Tax Strategies for Outrageous Bonuses

Insurance company AIG has received over $160 billion in federal money to bail them out over losing bets on “credit default swaps,” a new form of financial insurance that AIG helped create. Yet we just learned that the company paid $165 million in "retention bonuses" to the top employees at the “Financial Products” unit that lost all the money in the first place. President Obama, members of his administration, members of Congress, and ordinary Americans have all expressed outrage over these bonuses, and many are scrambling to find ways to claw them back for the benefit of the taxpayers.

Would it surprise you to learn that the Tax Code may hold the key to reclaiming those bonuses on behalf of the public?

The IRS has a long history of stepping in where traditional law enforcement fails. Back in the 1920s, Americans, and especially Chicagoans, were outraged at bootlegger Al Capone. (The St. Valentine's Day Massacre didn't help his public image either.) Capone eventually wound up in Alcatraz. But not for bootlegging or racketeering – he was actually convicted of tax evasion. (The IRS doesn’t care how you make your money. They just want their share!)

Some of the lucky recipients have been shamed into giving back their bonuses. And AIG has asked the rest to give back at least half. But how can the IRS help with those who would rather just take the money and run?

The House of Representatives voted last week to impose a special 90% tax on bonuses over $250,000 paid to executives at companies receiving over $5 billion in bailout money. But the AIG bonuses have already been paid, and it's unusual for Congress to make tax laws retroactive. Some authorities doubt that this move is constitutional, and others are uncomfortable using the tax code as a political weapon.

Another approach would be to stop AIG from deducting those payments from their own taxes. The Tax Code lets businesses deduct "reasonable compensation" they pay to employees. In this case, it's easy to argue that million-dollar bonuses are unreasonable given the results those employees produced. This would mean both AIG and the employee pay tax on the same money. It’s also something the IRS could do on its own, in an audit, rather than requiring Congress to pass special legislation.

You’re probably not worried about protecting a seven-figure bonus of your own. But there is a lesson here for everyone who pays taxes. The Tax Code reaches deep inside all of our financial decisions. It’s important that you understand the tax consequences of those decisions so you can keep as much as you’re legally allowed.

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