Repaying a Signing Bonus or Carry Clawback: How the Tax Works

Do I repay a signing bonus gross or net, and why does it matter?

Your repayment agreement decides. It may ask for the full gross bonus, even though you received it after income tax, Social Security and Medicare were withheld. The withheld tax does not come back with the repayment. You recover it separately, and the route depends on whether you repay in the same calendar year you were paid or a later one. If the agreement asks for the net amount, you repay less, and any deduction or credit is figured only on what you actually repay.

Sources: Publication 15, "Wage Repayments"; Publication 525, "Repayments".

Gross versus net matters for cash: repaying gross means paying out more now and waiting for the withheld tax to come back through separate claims. Counsel reads the agreement; the tax follows from what it says and when you pay.

Your case needs a closer look if you repay in a later year, the amount is large, your new firm pays the old one for you, you moved states, or the repayment is carry rather than pay. Gather the agreement, proof of payment, the original W-2 or K-1, the employer's letter and the earlier year's return. Working out the deduction-or-credit comparison and the refund claims is part of tax work for fund employees.

I repaid in the same year: what should my W-2 show?

Your Form W-2 for that year should show wages reduced by the repayment. An employer may offset a repayment against current-year wages only when the repaid amount was paid in that same year (Publication 15). Publication 15 writes this rule for wages paid in error, so confirm how your employer will report a repaid bonus. The calendar year decides the route: a bonus paid in December and repaid in January is a later-year repayment.

If the bonus was paid in an earlier quarter of the same year, the employer reports the adjustment on Form 941-X and recovers the income tax withholding and the Social Security and Medicare taxes on the repaid wages (Form 941-X instructions).

Ask the employer, before year-end, how it will report the repayment. If the W-2 still shows the full bonus, ask for a corrected one.

I repaid a bonus from an earlier year: deduction or claim-of-right credit?

If you repay more than $3,000 of wages you reported in an earlier year, you choose the method that leaves less tax: deduct the repayment, or take a credit equal to the tax the income added in the earlier year (26 USC 1341(a); Publication 525).

Sources: Publication 525; Schedule A instructions; Form 1040 instructions. Check the line numbers on the current year's form.

Three conditions decide whether you qualify:

1. Claim of right. When you reported the bonus, it must have appeared that you had an unrestricted right to it. A bonus that you had to repay only if you left early raises the question of whether that right was unrestricted. The answer depends on the agreement's terms, so have it reviewed. If it does not qualify, there is generally no federal deduction at any amount, because the repayment is then a barred miscellaneous itemized deduction (26 USC 67(b)(9) and (h)). Social Security and Medicare can still be recovered.
2. Over the line. The repayment must exceed $3,000. Publication 525 says to count the total repaid on that year's return, not each payment separately. Installments paid in two calendar years are tested year by year.
3. Repayment year. A cash-method individual claims it in the year the money is actually paid back (Publication 525).

The section 1341 deduction is not a miscellaneous itemized deduction (26 USC 67(b)(9)), so the bar described in the next section does not reach it. A nonresident filing Form 1040-NR can still take it (Form 1040-NR instructions).

What tips the choice between the methods

Two features can favor the credit. First, Method 1 helps only if you itemize; if your other itemized deductions are below the standard deduction, part of the repayment just replaces the standard deduction. Second, Method 1's deduction is an itemized deduction, and itemized deductions are reduced by 2/37 of the smaller of the deductions or the taxable income, figured before those deductions, above where the top bracket starts (26 USC 68(a)). Section 68 lists no exception for a claim-of-right deduction. The credit is figured without the deduction, at the earlier year's rates. Still, figure both: if your rate in the repayment year is higher than in the bonus year, Method 1 can win.

Why does a repayment of $3,000 or less give no federal deduction?

A repayment of $3,000 or less of wages can only be a miscellaneous itemized deduction, and none is allowed for any tax year beginning after 2017 (26 USC 67(h)). Public Law 119-21, section 70110, removed the old end date, so the bar is now permanent. Publication 525 says plainly that you aren't able to deduct a repayment of that size.

