adjudicated in the criminal trial. The court concluded that the question of whether Nacchio acted with the mistaken belief required by Sec. 1341 was a factual one to be decided at trial. Rather than try these issues, the government stipulated to a final judgment in favor of Nacchio, reserving its right to appeal the trial court's decisions on deductibility and Nacchio's right to argue his state of mind in the tax refund litigation.
On June 10, 2016, the Federal Circuit overturned the stipulated judgment of the trial court and found that Nacchio's repayment was a forfeiture in the nature of a fine or other penalty within the meaning of Sec. 162(f) and not deductible restitution. Nacchio was denied relief under Sec. 1341 because deductibility of the amount repaid is a prerequisite to the application of Sec. 1341. Having decided that Sec. 1341 relief was thus unavailable to Nacchio, the Federal Circuit found it unnecessary to consider whether Nacchio was barred from litigating his subjective state of mind with respect to the receipt of the income that he ultimately forfeited.
Following the Nacchio decision, taxpayers who are accused or even convicted of having wrongfully received income may still have the opportunity to argue that in the year of receipt they subjectively believed that they had an unrestricted right to it. Since clawbacks under proposed Rule 10D-1 require no fault and are therefore similar to disgorgements under Section 16(b) of the Securities Exchange Act of 1934, it appears that the question of deductibility is more certain than in the case of insider profits forfeitures. However, where the factual setting of a Rule 10D-1 clawback includes the possibility of some wrongdoing on the part of an executive, the government may argue that Sec. 1341 is inapplicable. The trial court's decision in Nacchio provides some authority that even if there is an allegation or a finding of wrongdoing, taxpayers may still be in a position to argue that they subjectively believed that they had an unrestricted right to the income in the year received.
In analyzing whether the claim-of-wrong doctrine can apply to deny Sec. 1341 relief to a taxpayer whose compensation is clawed back, it is necessary to first determine whether there may be intentional wrongdoing on the taxpayer's part and whether, notwithstanding the existence of such wrongdoing, the taxpayer subjectively believed that he or she had an unrestricted right to the income. The decision in Nacchio is also instructive regarding the advice given to taxpayers facing prosecution for insider trading activity. If the taxpayer pleads guilty to insider trading, he or she may have foreclosed the opportunity to obtain Sec. 1341 relief with respect to the forfeiture, since the guilty plea is likely to be viewed as an admission that the taxpayer did not subjectively believe that he or she had an unrestricted right to the income from the insider trading.
Professional Responsibility Concerns
The law regarding the availability of Sec. 1341 is evolving. Proposed Rule 10D-1 has already proved to be controversial, as evidenced by multiple comment letters and the fact that support for the proposed rule by SEC commissioners was split. One of the most controversial aspects of the proposed regulation is the "no-fault" provision requiring the clawback of executive compensation even where executives are not at fault for the errors or there is no instance of misconduct. This creates a strict-liability standard for corporate executives where Congress did not mandate one in the Dodd-Frank Act.37 The no-fault provision, coupled with the broad-based definition of what constitutes an executive officer and the limited relief available under Sec. 1341, creates the potential for substantial injustice that seems to contradict the purpose of the business-judgment rule.
The business-judgment rule requires an executive to exercise due care and to use best judgment in making business decisions; yet it recognizes that executives are not insurers of business success. Under the business-judgment rule, executives are not liable for corporate damages due to honest mistakes and poor corporate decisions. Due care is process-oriented and measured by a standard of gross rather than simple negligence, and the burden of proof is placed on the party challenging the executive's decision. Critics of the proposed regulations have stated that Rule 10D-1 is too broad, in that executives who share no responsibility in financial reporting will ultimately see their compensation clawed back in the instance of an accounting restatement. The fact that these no-fault executives, along with those who make mere errors or are involved in bona fide disputes, might not gain relief under Sec. 1341 adds insult to injury, creating professional responsibility concerns.
When providing advice regarding the application of Sec. 1341, the adviser must be cognizant of professional responsibility requirements and the possibility that the executive claiming the benefits of Sec. 1341 could be exposed to the understatement penalty under Sec. 6662. The adviser could be subject to the preparer penalty under Sec. 6694 as well as sanctions for violating provisions of Circular 230,38 including Sections 10.34 and 10.37.
