Mishandled Taxes on Employee Pay Clawbacks Are Tricky to Correct

Clawing back employee compensation is an unhappy yet common situation that happens when, for example, employees don’t meet subsequent conditions for bonuses or excess payments are made by mistake. Employers who mishandle tax treatment of these clawbacks risk reporting, withholding, and deposit penalties.

Unfortunately, correcting these payments isn’t intuitive for employees or employers. The method of correction, as explained here, depends on the year the clawback occurs and the type of tax being corrected.

Virtually all payments made in contemplation of services performed are treated as wages (and income) and subject to payroll tax and withholding. This includes contingent payments. The employer must withhold payroll and income tax at the time of payment.

When the employee repays the excess compensation, both the employer and employee may need to seek adjustments from the IRS to avoid overpaying on taxes.

Same-Year Corrections

The easy case, requiring no corrections, is when compensation is clawed back in the same year it is paid. Amounts repaid by an employee in the same year reduce the employee’s taxable income and wages in that year. This allows employees and employers to make a pre-tax correction to an employee’s compensation.

For example, if an employer pays commissions to an employee and then determines that some or all the conditions for the commissions weren’t met, it can collect the overpayment from other compensation paid in that year (subject to state withholding laws).

That puts the employee in the same position as if the excess amount hadn’t been paid in the first place, other than a small timing difference with respect to income tax withholding and Federal Insurance Contributions Act tax withholding and remittances. The employer doesn’t need to make an adjustment to its quarterly federal tax return (Form 941) or otherwise account for this timing difference.

Subsequent-Year Corrections

The more complicated situation is when clawed-back compensation is repaid in a subsequent year.

In this case, an amount that is held back from wages to satisfy an employee’s debt to the employer doesn’t reduce the employee’s wages (or income) for that year.

The proper method to correct these amounts depends on whether an employer is correcting for income tax withholding or FICA tax, as outlined below.

Income tax withholding can’t be corrected by the employer: As mentioned, subsequent-year repayment doesn’t decrease previous-year income, though in certain circumstances an employee may be entitled to a deduction or credit under Section 1341 in the year of repayment.

Say an employee receives a $10,000 bonus in 2025, which is included in taxable income for that year, and then is clawed back in 2026. The employee’s taxable income doesn’t decrease by $10,000 in 2025 (when the payment was made) or in 2026 (when the payment was clawed back).

That’s because, for purposes of income tax reporting and withholding, an employee’s wages means all wages paid or constructively paid to the employee in that year.

The $10,000 was paid in 2025 and is withheld by the employer from wages paid to the employee in 2026. A deduction or credit against the employee’s income may be available to the employee in the year of repayment under Section 1341, but only if certain requirements are met, including a repayment exceeding $3,000.

FICA tax, except Additional Medicare tax, withholding may be corrected by the employer: In contrast to the treatment of income tax, IRS guidance permits adjustment of FICA taxes retroactive to the original payment of excess wages.

When an employee repays excess compensation, the employer can reduce the employee’s FICA wages in the year of the original payment. The method for recovering overpaid FICA taxes depends on whether the employee pays the clawed-back amount gross or net of FICA taxes.

If the employee repays the gross amount (the full value of the overpayment including withheld FICA taxes), the employer has two options. The employer can obtain written consent from the employee and file Form 941-X to claim a refund for both the employer and employee portions of excess FICA taxes, remitting the employee’s share back to her.

Alternatively, the employer can file Form 941-X to claim its share of excess FICA taxes only and allow the employee to file Form 843 for a FICA tax reimbursement.

If the employee repays the net amount, the employer must obtain a written statement from the employee confirming that the employer effectively reimbursed the employee for FICA taxes. The employer may then file Form 941-X to claim a refund for employer- and employee-side FICA taxes for itself.

In either case, if the employer seeks the refund on behalf of the employee, the employer must obtain a written statement that the employee hasn’t claimed a refund (or a refund claim was rejected) and that the employee won’t claim a refund.

Notably, these rules don’t apply to Additional Medicare tax, which requires employees to file refunds individually. The employer should issue a corrected wage and tax statement (Form W-2c) to the employee with a corrected “Medicare wages and tips” (box 5). The employee then files an amended US individual income tax return (Form 1040-X) to claim a refund for Additional Medicare tax.

Looking Ahead

Navigating the tax consequences of clawbacks is tricky, particularly since it may require coordination with, and the cooperation of, employees. Tax counsel can structure repayment processes to ensure compliance across departments.

Tax counsel also can help with communication to employees. This is important because employees generally don’t expect to be taxed on wages they didn’t receive and may have difficulty handling reimbursement of income or FICA tax overpayment without some direction. Engaging tax counsel early (and often) can alleviate pains for employers and employees.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Harrison Richards is a tax associate at Ivins, Phillips & Barker focused on federal income tax issues.

Renee Suzich is an employee benefits associate at Ivins, Phillips & Barker.

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