A small repayment can still recover Social Security and Medicare (next section). Some states allow a deduction where the federal return does not. California, for example, still allows one for a repayment of $3,000 or less, subject to a floor of 2% of adjusted gross income (Schedule CA (540) instructions). Check your state's rules.

Can I get back the Social Security and Medicare on a repaid bonus?

Often, if the refund period is still open, and through the employer first. For wages paid in a prior year, the employer reports an adjustment on Form 941-X to recover Social Security and Medicare, and files Form W-2c to correct the Social Security and Medicare wages, but not box 1 (Publication 15).

Sources: Publication 15; Publication 525.

Points to know before you ask:

• The wage base limits Social Security. Social Security applies only up to that year's wage base. If your other wages that year were above it, the repaid bonus carried no Social Security, and only Medicare comes back.
• The employer asks for your statement. To claim a refund of prior-year employee tax, the employer certifies that it has written statements from employees that they have not claimed and will not claim the refund themselves (Form 941-X instructions).
• If the employer will not adjust. File Form 843 yourself and attach a statement from the employer showing what it repaid you and what it claimed. If you cannot get one, attach your own statement with the same facts and explain why, plus a copy of the W-2 (Form 843 instructions). Form 843 cannot be used for income tax or Additional Medicare Tax.
• Deadlines run from the bonus year. For Social Security and Medicare, the employer's Form 941-X or your Form 843 is generally due within 3 years of April 15 of the year after the bonus was paid, when that year's payroll returns count as filed (26 USC 6513(c); Form 941-X instructions). The Form 1040-X for Additional Medicare Tax runs from your bonus-year return: 3 years from filing it or 2 years from paying, whichever is later. Repay several years later and these periods may have closed; the deduction or credit is not affected.

My new firm paid the clawback for me: is that taxable?

Usually yes. When someone else pays a debt you owe in return for your work, you are treated as receiving the money (Old Colony Trust Co. v. Commissioner, 279 U.S. 716). Expect the payment to appear as wages from the new firm, with withholding. If the new firm's payment is included in your income, the repayment to the old firm then follows the rules above, as if you had paid it yourself: same-year W-2 adjustment, or Method 1 or 2 in a later year.

Confirm with both firms how each will report the payment. For make-whole payments and the rest of a move between firms, see Leaving a fund with unvested pay and carry. For estimated tax in a year with two employers, see Estimated tax in a big bonus year.

A portfolio manager draw recouped against losses: is that a repayment?

Usually not, if the draw (an advance against your future pay) is only offset against later pay: the later pay is simply lower, so there is nothing to deduct. It is a repayment if you pay cash back for a draw taxed in an earlier year; then the rules above apply. Read the draw agreement to see which one you have.

Our GP must give back carry: is that a capital loss, a deduction or a claim-of-right credit?

The answer is unsettled. No IRS guidance addresses carried interest clawbacks directly. The starting point is the character of the income you gave back. Under Arrowsmith v. Commissioner, 344 U.S. 6, a later payment generally takes the character of the income it reverses, and Publication 525 says a repayment of income reported as capital gain is deducted as a capital loss. So a capital loss is the usual starting point, to the extent the carry was capital gain. A capital loss offsets capital gains, plus only $3,000 of other income a year (half that if married filing separately); the rest carries forward to later years (26 USC 1211(b); 26 USC 1212(b)).

Whether section 1341 also applies is the open question. Section 1341 needs a deduction that is allowable because you turned out not to have an unrestricted right to income you reported. Whether a carry giveback meets that test, and how it combines with the capital-loss character, has no direct answer in the statute or IRS guidance. Who pays also matters:

A hedge fund's incentive allocation is usually set against a high-water mark (the fund must earn back earlier losses before a new allocation), so later losses reduce future allocations rather than requiring repayment. If your fund's documents call for repayment, the carry questions above apply, including what is unsettled. For how carry is taxed when received, see Carried interest and the three-year rule. For carry points you forfeit before they pay anything, see Carry points for fund employees. If the general partner's own return was wrong, see Correcting a filed business return.

Our clawback is net of taxes or backed by escrow: what changes?

