The following article is reprinted from The M&A Tax Report, Vol. 13, No. 9, April 2005, Panel Publishers, New York, NY.


By Robert W. Wood and Richard C. Morris

In 2002, Congress passed the Sarbanes-Oxley Act in reaction to the explosion of corporate malfeasance which surfaced in the post dot-com era. Although some sections of Sarbanes-Oxley have received significant media attention, one of the neglected sections relates to the reduced security for corporate executives in retaining bonuses. Under Section 304 of the Sarbanes-Oxley Act, certain executives may now be required to forfeit bonuses and profits. Generally speaking, if a public company has to re-issue financial statements as a result of misconduct, the CEO and CFO may have to reimburse the company for any bonus or other incentive type compensation, and for any profits made from the sale of the company's stock within the prior year. Notably, CEOs and CFOs don't need to be the reason for the restatement. Basically, this is the government finally saying that the big dogs can't have their incentive compensation cake and eat it too.

While the purpose of Section 304 is laudable, unfortunately it is toothless; there is no enforcement mechanism provided by the statute. In addition, the Act does not define misconduct, nor does it provide whether it applies to former CEOs and CFOs. Really, if the CEO is caught with his hand in the till, do you think the board is going to wait around to determine if Sarbanes-Oxley will come to the rescue? It seems doubtful.

Pay It Forward

In a highly unusual development, however, some Nortel Networks executives may voluntarily do what Congress couldn't find a way to require public company executives to do: repay huge bonuses which were given based on financial statements now being restated.

On January 11, 2005, the giant telecom company, Nortel Networks, released restated financial statements for 2001 through 2003, noting that some executives had manipulated the results to obtain bonuses. In February, Nortel filed suit against three former executives who may have been responsible for the prior manipulation, seeking to recover $10.5 million in prior bonus payments. Nortel, however, said other executives, who also received bonuses based on the original financial statements, but were not implicated with the manipulation, would voluntarily repay $8.6 million of cash bonuses over the next three years, and give back certain restricted stock, which had also been previously provided as a bonus.

Nortel is a Canadian corporation publicly traded both on the Toronto Stock Exchange and on the New York Stock Exchange. While its headquarters are located in Ontario, Canada, Nortel maintains a substantial presence in the U.S. Even though Nortel is a Canadian corporation, it is subject to the Sarbanes-Oxley Act since it is listed on the New York Stock Exchange. For purposes of this article, we assume the Nortel executives who are giving back their bonuses are US tax residents.

The voluntary repayment of cash bonuses and restricted stock raises some interesting tax questions. For example, does the Code allow the un-doing of a prior transaction? If not, can the executives be made whole? Would a deduction for the repayment make the executives whole? If a deduction is warranted, what would be the timing and character of the payment?

Make Me Whole

It may be possible to make the executives whole if they are able to claim a deduction under Section 1341 for restoring an amount held under claim of right. To understand how Section 1341 operates, however, we need to take a brief detour into the claim of right doctrine. Section 1341 was enacted to alleviate the inherent unfairness of the claim of right concept.

The claim of right doctrine requires a taxpayer to pay tax on an item of income in the year in which he received it under a claim of right, even if it is later determined that his right to the item was not absolute, and he is required to return it. The rule is based on the proposition that since the taxpayer has the free and unfettered use of funds from the time of receipt, the taxable year in which that receipt occurs is the appropriate time to fix the tax liability. Essentially, this is a manifestation of the annual accounting principle upon which our tax system is based.

Under Section 1341, generally speaking, a taxpayer who has previously reported income under a claim of right may be able to later deduct the repayment in a subsequent year (but only if the amount restored is greater than $3,000). A Section 1341 deduction usually provides a better result than a deduction under other Code sections since it attempts to place the taxpayer back in the position he would have been in had he never received the income. Frequently, other deductions can be subject to limitations, phase outs, floors, etc.

Not So Fast

Taxpayers must meet certain requirements to obtain a deduction under Section 1341, and the Nortel executives may not meet these requirements. First, the taxpayer must have included the item in gross income in the prior year because he had an unrestricted right to the item. The executives may meet this first requirement since at the time the bonuses were provided to the executives, they surely had no knowledge or belief that they might have to return any part of these bonuses.

Second, a deduction must be allowed under another Code section. As discussed in more detail below, the executives may be allowed a deduction under Section 162 as an ordinary and necessary business expense.

A third requirement for a deduction under Section 1341 is that it must turn out in a subsequent year that the taxpayer did not actually have an unrestricted right to the item. Courts have frequently interpreted this to mean that taxpayers were compelled by law to repay the amounts. In other words, the taxpayer's repayment must be involuntary. While not entirely free from doubt, our Nortel executives may have trouble proving that they were compelled to return the bonuses.

Section 1341 allows the taxpayer the greater benefit of either (1) deducting the repayment in the year of repayment, or (2) reducing his tax liability by taking a credit for the amount of tax he could have avoided if he had excluded the item from income in the prior year. Furthermore, unlike an ordinary and necessary business expense the executive might obtain under Section 162, the deduction provided by Section 1341 is not a miscellaneous itemized deduction. Section 1341 also makes a taxpayer whole as if the prior transaction hadn't occurred at all, including the restoration of basis.

Where's the Beef?

There is not much authority regarding the application of the claim of right doctrine to repayments of compensation. Perhaps compensation if not often repaid. Most of the authority that is present pertains to closely-held private corporations, and to repayments non-deductible excessive compensation by controlling shareholders who are also either officers, directors or employees.

