TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Thursday, March 26, 2009

Tax Problems of AIG Employees Who Repay Their Bonuses

Wall Street Journal: Give Back That Bonus! Oh, and By the Way, You Still Owe Taxes on It:

The good news is that the House bonus-confiscation bill specifically excludes "any amount if the employee irrevocably waives the employee's entitlement to such payment, or the employee returns such payment to the employer, before the close of the taxable year in which such payment is due," provided that the employee does not receive "any benefit from the employer in connection with the waiver or return of such payment."

That means you won't be taxed at 90% on the money you held only briefly. But you will be taxed. As Belzer explains:

All compensation, including the retention bonuses, received by employees for services is included in the recipient's gross income, and in determining his adjusted gross income (AGI). If a bonus recipient gives it back, does the bonus vanish from the employee's income?

No. Because the recipient was entitled to receive the amount of the bonus, and actually received it, it cannot be excluded from gross income or AGI. ...

[U]reimbursed business expenses, while deductible from the ordinary income tax, are subject to the alternative minimum tax. Thus you will pay at least 26%, and probably 28%, of the bonus you no longer have in AMT.

Add it all up, and the cost of returning your bonus is somewhere north of 130%. Suddenly that 90% rate doesn't sound so bad.

John Prebble (Victoria University of Wellington, New Zealand):

Meet Douglas Poling: According to a story in Friday's WSJ, it was an in-house lawyer (a lawyer!) at AIG who received the highest of the so-called retention bonuses. According to the story, Poling received more than $6.4 million before offering to return the money amid the political and public firestorm."

Tax people in other countries who are not familiar with the arcana of the U.S. Tax Code are intrigued. In most jurisdictions, a revenue receipt is derived when it accrues or, for employee remuneration and for some other receipts, when it is received in cash or banked. Derivation very rarely occurs at some undefined time after property has passed, especially if that property is money. Later actions may result in offsetting losses or deductions, but no subsequent transaction can cause a revenue receipt to cease to be a revenue receipt. The status of the receipt is fixed on derivation, not, for instance, at the end of the tax year or when one lodges a return. Is the position the same in the USA?

If so, Mr Poling's bonus would seem to have been taxable immediately he received it, though I expect that the U.S. system allows him a few months to pay, depending on when the tax year ends. Also, he may have losses or deductions to take into account.

As I understand it, if Mr Poling were a resident of New York City the aggregate tax rate would be 101.948% and the tax bill for the bonus would be $6,524,672.00. Let's hope that Mr. Poling's home town and home state, Fairfield, Conn, are less grasping.

Does the U.S. Internal Revenue Code allow people to undo transactions that they think better of? How long do taxpayers have for thinking? According to Compaq Computer v Commissioner, 277 F. 3d 778 (5th Cir. 2001) they have less than one hour. If I have understood it correctly (Prebble, Prebble & Postlewaite, 62 Bull. Int'l Tax'n 151, 165 (2008)) Compaq involved a pair of economically self-cancelling transactions separated in time by about an hour. The court held that for legal and tax purposes the transactions were independent. What duration separated Mr Poling's transactions?

On the basis of Compaq, Mr. Poling's transfer of $6.4 million to AIG appears to have been a new transaction. There was no legal obligation on Mr Poling to make the transfer: it was a gift from an employee to an employer. Does the U.S. tax code authorize deductions for gifts by employees to employers? If not, what saves Mr. Poling from tax on the $6.4 million?

Down here in the Southern Hemisphere we are wondering if Mr Poling's saviour is the generous U.S. exemption for gifts to charities. Clearly, well-disposed people, notably the handing-money-out branch of the United States Government, see AIG as a charity. But is the IRS, the taking-money-in branch of the United States Government, bound by other people's characterizations?

All this assumes that Mr Poling has in fact paid $6.4 million to AIG. If Ashby Jones was correct when he wrote, and if Mr Poling has so far only offered to pay the money to AIG, should Mr. Poling, as an experienced tax counsel, advise himself to hurry?

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The analysis here strikes me as not necessarily complete. In Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940), the court allowed an employee to exclude from gross income compensation that he had received under a stock bonus plan; the exclusion was allowed because the employee and the employer agreed to unwind the arrangement and the employee returned the payment before the end of the calendar year in which payment had been made. The AIG employees who return their bonuses presumably would want to explore whether the unwinding doctrine would allow them to exclude the returned payments.

Posted by: Michael Doran | Mar 27, 2009 2:20:35 PM

How would the Service treat an accidental overpayment of salary that was later returned? Wouldn't the Service allow you to just net that out? How is these bonuses distinguished from an accidental overpayment? Is it the legal obligation to pay the bonus? Could the taxpayer claim that the threatened "name and shame" prevented the taxpayer from having "complete dominion and control" over the payment?

Posted by: Rob | Mar 27, 2009 5:05:33 PM

I think that Section 1341 of the code applies here. See US v. Lewis, 340 U.S. 590 (1951). Then read Section 1341.

Posted by: gcwright | Mar 28, 2009 6:11:04 AM

1341 and Lewis don't apply. For either to apply, the employee must be compelled (either under a contract or a court decision) to return the payment. The AIG executives had no legal obligation to return the money - the only legal obligation here was for AIG to pay them the money.

It seems the tax law would treat this as income to the AIG executives, followed by a gift by the executives to AIG.

Posted by: anon | Mar 28, 2009 10:20:22 AM

There are additional issues under Welch v. Helvering and Friedman v. Delaney.

The toupees in Congress should have explicitly made the repayments deductible above the line. This, however, would have required actual thought.

Posted by: Jack Bog | Mar 28, 2009 9:58:34 PM

This is wonderful theory, but if it were me and I returned the bonus because U.S. Congressmen and the Attorney General of New York threatened me, you can bet your bottom dollar I wouldn't include it in my gross income.

Let them audit me.

I salivate at the thought of taking one of these puppies to tax court.

Incidentally, your post nicely illustrates the difference between theoreticians and practitioners.

Posted by: peter | Mar 30, 2009 12:47:27 PM