To retain employees, many companies offer incentives. A common example of an incentive is the sign-on bonus given when a new employee accepts an employment offer. There are often clauses in the contract whereby if the employees quit before a specified period, they must return the sign-on bonus. Tax treatments of the bonus repayment can be complex. We have many clients reaching out to us as they would like to get the taxes paid back in prior years for the bonus they are going to return.
Bonuses are considered paid when received so it must be included in the employee’s income. The employee needs to pay tax in the year they receive such bonus. If the employee quits the job and returns the bonus in the same year as he/she receives it, he/she can request a corrected W2 from the employer to reflect the repayment of the bonus. If the return of bonus happens in a different calendar year, the employee will need to either amend his/her original tax return to claim a refund of taxes overpaid or request a credit for taxes paid in the year in which they are returning the bonus.
So, the summary is this:
- Taxpayer receives bonus in year one & is taxed accordingly
- Taxpayer must return the full bonus in year two – this is where the client normally says “why am I returning the full bonus? What about the tax that I already paid on the bonus?”
- There are two options here:
- The employer provides a W2C for the original tax year in which the employee received the bonus. The employee can then amend that original tax year to receive back the amount of overpaid tax
- The employer refuses to issue a W2C for the year that the bonus was originally given to the employee. In this case, the only action the employee can take is wait until the end of the year in which they are returning the bonus & then file for a section 1341 “claim of right” for the overpaid tax
- There is yet a 3rd option, which I will not address here, that generally is not in the taxpayers benefit, which is to claim the overpaid tax on schedule A. However, this does not result in the dollar-for-dollar credit that would be fair in this situation
Option two as described above is the most common route taken, as most employers do not issue a W2C. You must wait until the end of the tax year & file a return with a section 1341 credit. This credit is computed based on the amount of tax you overpaid from previous years, which requires computation. This type of credit is also frequently audited, especially if the amounts are large, so you should have backup & working papers to support the computation.
The credit is available for both federal and state.
The US Tax Code Section 1341 allows a taxpayer to claim a refund of taxes paid in prior tax periods due to the decrease in gross income. We have quite a few clients with similar situations and we have expertise built up for this specific issue.
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