Thursday, December 23, 2010
News that former Maryland law dean Karen Rothenberg has agreed to repay $300,000 of a retention bonus subsequently determined to be improper has caused tax law faculty to ponder the tax consequences. Though there are Maryland income tax considerations, those need to be left to the musings of Maryland income tax experts.
For federal income tax purposes, there are four issues:
1. Is the $300,000 repayment deductible? According to Supreme Court dictum, if the amount being repaid had been included in the taxpayer’s gross income under the claim of right doctrine when received, the taxpayer is entitled to a deduction on repayment. However, the taxpayer needs to demonstrate that the repayment meets the tests of any of the statutory provisions permitting deductions. Though it is tempting to assume the $300,000 was included in gross income when received, the lack of absolute knowledge with respect to that fact precludes reaching a conclusive answer on the first issue.
2. In what year is the repayment made? The answer to this question determines the year in which the deduction is allowable. The answer to this question rests on the answer to another question, namely, is the taxpayer a cash or accrual method taxpayer. Again, though it is a good guess that the answer is “cash method,” best practices requires confirming that conclusion.
3. Is the section 1341 mitigation provision available? Section 1341, in effect, permits the taxpayer to forego the deduction and instead reduce tax liability for the year of repayment by the amount of tax liability generated by the inclusion of the amount in question in gross income in the earlier taxable year. To afford themselves of this provision, taxpayers must show five things: (a) that the item was included in gross income in the previous year, (b) that it was so included because the taxpayer appeared to have an unrestricted right to the item, (c) that the taxpayer is entitled to a deduction for the repayment, (d) that the deduction is allowed because after the close of the year in which the inclusion occurred, it was determined that the taxpayer did not have an unrestricted right to the amount in question, and (e) the deduction exceeds $3,000. Whether these requirements have been satisfies cannot be determined until the presumed previous inclusion is confirmed.
4. Should the taxpayer, if entitled to use the section 1341 mitigation provision, use it? The answer is, “It depends.” It depends on whether the reduced tax liability generated by the mitigation provision exceeds the tax liability reduction generated by taking the deduction in the year of repayment. Only a person with access to all of the taxpayer’s entire tax return information for the year of repayment and for the year of inclusion can perform the necessary computations.
There’s a full explanation of the claim of right doctrine, deductions for repayments, and section 1341 in Maule, T.M. 502-3, Gross Income: Tax Benefit, Claim of Right, and Assignment of Income.