Compensation clawbacks can raise difficult, and often adverse, tax issues for employees and other service providers. Specifically, for clawbacks that are effected on a gross (pretax) basis, questions arise as to how the clawback is treated for income tax purposes and what avenues an individual may have for recovering any taxes previously paid on the recouped amount. As we describe in this client alert, the answers to these questions are far from straightforward, often counterintuitive, and largely dependent on the facts and circumstances of the original payment and its clawback. As a result, an affected individual's likelihood of being made whole for taxes previously paid on recouped compensation will often need to be critically evaluated by a personal tax advisor

The December 1, 2023 deadline for public companies to adopt clawback policies in accordance with Nasdaq Listing Rule 5608 or Section 303A.14 of the NYSE Listed Company Manual (Listing Rules) has focused attention on the tax implications of compensation recoupment and on the possible means of mitigating unfavorable tax results. The adoption of the Listing Rules was mandated by Rule 10D-1 of the Securities Exchange Act of 1934, as amended (Rule 10D-1). For a refresher on the key provisions of Rule 10D-1, please see our prior client alert.

While the concepts discussed in this alert generally apply to all kinds of clawbacks (including, for example, the clawback of a sign-on bonus that may be recouped if a new hire doesn't remain employed for a specified period following the individual's start date), in this alert we focus on the clawback of compensation under policies adopted under the new Listing Rules.

New Compensation Clawback Listing Rules

The Listing Rules adopted by the New York Stock Exchange and Nasdaq closely align with the provisions of Rule 10D-1. Under the Listing Rules, listed companies are required to adopt clawback policies mandating that—in the event such a company prepares an accounting restatement due to its material noncompliance with any financial reporting requirement under applicable securities laws—the company must recover "incentive-based compensation" that is "received" by the company's covered executive officers during a three-year period before the accounting restatement. The Listing Rules apply on a no-fault basis, meaning even covered executives who have no responsibility for the misstated financials remain subject to having their incentive-based compensation clawed back. 

Incentive-based compensation for this purpose is any compensation—whether cash or equitybased—"that is granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure." This would include compensation that is granted, is earned or vests based on the satisfaction of financial performance goals tied to items such as stock price, total shareholder return, revenue, net income, operating income, profitability and EBITDA (among a host of other possible financial measures). Incentive-based compensation is considered "received" for purposes of the Listing Rules in the year during which the financial reporting measure applicable to the compensation is satisfied, even if the actual payment or grant of the incentive-based compensation to the executive occurs at a later time.

If a clawback is triggered, the amount is equal to the compensation received by the executive in excess of what would have been received had the amount of the compensation been determined on the basis of the restated financials. And, critically, the amount of the clawback must be calculated on a gross basis, without regard to any taxes paid by the covered executive in connection with the original receipt of the compensation.

Tax Implications of Clawbacks for Executives

From a federal tax perspective, the tax treatment of a clawback and the avenues an executive may have for recovering any taxes previously paid with respect to the original payment depend in large part on timing. Specifically, the analysis centers on when the compensation subject to clawback is recouped relative to the time when such compensation is included in taxable income—i.e., if the clawback occurs (1) before a tax recognition event, (2) in the same year the compensation is paid (or is otherwise taxable) or (3) in a year after the year the compensation is paid (or otherwise taxable). In this context, the definition of when incentive compensation is taxable under the Internal Revenue Code of 1986, as amended (Code) takes on particular importance because the date of taxation of incentive compensation may, and often will, differ from the date the compensation is considered received for purposes of a clawback policy. We address each of these scenarios below.

Clawback prior to tax recognition

The most straightforward scenario is when a payment is clawed back before a tax recognition event occurs. In that case, there are no tax consequences to the executive in connection with the clawback. 

  • Example: The tax recognition event for a stock option that is not an incentive stock option typically occurs when the stock option is exercised. If a stock option that is granted or that vests based on the achievement of a financial performance measure is clawed back before the stock option is exercised, the clawback should have no tax impact to the executive because no income was previously recognized by the executive with respect to the stock option.

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