By Laura Johnson, EA

Generally, clawback repayments are amounts previously reported as income that are required to be repaid by the taxpayer in a future year. For example, if an executive must return a portion of last year’s bonus after the company determines the bonus was too high. Or – remember Bernie Madoff? -  if a taxpayer received Ponzi scheme payments which later must be repaid to make other investors whole.

Next question, how do you treat the repayment? Do you have to file an amended return for the year you originally received the income? Is it a deduction against income in the current year?

The paying party can choose one of two methods to report the repayment. The taxpayer can either:

• Claim a deduction, in the year of repayment, for the amount paid back. The deduction is a non-theft investment loss, that isn’t a capital loss (and so NOT subject to the $3,000 capital loss limitations) and isn’t subject to the 2% floor for miscellaneous itemized deductions. This is Method 1. This method could be advantageous if your tax bracket is higher in the year of repayment than it was in the year you received the income.

• Or you can claim a credit calculated under Code Sec. 1341. This is Method 2. This method generally would be claimed under the opposite scenario, where your tax bracket is lower in the year of repayment than it was in the year you reported the income.

The taxpayer can choose to apply whichever method results in less tax in the clawback year.

How do you figure out which is better? You do a little math.

Under Method 1, in the year of repayment, figure your tax claiming a deduction for the repayment. Easy.

Method 2 is more involved:

Step 1 - Figure your tax without the current year deduction for the repayment.

Find the tax return which included the original income. Let’s call this the income year. Figure the tax for the income year without including in income the clawback payment. Subtract the hypothetical tax from the actual tax paid in the income year (the credit). Now subtract the credit from the tax as calculated in Step 1.

Which method results in lower tax for the repayment year? You have your answer.

At John Schachter + Associates, we help our clients calculate and claim Section 1341 benefits when required. Let us know how we can help you!