By: Sam Brunson
Yesterday, both my Facebook and WBEZ told me about how the Pentagon is clawing back bonuses it paid—a decade ago!—to members of the California National Guard as reenlistment bonuses. [Update, 10/26/16: today, Defense Secretary Ash Carter ordered the Pentagon to suspend its efforts to claw back the bonuses. Note, though, that there’s no indication that it will return any portion of bonuses that have already been clawed back, so the tax issues still stand, afaik.]
The whole story is pretty enraging, but, so that I don’t bury my particular lede too far: though the stories don’t discuss the tax consequences to the soldiers, the soldiers are likely to miss out on significant deductions that they deserve.
To understand why, you need to know about the clawbacks. I’ll let the LA Times do the hard explanatory work, but in brief: in the mid-2000s, the military was facing recruitment shortfalls, so it started offering super-generous incentives to the military to get them to reenlist, and it paid those incentives (often $15,000 or more) upfront, essentially replicating private sector signing bonuses.
As a result of fraud and mismanagement by California National Guard officials, it turns out that many of the people who received these reenlistment bonuses should not have received them (though it’s worth noting that, in the news coverage I’ve read and heard, there’s no reason that the people who received the bonuses would have known that they shouldn’t get them). And now the Pentagon has required the California National Guard to claw those bonuses back.
What does that mean? The soldiers who received these bonuses—10 years ago!—must repay the amounts they got (and already spent) or face wage garnishment and tax liens. The human stories here are outrageous, and the LA Times presents them.[fn]
But, of course, my first thought was, What are the tax consequences?
There’s probably a clear answer, but the question is not as frivolous as it originally appears.
The outline of the law is clear: if you get money under a claim of right, you have to pay taxes on that money. Ten years ago, when the government paid these reenlistment bonuses, the soldiers included the amount in their gross income and paid taxes on it.
The question becomes, what do you do if you have to repay that money in a subsequent year? The law’s pretty clear here, too: you can’t amend your earlier tax return. Instead, you can take a deduction in the year that you repay the money, provided there’s some provision of the tax law that allows for the deduction.
Here, there probably is: working is a trade or business, and section 162 allows a deduction for trade or business expenses. Section 162, though, is an itemized deduction, and subject to some limitations of an itemized deduction. Also, it may not match up to the original inclusion: there’s no interest on the overpayment, and the deduction is at a taxpayer’s current marginal tax rate. If the soldier pays taxes at a lower rate in 2016, when she repays the bonus, than she did in 2006, when she received the bonus, her earlier tax payment will be higher than her current deduction.
In 1954, Congress passed section 1341, which fixes some of these problems. Basically, under that provision, if a taxpayer (a) received money under a claim of right, (b) later has to repay that money, and the repayment qualifies as a deduction, and (c) the amount is greater than $3,000, her deduction will the higher of what it is at her current marginal tax rate or what it would have been at her marginal tax rate in the year she paid taxes on it.
Although section 1341 doesn’t allow for interest, it puts her in a pretty good position. But there are still some problems.
The problems mainly derive from the fact that there’s not a ton of precedent around section 1341, and what precedent there is largely deals with these claim-of-right issues for shareholders of closely-held corporations.
The issue of salary clawbacks has likely become more salient, and we are likely to get better guidance, as a result of Dodd-Frank and SEC rules that will require executives to pay back incentive compensation to which they were not entitled.
But the SEC passed its new rules last year, meaning the tax consequences have not been teased out in the courts and with the IRS yet. So we don’t have super-clear guidance.
That doesn’t really matter for executives, of course: they can afford tax advice, and, as a matter of course, probably get it.
That same level of advice is probably out of reach of most former soldiers who have to pay back their bonuses. That’s not to say they can’t take the deduction, but it is to say this: they probably won’t.
I mean, it turns out that TurboTax (and, I assume, most other tax software) can handle section 1341 deductions. I suspect that H&R Block and other retail tax advisers can, too. But the former military member would have to know that the deduction existed, and would have to figure out herself that she qualified for it (which, as I’ve tried to suggest, she probably does, but it’s not completely clear).