Generally, no deduction is allowed under Section 1341 where the taxpayer executes a contract requiring the return of the non-deductible portion of the compensation, if the taxpayer executes the contract only after the Service disallows the deduction. This repayment is deemed to be voluntary. However, a deduction should be allowed if, prior to the Service disallowing the corporate compensation deduction, the corporation's board enacts a resolution requiring repayment if the corporation cannot obtain a deduction and the taxpayer executes an agreement with his employer to do the same. At this point, it is unclear whether Nortel has a by-law requiring repayment or if the executive's employment contract requires repayment.

The executives could also obtain a deduction under Section 1341 if Nortel obtained a judgment against the executives, requiring them to return the bonuses. A judgment requiring repayment would be the paradigm of an involuntary repayment. Of course, this rule might lead to an improbable and highly ironic result: the fired Nortel executives could obtain a deduction under the claim of right doctrine if they lose their upcoming legal battle against Nortel. Yet a more altruistic executive who gave back the money because it's the right thing to do could not! Such perversions invoke Dickens' admonition that the law is an ass, an idiot.

Second Best

In lieu of obtaining a deduction for restoration of amounts held under a claim of right under Section 1341, the next best thing for the Nortel executives would be for them to deduct the repayment as an ordinary and necessary business expense under Section 162. It is the next best thing because when compared to a deduction under Section 1341, a Section 162 deduction is only a current year deduction, and does not necessarily make the taxpayer whole. Section 162 only provides for a miscellaneous itemized deduction, subject to the 2% adjusted gross income floor. Since deductions under Section 162 are below-the-line, the deduction may also subject the taxpayer to AMT issues and deduction limitation phase outs.

Just about every tax person knows that Section 162 provides a deduction for ordinary and necessary business expenses. While Section 162 has almost infinite nuances, generally, to be deductible, an expense must be (1) ordinary, (2) necessary, and (3) a business expense.

Numerous courts have held that the act of performing services as an officer or employee should constitute a trade or business. Additionally, the repayment would likely be considered ordinary, and this article will so assume. It is unclear, however, whether the expense would be considered necessary. The key to the necessary determination is whether the payment made was made voluntarily or was legally required.

The determination of legally required under Section 162 appears to be similar to the determination under Section 1341, in that a voluntary repayment of compensation in a subsequent tax year does not allow the taxpayer to take a Section 162 deduction. A contract to return non-deductible compensation executed by the taxpayer after the Service disallows a compensation deduction will be deemed to be voluntary. It does not matter whether the taxpayer makes this post-audit contract retroactive. However, a pre-existing legal obligation requiring the taxpayer to return the money should allow a Section 162 deduction. Case law suggests that the obligation could be a corporate by-law.

Of course, this analysis may not be dispositive to the case of our Nortel friends. It's unclear how much weight the Service or the courts might afford prior case law. Almost all of it deals with controlled privately-held corporations where the majority shareholder was either a director, officer or employee (or in some cases, all three). There doesn't seem to be any cases in which the director, officer or employee was not at least a significant, if not majority, shareholder.

Prior cases are quite different from one in which a major public company has affected executives who are neither board members nor controlling, or even significant, shareholders. In the prior cases, the elephant in the room, frequently not discussed in the cases, is whether the excessive compensation is really a disguised dividend. Since the executives are not significant shareholders, perhaps this elephant can be returned to the wild.

The IRS has not determined, and probably would not determine, that the bonus payments to the executives were "excessive compensation". The executives are not repaying the compensation upon an IRS finding that the corporation could not obtain a tax deduction. The executives are repaying their bonuses on their own. Tax motivation is not the driving force behind the repayment. Indeed, it would seem that the Nortel executives have primarily a business purpose, and not a tax incentive, in making the repayment. Maybe this, along with the strong public policy incentive, should be sufficient to allow the Nortel executives to obtain a deduction.

Some — perhaps even the executives — might argue that they have a moral obligation to return the bonus. Others may argue that an implied job security issue exists (which may provide a good business purpose for a Section 162 deduction). Yet others may believe the repayment is completely altruistic. Speculation abounds. Of course, some of us may just be wondering how to justify multi-million dollar bonuses, but I will leave that subject for another day.

Other Ideas

A few other repayment ideas jump to mind. The Service will not allow the Nortel executives to amend their prior year returns since the repayment would be viewed as a separate transaction. Neither courts nor the Service allow netting across tax years.

Perhaps more interesting would be for Nortel to reduce the executives' current year salary to exact repayment. While there does not appear to be any direct authority on point disallowing this arrangement, it does seem that the Service would likely argue that in fact two transactions (a current salary and a repayment of a prior year's salary) are being netted, and each must be reported separately.

Repayment of a bonus upon which the Nortel executives (and Nortel) have already paid employment tax puts forth the possibility that the executives and the company may end up paying employment tax on income the executives don't ultimately retain. If the statute of limitations has not yet expired, the company is obligated to refund this. However, once the statute expires, the Nortel executives only recourse may be to Nortel's compassion.


The executives do not appear to have any certainty regarding obtaining the benefit of a deduction for restoration of amounts held under a claim of right under Section 1341, or for an ordinary and necessary business expense deduction under Section 162. In fact, the limited, albeit not dispositive, authority that exists points towards no deduction. Of course, the prior authority may all be distinguishable.

Acknowledging the murkiness of the current state of the law, it would be interesting to see how the IRS (or perhaps Canadian tax authorities) approach this good deed. Indeed, sometimes a taxpayer who has performed a noble deed in truest boy scout fashion finds that the Service returns the favor by giving him a pie in the face. Oh, the moral dilemma of it all.

Giving Back the Bonus, by Robert W. Wood and Richard C. Morris, Vol. 13, No. 10, The M&A Tax Report (May 2005), p. 5.