Employee Repayment of Compensation - Update
Posted on 05/26/2023 at 10:56 AM by David Repp
Occasionally a terminated employee will owe his or her employer upon termination because of a prior advance of compensation. This may occur when a sales person receives estimated commissions that are not fully earned or a new employee may have to return a signing bonus. The tax reporting rules can be a little confusing and complex.
Generally, under the Claim of Right Doctrine, payments made to employees are taxed as payroll when received by the employee regardless of whether it is yet earned. North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932); Treas. Reg. § 1.451-1. Thus, the employer must perform all the normal payroll practices including withholding for FICA and income tax. How the repayment is reported depends on which year the employee repays the compensation to the employer.
Repayment in same year.
If the employee repays the compensation in the same year as received, the employer simply reverses everything and generally treats the transaction as never occurring. This may not be intuitive in its implementation. The employer should only recover the net payment made to the employee. The employer will recoup the remainder by amending its 941 returns and seeking refund of the overpaid payroll tax. Treas. Reg. § 31.6413(a)-1(a); IRS Publication 15. The employee’s W-2 for the year should exclude the repaid income. In other words, treat the repaid compensation as never having been paid to the employee.
For example, assume an employee was paid a $1,000 signing bonus that must now be repaid because the employee terminated during the year. The employer paid the employee $690 and withheld $310 for FICA and income tax. The employee will return $690 to the employer and the employer will amend its Form 941 to recoup the $310. The employee’s W-2 for the year will not include the $1,000 or any of its related withholdings.
Repayment in subsequent year.
If the employee repays the compensation in a subsequent year, the employee must repay the net payment plus the income tax withheld. The employer will recoup the FICA tax withheld by amending its 941 returns. The employer must also issue a corrected W-2 showing the employee’s corrected Social Security and Medicare compensation, and corrected Social Security and Medicare withholdings (boxes 3, 4, 5 & 6). Rev. Rul. 79-311. However, the W-2 compensation reported in box 1, and the withholding in box 2, stays the same. The reason is that the employee has received the benefit of the income tax withholdings when the employee filed his or her income tax return for the year.
For example, assume the same facts as above except the $310 of withholdings consisted of $76.50 of Social Security and Medicare and $233.50 of income tax. The employee will need to repay $923.50 ($690 + $233.50). The employer will recoup the $76.50 by filing an amended 941 return. Of course, if the employee was over the Social Security wage limit, there would be no Social Security withholding to recoup. The employee will be entitled to deduct the repayment in the year paid as a miscellaneous itemized deduction. CCA 2005-0146. Unfortunately, for tax years beginning after 2017 and ending in 2025, taxpayers can no longer claim any miscellaneous itemized deductions, so affected taxpayers aren’t able to deduct it from income in the year the taxpayer repaid it. IRC § 67. However, if the repayment was more than $3,000, the employee may be able to compute a tax credit rather than a deduction. IRC § 1341(a) and IRS Publication 525.
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