And I don’t know how many people will know in the first place that this deduction exists. It’s not intuitively obvious that they qualify for a deduction. After all, individuals can’t deduct most amounts that they spend. And with a 10-year lag, I suspect it won’t occur to most of the bonus recipients that they already paid taxes on the amount they’re repaying—after all, some significant portion of them are going to be more worried about finding $15,000 to repay to the government than they will be thinking about the proper tax consequences.
How can we solve the problem? I mean, the best way is for Congress to pass legislation that doesn’t require soldiers to repay their bonuses.
If Congress won’t do that, though, I do have one suggestion: have the IRS draft a targeted revenue ruling stating that it will not challenge those soldiers being clawed back if they claim a section 1341 deduction. Then have the Pentagon or the California National Guard write to each person subject to the clawback and explain that they can deduct the amounts they repay, and somehow signal that they should use section 1341.
It would be the right thing to do.
[fn] Note that Congress is outraged, too, so there’s at least a chance it can fix the problem. After all, it did allow winning Olympians to not pay taxes on their Olympic prizes.
The Surly Subgroup 
Very interesting and sympathetic story. However, I’m not clear on what problem for the soldiers a lack of IRC § 1341 precedent creates. Are you referring to the soldiers’ difficulty in knowing how much tax they paid on the bonus 10 years ago? (Technically, in the repayment year, if § 1341 applies, the taxpayer doesn’t get the choice of 2 deductions but rather gets the better of a deduction for the repaid amount or a reduction in tax (essentially a credit) in the amount of the tax paid on the returned amount.)
Also, if section 1341 doesn’t apply because of the $3K threshold, that doesn’t preclude a deduction, as you point out. But does the repayment have to have an authorizing section, such as IRC § 162? For example, say the taxpayer has an activity not engaged in for profit, with nothing but losses every year, except that in only one year, the taxpayer won a prize of $1,000 related to the hobby and had no expenses from the hobby that year. The taxpayer paid tax on the $1,000. The next year—another year where the hobby had only expenses—the taxpayer is asked to return the prize because of some error, and does so. No deduction for the taxpayer? It violates tax logic for the taxpayer to have to pay tax on $1,000 the taxpayer did not get to keep. What about the North American Oil case referring (in dicta) to a deduction if the amount had to be repaid-—does the hypothetical deduction referred to there rely on IRC § 162?
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You’re absolutely right that my explanation of how 1341 works isn’t technically accurate (though it comes to the same place in the vast majority of cases). It was the easiest blog simplification I could do.
From what I’m reading, meeting the $3,000 threshold probably isn’t going to be a problem, since most of these bonuses were in the >$15,000 range (though the news isn’t clear on how quickly or slowly they’re being paid back).
And I’m not worried about how much they paid in taxes 10 years ago because, like you say, that’s not super-important here.
What worries me is (a) that soldiers likely don’t know about this deduction (and, even though my first thought was, They already paid taxes on this income received under a claim of right!, I suspect most people don’t share my emphasis), and (b) they’re taking on the risk that repayment is a trade or business expense under section 162. I think it almost certainly is, but there’s no precedent of which I’m aware that says the it clearly is. And most of the people being clawed back are probably unsophisticated and, I suspect, don’t go to a tax advisor. Rather, they go to H&R Block or use TurboTax. And I’d be happy to be wrong, but I suspect neither source is a wellspring of information about the criteria for taking a deduction under section 1341. So the deduction—which the soldiers should get!—puts the full burden of knowing it exists and figuring out if it’s applicable on the shoulders of people who aren’t in the best position to bear that burden.
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Thanks, Sam! How much the soldiers paid in tax does matter for claiming a credit under IRC § 1341. In other words, to make the IRC § 1341 comparison, that amount needs to be known.
You mentioned that the repayment has to be a business expense to be deductible. I had understood North American Oil as authorizing a deduction as a matter of tax logic, but you’ve caused me to question that. What do you think is the answer in my hobby/$1,000 repayment hypo?
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Ah, thanks. I didn’t think about their needing to know the amount of tax (though, in my defense, I was writing this after midnight this morning!). That’s definitely an extra wrinkle; if I have 10-year-old tax returns, it’s only because I was too lazy to purge them after six years.
