You may have read or heard that Lance Armstrong has been
stripped of his seven Tour de France victories because of doping. The UCI
Management Committee stated that it would not award the titles stripped from
Armstrong to any other riders. History books will show no winner of the race
between the years 1999 and 2005. UCI has demanded that Armstrong return his
winnings from the vacated years, an amount estimated at approximately $4
million.
SCA Promotions, a Dallas insurance firm, has indicated that
it will demand repayment of bonuses it insured for Armstrong’s wins in 2002,
2003 and 2004. It is reportedly seeking approximately $12 million.
There wasn’t much goodwill between SCA and Armstrong to
begin with. SCA delayed paying a $5 million bonus for his 2005 win, responding
to then-swirling allegations and controversies surrounding possible drug use.
Armstrong sued, and SCA settled the case.
Then there are the endorsements. Armstrong earned more than
$17 million in endorsements and speaking fees in 2005, when he won his last
Tour de France. That amount grew to an estimated $21 million in 2010. And do
not forget that Armstrong was the founder and driving force behind the Livestrong
Foundation, which assists those struggling with cancer. Nike, Honey Stinger and
Easton Bell Sports have dropped his endorsement, for example, and make seek
clawback of prior monies.
Let us suppose that Armstrong has to repay some of these
monies. What are the tax consequences to Armstrong?
The first step is easy: Armstrong will be entitled to a
deduction. The repayment is tied to monies originally earned in his trade or
business as a cyclist or spokesman, so the tax linkage is clear.
The second question is one of tax benefit. Armstrong paid
taxes on these monies in prior years. Can he go back and have the IRS refund
those monies? There is the rub. What would be your argument for amending those
tax years?
You: He had to
repay those monies.
Me: Did he not have unrestricted access to those monies in the prior year?
You: I am not
saying that. He did, but now he has to pay it back.
Me: So is the transaction we are talking
about for the year he received the money or the year he pays it back?
You: What is the
difference?
Me: He
earned it in 2004 but pays it back in 2013. What year do you amend?
You: You cannot
amend 2013. It hasn’t happened yet.
Me: So you would amend 2004?
You: Yep.
Me: There are two issues. The IRS is going
to have a problem with your argument that he did not receive the money and owe
tax. He did receive the money. And the IRS will expect its tax, because in
2004 he had no reason to think that he wasn’t entitled to keep the
money.
You: What is the second issue?
Me: You cannot amend 2004. Remember, a tax
year is open for only three years. The statute period has long since expired.
You: So I am
stuck with 2013?
Me: That’s
right.
Let’s pursue this point of tax
benefit a bit further. Let’s say that Armstrong was in the maximum tax bracket
in 2004. Let’s also say that his income for 2013 is not what it was in 2004. How
much tax does he recoup from repaying prior winnings? You guessed it: whatever
the deduction saves him in 2013, which can be a very different – and much
smaller – amount than what he actually paid in 2004.
You: That doesn’t
seem fair!
Me: There is one
more tax option.
That option is IRS Section 1341,
sometimes referred to the “claim of right” section. The “claim of right”
concept is something akin to “I thought at the time that the money was mine to
keep.” Section 1341 gives one the option to:
(1)
Deduct the payment in the year of repayment, or
(2)
Calculate a hypothetical tax, excluding the
repaid income from the tax year originally received. That gives one a change in
tax. One then calculates the tax for the year of repayment, not including the repayment
itself, and subtracts the previously-calculated change in tax from that tax.
You: Huh?
Me: Let’s use an example. Say that Armstrong
repays $3 million in 2013. Let’s further say (to keep this easy) that the
entire $3 million was attributable to 2004 winnings and endorsements. We go
back and recompute his 2004 income tax excluding that $3 million. Let’s say his
tax goes down by $1,050,000 (3,000,000 * 35%).
You: OK, so he
gets a $1.05 million tax break.
Me: Not yet.
There is another step.
Let’s say that his 2013 taxable
income is also $3 million. We estimate his 2013 tax on the $3 million to be
$1,027,000 (granted, no one can guess what taxes will be). His tax benefit is limited to $1,027,000, not
the $1,050,000 from 2004.
You: So he loses
over $22 grand. That isn’t too bad, all things considered.
In our example, you are right. The $22 grand is small potatoes.
But we used a very simple example.
Let us complicate the scenario. What if the athlete’s knock-it-out-of-the-park
income years are behind him or her? Let’s use a football player. Say that he had
an 8-year NFL career. What if he has to pay back $2 million several years after
retirement? It is very possible that he will never again be in the same tax bracket
as when he was playing. That said, he would never get back the actual tax he
paid on the income, whether one uses Section 1341 or not.
Let’s use another example. What if our athlete was frugal
and saved his/her career earnings? He/she now has a very attractive portfolio
of tax-exempt securities and dividend-paying stocks. Let’s say that the portfolio
will generate $2 million in 2013. He/she pays back $2 million. What do you see?
Tax-exempts are – well, tax-exempt. Their tax rate is zero. Next year tax rates
on dividends may go to the maximum rate. Let’s say they do. He/she will offset the
maximum rate on the dividends, but remember that dividends are only a part of
the $2 million the portfolio is earning. He/she is still not whole.
Section 1341 many times helps, but there is no guarantee
that one will get a tax break equal to the tax actually paid when one received
the income.
P.S. Armstrong resigned from the Livestrong board of
directors on November 4. He had previously resigned as chairman on October 17
but had kept a seat on the board.