The contract terms change the amount and the timing, not the rules above. Common terms work like this:

• Net of taxes. A cap limits what each partner repays to the carry received less an assumed tax on it. You repay less, and your loss or deduction is the smaller amount you actually repay.
• Tax distributions counted. Some agreements count cash the fund paid you to cover tax on carry as carry received. That can raise what you owe back.
• Guarantee. A personal guarantee makes you the payer, which affects whether the loss reaches you through a K-1 or as your own payment (previous section).
• Escrow or holdback. Carry held back until the fund's final accounting may count as received only when released. That changes the year you report it and the year any giveback counts.

For the fund's final waterfall true-up (the last recount of who gets what from the fund's profits) and its last K-1s, see Winding down a fund.

Can I get back state tax on a repaid bonus, especially if I've moved?

Often, but each state sets its own rule. New York and California both allow a claim-of-right credit, with conditions. Other states may follow the federal deduction, offer a credit or offer neither; check the state's instructions.

New York says Form IT-257 is filed with your return, and you need your original prior-year return to figure the credit. If you have moved, the state that taxed the bonus is the one to ask, which may not be the state you live in now. For which state taxed pay received around a move, see State tax on deferred pay after a move.

What records do I need?

Collect these before you file the return for the repayment year:

1. The agreement. Signing bonus, guarantee, draw or partnership agreement, showing the repayment terms and whether repayment is gross or net.
2. Proof of repayment. Wire confirmation or the employer's receipt, with the date. The date sets the year you claim it.
3. The original W-2 or K-1 for the year you were paid.
4. The employer's letter or statement. What it repaid you, what it claimed on Form 941-X, and any W-2c.
5. The earlier year's federal and state returns. Method 2 and the New York credit are figured from them.

The deduction or credit is claimed on the return for the year you repay. Do not amend the earlier year's return to recover the income tax; only Additional Medicare Tax goes on a Form 1040-X (Publication 15).

Example

These figures are illustrative, in US dollars, and assume one person in the top bracket in both years with no other changes, and a repayment that meets the claim-of-right test.

A $400,000 signing bonus repaid the next year

In Year 1, a new portfolio manager gets a $400,000 signing bonus and reports it as wages. In Year 2, the manager leaves early and repays the gross $400,000.

• Method 2 (credit). Refiguring Year 1 without the bonus lowers Year 1's tax by about $148,000 (37%). That is the Year 2 credit.
• Method 1 (deduction). The $400,000 is an itemized deduction in Year 2, cut by 2/37 of it (about $21,600) under section 68. The remaining $378,400 at 37% saves about $140,000, assuming the manager's other itemized deductions already exceed the standard deduction.
• Social Security and Medicare. Year 1 salary was already above the wage base, so the bonus carried Medicare only. The old employer files Form 941-X and a W-2c and refunds about $5,800 (1.45%). The manager files Form 1040-X for Year 1 for about $3,600 of Additional Medicare Tax (0.9%).

The credit leaves less tax, so Method 2 applies.

The same bonus repaid within the same year

The manager is paid $400,000 in March and repays it in October of the same year. The employer reduces that year's wages on the W-2 and recovers the withholding. There is no deduction or credit to claim, because the bonus never stays in income.

A $2,500 repayment

An employee repays $2,500 of a prior-year bonus. The amount is not over $3,000, so there is no federal deduction or credit. The employee can still ask the employer for the Social Security and Medicare on it.

Different for you?

• You are repaying a prior-year bonus or a clawback and want both methods figured. Tax work for fund employees compares the deduction and the credit and handles the refund claims.
• You are leaving your firm with unvested pay, carry or a make-whole. See Leaving a fund with unvested pay and carry.
• You moved states between the bonus and the repayment. See State tax on deferred pay after a move.
• You have two employers and a large bonus in one year. See Estimated tax in a big bonus year.
• Your carry points lapsed before paying anything. See Carry points for fund employees.
• Your carry is taxed under the three-year rule. See Carried interest and the three-year rule.
• The fund is winding down and the waterfall is being trued up. See Winding down a fund.
• The general partner's filed return must change. See Correcting a filed business return.