My understanding is there has to be an authorizing deduction for 1341 to apply. It doesn’t have to be section 162, but that’s the likeliest candidate for the repayment of a deduction. But unless there is some provision that creates a deduction, the mere fact of repayment doesn’t trigger a 1341 deduction.
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Thanks, Sam! I don’t see an answer to the authorizing section issue in the regs. An IRS Pub agrees with you, but this answer troubles me. What if the soldier retired 5 years ago and lacks a trade or business now–does the characterization relate back to the time of the receipt? If not, the result is not only arbitrary, it violates normative tax principles in any case where the deduction is not allowed despite the income inclusion for the amount returned.
More generally, shouldn’t the deductibility of the repayment depend on the treatment of the receipt? Example: Taxpayer, who engages in no income-producing activities, finds a paper bag on the street in Year 1 containing $1,000. In Year 2, the true owner comes forward and taxpayer returns the $1,000. The $1,000 is gross income in Year 1 under North American Oil. Wouldn’t the taxpayer have a strong argument that the Year 2 repayment relates to the Year 1 income (e.g., under IRC § 212) and should be deductible? Given that the taxpayer netted nothing as an economic matter, it would violate tax norms not to allow a deduction once there is a gross income amount.
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This issue has continued to trouble me since our exchange on this last week. This week, in teaching losses, I reread Rev. Rul. 2009-9. It’s in a different context (theft loss from a Ponzi scheme) but, in computing the amount of a deduction, it includes the amount that the defrauded taxpayer included as gross income (but never received from the defrauding fund manager). It doesn’t provide authority for that but it strikes me as absolutely correct. If the taxpayer included in gross income in Year 1 the $10K included on an investment statement that later turned out to be fraudulent, the taxpayer’s deduction in a later year should include that $10K, assuming we don’t allow the taxpayer to amend the Year 1 return based on subsequent-year hindsight. It’s something of the converse of the tax benefit rule, and it shouldn’t matter whether the income was related to a 212 activity or not–the fact that it was gross income should be the key. The same should be true in the claim-of-right context. I did a little research and the authorities seem more mixed than I expected. Harold Dubroff’s article on this, The Claim of Right Doctrine, 40 Tax L. Rev. 729, 748-49 (1985), summarizes the law as it existed at that time and also advocates for the equitable result. His article states:
“The question can be raised whether the claim of right doctrine itself supports an offsetting deduction for the repayment if no specific statutory deduction provision is applicable. This issue may arise, for example, if the repayment is a refund of part of the proceeds of sale of personally used property. Because individuals generally cannot deduct losses with respect to personally used property, should a deduction be allowed if, for example, the seller of a personal residence receives the amount realized under a claim of right, but is thereafter required to relinquish part of this amount? The answer should depend on whether gain was recognized on the original sale. If such a gain occurred, it would be inequitable to deny a deduction in the year of repayment since the transactions are clearly related. A deduction could be justified under a liberal application of the tax benefit doctrine and, in fact, regulations under section 1341 appear to sanction such a result,[FN 104] even though there is some authority for the proposition that no deduction is allowable absent a specific authorizing provision.”[FN 105]
[FN 104: “Reg. § 1.1341-1(h). Normal application of the tax benefit doctrine in favor of taxpayers permits exclusion of recoveries of amounts previously deducted if such deductions did not result in a tax benefit to the taxpayer. See I.R.C. § 111. A reverse application of the doctrine could permit deduction of repayments of items previously included in income. In addition, the doctrine has been applied in favor of the government to limit the deduction of claim of right repayments on essentially equitable grounds. See United States v. Skelly Oil Co., 394 U.S. 678 (1969) (deduction for repayment of claim of right income reduced by associated percentage depletion tax benefit which arose from earlier inclusion). This application provides further indirect support for not insisting on specific statutory authority.”
FN 105: Equitable Life Ins. Co. v. United States, 340 F.2d 9 (8th Cir. 1965); National Life & Accident Ins. Co. v. United States, 244 F. Supp. 135, 139 (M.D. Tenn. 1965), aff’d, 385 F.2d 832 (6th Cir. 1967).”]
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