Where there is a clawback of executive compensation under proposed Rule 10D-1, the door to relief under Sec. 1341 is not closed. However, the opening is narrow and depends on a detailed analysis of the facts and circumstances giving rise to both the receipt of the income and the repayment of it. The IRS is not willing to expand the application of Sec. 1341, especially where a taxpayer acquires the income by a wrongful act, whether established or alleged.
As explained, permitting a deduction in the year of repayment may not put the taxpayer in the same after-tax economic position as the taxpayer would be in if the income had not been taxed in the year of receipt. Problems exist in the year of repayment if the marginal tax brackets have changed or capital gains may not be available to absorb capital losses, or if one of the various limitations and phaseouts applies to the taxpayer's deductions.
If there is a factual or legal uncertainty concerning a taxpayer's right to an item of income in the year of receipt and the uncertainty is beyond the taxpayer's control, not due to the taxpayer's own error, and there is a substantive connection between the right to the item of income at the time of receipt and the subsequent repayment, Sec. 1341 relief can be available.
1SEC Release Nos. 33-9861; 34-75342; and IC-31702; see also SEC Press Release 2015-136.
2Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, P.L. 111-203. Prior to the proposed regulations, many companies had voluntarily adopted clawback policies. See the January 2015 PwC second annual Executive Compensation: Clawbacks—2014 Proxy Disclosure Study, which analyzes the compensation recoupment or clawback policies of 100 large public companies (including Fortune 500 companies) as disclosed between 2009 and 2013 in their year-end proxy statements.
3Proposed 17 C.F.R. Section 240.10D-1.
4Proposed 17 C.F.R. Section 240.10D-1(b)(1)(iii).
5Proposed 17 C.F.R. Section 240.10D-1(c)(4).
6Proposed 17 C.F.R. Section 240.10D-1(c)(3).
7Proposed 17 C.F.R. Section 240.10D-1(c)(1).
8This example ignores state income taxes and other state and federal taxes based on income or wages.
9North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932).
10Lewis, 340 U.S. 590 (1951), rev'g 117 Ct. Cl. 336 (1950); Healy, 345 U.S. 278 (1953).
11Arrowsmith, 344 U.S. 900 (1952).
12Sec. 1341 is part of Subchapter Q of the Code relating to readjustment of tax between years and special limitations. See S. Rep't No. 1622, 83d Cong., 2d Sess. 118 (1954): "Under present law if a taxpayer is obliged to repay amounts which he had received in a prior year and included in income because it appeared that he had an unrestricted right to such amounts, he may take a deduction in the year of restitution. In many instances of this nature, the deduction allowable in the later year does not compensate the taxpayer adequately for the tax paid in the earlier year."
13Secs. 1341(a)(4), (a)(5), and (b)(1). See also Sec. 67(b)(9), which allows the deduction without regard to the 2% floor on miscellaneous itemized deductions that would ordinarily apply to employee business expenses.
14Sec. 1341(a)(1). Regs. Sec. 1.1341-1(a)(2) provides that for purposes of Sec. 1341, "'income included under a claim of right' means an item included in gross income because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to such item."
15Sec. 1341(a)(2). Under Regs. Sec. 1.1341-1(a)(1), the taxpayer must be entitled to a deduction in the year of repayment "because of the restoration to another of an item which was included in the taxpayer's gross income for a prior taxable year (or years) under a claim of right." "'[R]estoration to another' means a restoration resulting because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item (or portion thereof)" (Regs. Sec. 1.1341-1(a)(2)); see also Sec. 1341(a)(2). Regs. Sec. 1.1341-1(a)(1) requires the taxpayer to be entitled to a deduction under the provisions of Chapter 1 of the Internal Revenue Code. Sec. 1341 does not, of its own force, allow a deduction for the repayment.
17Rev. Rul. 61-115; Cummings, 506 F.2d 449 (2d Cir. 1974), rev'g 61 T.C. 1 (1973), cert. denied, 421 U.S. 913 (1975).
