The AIG Bonuses, Part 4:
Return your bonus? Pay more in income taxes

25 Mar 2009 in Regulatory Economics, Regulatory Policy

We have blogged on the original AIG bonus controversy, the House of Representatives' decision to confiscate these bonuses, and the extent to which the government's actions could undermine the Obama Administration's new Legacy Loans Program.

In short, the House's action, which President Obama did not contemporaneously discourage, creates the precedent that the government may choose not to honor the legal commitments it makes to investors who participate in the Treasury Department's new program. If investors earn "too much" in profit -- a term that would be defined subjectively after the fact -- they may be prevented from realizing these earnings. It is reasonable for prudent investors to discount the government's credibility.

The Obama Administration could have included strong language promising to protect these property rights in its Legacy Loans Program, but it did not do so. Such a promise might prove to be unenforceable in fact, but the absence of a promise means there is nothing yet for investors to rely upon. This uncertainty may (or may not) be resolved when the Treasury Department issues implementing regulations. For now, the cleanup of underwater financial assets has entered a zone in which political risk -- uncertainty about the government's reliability -- may be as great or greater than financial risk.

Even if Treasury's regulations appear bulletproof, it is not clear they can ever constrain Congress from undermining them. Finally, nothing can constrain other political actors, such as New York Attorney General Andrew Cuomo, from exercising other legal and extralegal powers. As an example of extralegal power, Washington Post staff writer Brady Dennis says Cuomo threatened to publicize the recipients names, thereby exposing them to public ridicule and potential risk of physical harm, if they did not agree to return their bonuses:

[AIG's] chief operating officer, Gerry Pasciucco, had set a 5 p.m. Monday deadline for staffers to indicate whether they planned to return their retention payments, and if so, what percentage. His e-mail included what appeared to be a tacit ultimatum from Cuomo.

"We have received assurances from Attorney General Cuomo that no names will be released by his office before he completes a security review which is expected to take at least a week," Pasciucco wrote. "To the extent that we meet certain participation targets, it is not expected that the names would be released at all."

Yesterday afternoon, 18 of the 25 most senior Financial Products executives had agreed to return their retention payments, amounting to more than $50 million thus far. Company officials expect more employees to follow suit.

"They are doing the right thing," Cuomo said on a conference call with reporters, adding that he now saw no need to reveal the names.

Returning one's bonus is not the end of it, however. Recipients still will be subject to significant taxes. We address that issue today.

UPDATE: There are technical errors in this post. Please see the subsequent post with corections here.

All compensation, including the retention bonuses, received by employees for services is included in the recipient’s gross income, and in determining his adjusted gross income (AGI). If a bonus recipient gives it back, does the bonus vanish from the employee's income?

No. Because the recipient was entitled to receive the amount of the bonus, and actually received it, it cannot be excluded from gross income or AGI. Under the Internal Revenue Code, the best a taxpayer could do is argue that he was forced by circumstances beyond his control to forgo compensation to which he was entitled. This might be easier to argue if the taxpayer returned a bonus in conformance with H.R. 1586 section 1(a)((2)(C), which reads:

WAIVER OR RETURN OF PAYMENTS- [The term "disqualified bonus payment"] shall not include any amount if the employee irrevocably waives the employee's entitlement to such payment, or the employee returns such payment to the employer, before the close of the taxable year in which such payment is due. The preceding sentence shall not apply if the employee receives any benefit from the employer in connection with the waiver or return of such payment.

However, even this language is probably insufficient, for it does not exclude a returned bonus from gross income, but only from the definition of a “disqualified bonus payment” that is taken into account in determining the taxpayer’s income tax liability. (This issue also affects an employer’s reporting requirements on its employment tax returns and the employees’ Forms W-2.)

Can this tax be avoided? Maybe. A recipient could donate all or a portion of the bonus to charity. The amount donated would be deductible on the employee’s 2009 return to the extent it does not exceed 50% of his AGI (as increased by the amount of the bonus). Any excess may be carried over and deducted in the succeeding 5 years, always subject to the 50% limit.

Another option may be to deduct the amount of the bonus returned to the employer as an unreimbursed business expense, incurred to avoid litigation or public disparagement that could harm the employee’s current or future employability. Understandably, the instructions for IRS Form 2106 do not address a situation like this, and it is entirely possible that it has never previously occurred.

Assuming that the IRS were to agree, then the employee would be able to deduct the portion of the bonus exceeding 2% of AGI (again, as increased by the amount of the bonus). The proportion of the bonus that would be deductible depends on the relative size of the bonus to total AGI. No matter the ratio, the employee's tax bill would go up in proportion to the size of the bonus even though he did not keep it.

Regardless of whether a bonus recipient donates the money to charity, or claims a deduction for the return of the bonus, if his AGI in 2009 exceeds $166,800 (if single, or married and filing a joint return), his itemized deductions (other than for medical expenses, investment interest, and certain losses) are reduced by the lesser of (1) 3% of the difference between his AGI and $166,800, or (2) 80% of his otherwise allowable itemized deductions. For many bonus recipients, this will mean that a significant portion of the bonus is not deductible.

From press accounts, it is unclear whether employees who received bonuses have actually returned them or promised to do so. Recipients who have already returned them will pay taxes on a portion of the money they returned unless the IRS issues an authoritative opinion stating that they are permitted to exclude returned bonus payments from gross income. The IRS might not have the authority to do this, and if they cannot, it seems highly unlikely that Congress would enact such a law.

Recipients who have promised to return their bonus payments may choose to wait -- first to see if the IRS addresses the issue; second, to see if Congress enacts (and President Obama does not veto) H.R. 1586 or a similar bill; and third, to allow them to take account of whatever events occur between now and December 31, 2009. As passed by the House, H.R. 1586 provides some relief for employees who return bonus payments. Congress is not obligated to keep that provision in a final bill. If the relief provision is dropped, employees who return their bonuses would face income tax liability just as if they had kept the money.

At least one bonus recipient has decided to resign from AIG, having concluded that he has been "betrayed by A.I.G. and [is] being unfairly [sic] persecuted by elected officials." He has promised to donate to charity the net proceeds of his bonus, but he appears to know that he cannot determine his net proceeds until the year is essentially over. And the answer is a complicated one. As we pointed out above, if he donates the full amount to charity, he still owes income taxes on $371,000.

And a lot could happen before the end of the year. For example, this bonus recipient would be better off if H.R. 1586 is enacted. Having agreed to work for a salary of $1 per year, the first $249,999 of his $742,006.40 bonus would be exempt from its confiscatory tax rate, and he would be assured of owing no tax on income he did not receive. An income tax rate of 66% is certainly high, but it is not as high as the 100% tax rate implied by donating the entire amount.

For the bonus recipient who believes he has been wrongly treated, "going public" has important advantages, and there are few more prominent places to do so than the New York Times. First, it takes away most, if not all, of the extralegal power Attorney General Cuomo and others have been threatening to wield by publicizing his name. Second, it allows the recipient to protect his professional reputation rather than try to defend it, often under impossible conditions, such as in front of a hostile congressional committee where the person testifying is always under oath and his inquisitors never are.

There is ample research evidence in the risk communication literature showing that targets of controversy often do much better when they take the initiative rather than try to hunker down. Through candor and transparency, they can persuade some people to their side.

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Return your bonus? Pay more in income taxes

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