Tax Cuts & Jobs Act ("TCJA") and Clawback Compensation

One sleeper item in the TCJA affects compensation clawbacks, including repayments correcting certain Section 409A overpayments where the repayment occurs in year after the year of the overpayment. Before the TCJA, the employee or former employee in this case got a Code Section 162 or 165 deduction for the repayment. Because of the individual's deduction for the repayment, the future distribution of the repaid amount was treated as taxable to the individual.  Rev. Rul. 2008-113, Part V.B.3 (409A overpayment correction). The TCJA suspended the miscellaneous itemized deductions under Code Sections 162 and 165 until 2026, so there is now a question how the repayments work.

One possibility is that the individual may be entitled to a deduction for the repayment under Code Section 1341 because Code Section 67(b)(9) provides that a Code Section 1341 deduction is not considered an itemized deduction subject to the 2% floor. There are two problems with the Code Section 1341 theory, however . First, Code Section 1341(b) provides that Code Section 1341 applies only if a particular payment is otherwise deductible under the Code, and the underlying Code Section 162 and 165 deductions have been suspended. Further, Code Section 1341 also has been interpreted very narrowly by the IRS and it may not apply to all repayments. For example, the IRS takes the position that Section 1341 does not apply where the claw back was occasioned by an event after the initial distribution was made (e.g., a clawback based on an accounting restatement).

If no deduction is available for a repayment, the repayment is just an after-tax payment from the employee to the company, and the employee presumably gets a basis under the plan from which the payment was made. The IRS has held that an employee has a basis for an after-tax contribution to an unfunded plan and the employee is not taxed on the subsequent payment of that amount (PLR 8028104).

The employee-basis construct has two problems associated with it. First, it requires the company or recordkeeper to keep track of the individual's tax basis under the plan. Second, and perhaps more troubling, it might result in the loss of a deduction for the company.

If an overpayment was made for a deferred compensation plan, the company would have taken a Code Section 404(a)(5) deduction for the entire payment in the original payment year. When the individual repays part of the original distribution in a subsequent year, the company has income under Section 61 or by reason of the tax benefit rule (recovery of a deducted amount). The income inclusion effectively offsets the value of the original deduction for the payout. If the employee has a basis in the repaid amount in the absence of a Section 162 or 165 deduction, the eventual payout of the repaid amount is a tax-free recovery of basis by the employee. If the payout is tax free to the participant, there is a question whether the company receives a deduction under Code Section 404(a)(5) because that deduction applies only when the amount is "includible in the gross income of employees participating in the plan." There is some confusion under the Code Section 404(a)(5) regulations whether the company's deduction is when an amount is "includible in income" or when it is "paid," but suffice to say there is ambiguity on the deduction point. Compare Treas. Reg. § 1.404(a)-12(b)(1) with Treas. Reg. § 1.404(a)-12(b)(2).

The suspension of itemized Section 162 and 165 deductions also affects repayments of qualified plan overpayments. In Revenue Ruling 2002-84, the IRS noted that an employee gets a Section 165 deduction for a repayment to a qualified plan, and in the absence of that deduction, there is now a question whether the individual gets a basis under the plan under Code 402, which applies Section 72 principles. For plans that do not otherwise contemplate non-Roth after-tax employee contributions, the basis requirement may have cost implications because it will require changes to the plan’s recordkeeping system.