Cash incentives, including signing bonuses and other incentive-based compensation, are a common means of attracting and motivating employees, especially in a tight labor market. For a variety of reasons, not all employees satisfy their contractual obligations and must repay compensation received.
A "clawback" happens when compensation that has already been paid to an employee must be returned to the employer. When that happens and an employee has elected to make a 401(k)-deferral based on the clawed-back amounts, it can create substantial headaches for the employer—especially if the employer has also made a matching contribution based on the deferral. Employers who use clawback provisions should be aware of some valuable steps they can take to protect themselves—and know that it's critical to pay attention to the letter of the law to avoid plan disqualification.
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Clawbacks & 401(k) deferrals: The basics
Typically, employers may recover already-paid compensation from an employee who fails to satisfy contractual obligations that are tied to cash incentives paid up front. These types of clawback provisions are often included in contracts between the employer and employee. In many cases, the employee must repay amounts that have already been paid with interest or penalties.
Amounts subject to clawback are almost always included in the employee's taxable compensation when paid. That means they're also available for 401(k) deferrals.
There are three "safe harbor" definitions of compensation that qualified plans typically use: (1) W-2 compensation (amounts reported in Box 1 of the employee's Form W-2); (2) Section 415 compensation; and (3) Section 3401(a) compensation (wages for tax withholding purposes). If any of these safe harbor definitions are used, the incentive compensation will be included for purposes of compliance testing and contributions (which, in turn, will impact any employer matching contribution obligations).
If the incentive compensation is not specifically excluded from the plan definition of eligible compensation, the employee can elect to make 401(k) contributions from the amount received immediately. That's true assuming the employee is eligible to participate in the 401(k) plan at the time. These deferrals can then trigger the employer's obligation to make matching contributions.
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If the amounts are clawed back at a later date, there is no guidance that would specifically allow the plan to simply reverse the deferral if the deferral was based on eligible plan compensation at the time the deferral was elected. Added complications can arise if some time has passed and the amounts contributed to the 401(k) have generated earnings (or losses in a down market).
However, the employer may be entitled to reduce their matching contribution if the clawed-back amounts are returned in the same year as the matching contribution. Matching contributions are usually based on a percentage of the employee's total compensation. If the clawed-back amounts are repaid in the same year, the employer could adjust the employee's compensation downward and reduce their required match.
On the other hand, if the clawback amount was repaid in a later year, the employee's W-2 compensation for the year would already reflect the clawed-back amounts, so the match likely could not be adjusted.
How can employers minimize the impact of clawbacks on 401(k)s?
Neither the Internal Revenue Code nor IRS regulations address the issue of clawbacks in the 401(k) elective deferral context. There are steps that the employer can take to minimize the problems associated with clawbacks in the 401(k) arena. Each option has its own set of complications and consequences.
The most obvious solution is for the employer to amend the plan document so that any compensation that is subject to a clawback is excluded from the definition of eligible compensation for 401(k) contribution and matching purposes. However, because the amendment would remove the plan's definition of "compensation" from the safe harbor definitions, the plan would be subject to additional nondiscrimination testing requirements.
A second option would be to change the eligibility rules for participation in the plan. However, because of the rules governing 401(k) eligibility requirements for qualification purposes, this option would typically only work for employers who only use clawbacks with respect to incentive compensation paid as a hiring incentive (for example, via the use of signing bonuses subject to clawback).
Clawbacks can create operational failures when a portion of the underlying compensation was contributed to a 401(k) plan. For many plan sponsors, the best option may be to leave the amounts in the 401(k) rather than risk disqualification. However, the plan sponsor should consult competent tax professionals and ERISA compliance counsel before taking any action with respect to these amounts.
Prof. Robert Bloink has taught at the Texas A&M University School of Law and the Thomas Jefferson School of Law. Prof. William H. Byrnes is an executive professor and associate dean of special projects at the Texas A&M University School of Law. Bloink and Byrnes are also co-authors of Tax Facts, a reference solution that helps to answer critical tax questions and provides the latest tax developments.
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