18The subsequent-event test is articulated in Rev. Rul. 67-48 and extended in Rev. Rul. 67-437 and Rev. Rul. 69-115.
19Van Cleave, 718 F.2d 193 (6th Cir. 1983).
20For cases refusing Sec. 1341 relief when the agreement for repayment of excess compensation was entered into in a year after the payment was made to the employee, see Blanton, 46 T.C. 527 (1966), aff'd per curiam, 379 F.2d 558 (5th Cir. 1967); Berger, 37 T.C. 1026 (1962); and Pahl, 67 T.C. 286 (1976). The theory of these cases is that the repayment was voluntary. A better analysis would be that a fact that gave rise to the repayment (the agreement to repay) did not exist in the year of receipt.
21The decision in Van Cleave is contrary to the IRS's position in Rev. Ruls. 67-437 and 69-115. The IRS has not revoked those rulings but has backed off the position that it took in them and now appears to agree with the result in Van Cleave.
22There has been some suggestion that the IRS might rely on Rev. Rul. 68-153 in the case of compensation-related clawbacks. See Arora, "1968 Ruling Provides Insight on Executive Compensation Clawbacks," 2014 TNT 59-7 (March 27, 2014), reporting on statements made by a Branch 5 attorney, IRS Office of Associate Chief Counsel (Income Tax and Accounting), speaking on her own behalf, at the Tax Executives Institute 2014 midyear conference in Washington.
23See Chief Counsel Advice 200808019 advising that Sec. 1341 relief was available for a "disgorgement" of insider profits under Section 16(b) of the Securities Exchange Act of 1934 (relating to "short-swing" profits and not relying on wrongdoing, intentional or otherwise, for its application) because there was a bona fide legal issue regarding the taxpayer's obligations under the securities laws.
24Lewis, 340 U.S. 590 (1951).
25Although the Supreme Court and the majority of the Claims Court found that the taxpayer made his bonus calculation in good faith, the dissenting opinion in the Court of Claims questioned the taxpayer's bona fides but accepted the majority's conclusion on that point (Lewis, 117 Ct. Cl. 336 (1950)).
26McKinney, 574 F.2d 1240 (5th Cir. 1978), cert. denied, 439 U.S. 1072 (1979).
27James, 366 U.S. 213 (1961).
28Wilcox, 327 U.S. 404 (1946).
29"When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, 'he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent' " (James, 366 U.S. at 220, quoting North American Oil Consolidated, 268 U.S. at 424).
30Healy, 345 U.S. 278 (1953).
31"[E]ven when claimants know that they are nothing more than black-hearted trespassers, they can still adversely possess the property in question under a claim of right to do so if they use it openly, notoriously, and in a manner that is adverse to the true owner's rights for the requisite . . . period" (Tavares v. Beck, 814 A.2d 346 (R.I. 2003)).
32Parks, 945 F. Supp. 865 (W.D. Pa. 1996) (income repaid after civil fraud-related litigation).
33See Field Service Advice 200036011, settlement of actions without admission of wrongdoing, brought on behalf of the United States for alleged overcharges and violations of federal statutes including the False Claims Act.
34Wang, T.C. Memo. 1998-389, aff'd, 35 Fed. Appx. 643 (9th Cir. 2002), cert. denied, 538 U.S. 910 (2003).
35Nacchio, No. 2015-5114 (Fed. Cir. 6/10/16).
36Nacchio, 115 Fed. Cl. 195 (2014).
37See SEC, public statement by Commissioner Daniel M. Gallagher, "Dissenting Statement at an Open Meeting on Dodd-Frank Act 'Clawback' Provision" (July 1, 2015).
38Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10).
|David Casten is the executive-in-residence in the Accounting Department at Bryant University in Smithfield, R.I. He is a practicing attorney in Providence, R.I., and a retired partner of KPMG LLP. Michael Lynch is a professor of tax accounting and the director of graduate tax studies at Bryant University in Smithfield, R.I. He is also a practicing attorney in Providence, R.I. Nicholas Lynch is an associate professor of accountancy at California State University in Chico, Calif. He has a background in public accounting with a full-service advisory firm.