Employer Overpayment

[csedayski]

I was accidentally hugely overpaid during my internship in summer 2019 and this was reflected in my 2019 W2. I figured this out and filed an extension for my 2019 taxes. Now the company is saying that they cannot issue a new W2 for 2019 and I should pay taxes on the full income for 2019. They want me to pay them back the excess this year i.e. 2020 and use Pub 525 to get my excess 2019 tax back.

I have two questions:

1. Does this make sense? Is the company allowed to do this and not give me an updated W2?

2. I will be paying them a check this year. What documentation do I need from them to be able to use 525 in turbotax?

Thanks!

[Opus 17 · Accepted solution]

You're going to be in a tough spot, and depending on the amount, you might want to talk to a labor lawyer.  I'll explain the problem first, and how to report it on your return second.

The problem is that you need to either take a special itemized deduction, or use a procedure called "IRC 1341 Claim of Right".  The itemized deduction won't result in a full refund of the tax owed unless you already have more than $12,500 of other itemized deductions (or $25,000 if married).  The claim of right procedure would definitely get your tax money back, but to use it, you must have had a reasonable belief at the time you received the money, that you had an unrestricted right to the money.   And since you knew at the time you were being overpaid, you knew that you did not have an unrestricted right to the money.  If you had repaid the money in 2019, the company should have issued a correct W-2 for 2019.  If you file under IRC 1341, and if you were audited, you risk losing your case.  

Your 2019 W-2 can't be corrected because the wages you received are what you actually received, even if they were wrong.  If you made repayment during 2019 then the company should (and must) issue a corrected W-2 to reflect what you were actually paid.  But if you haven't made the repayment yet, the 2019 W-2 can't be corrected. 

If the overpayment amount is less than $3000 there is no tax relief available.

If the overpayment amount is more than $3000, you can either take a special itemized tax deduction for the amount of repayment, or you can take an IRC 1341 Claim of Right tax credit.  To claim the credit, you figure out what your tax would have been in 2019 without the extra wages, and the difference is the amount of your credit.  You have to figure the credit amount yourself, you can do this by preparing test tax returns (for 2019) with and without the additional wages.  Then, you manually enter the credit on Schedule 3 line 6 of your 2020 tax return, which you can only do using the desktop version of Turbotax installed on your own computer (not online).  That credit will come back to you as a refund of the amount of excess tax you paid on your 2019 tax return.  If you take the special itemized deduction, it will be at the bottom of the Deductions and Credits page under the listing for "other uncommon deductions."  The itemized deduction may save you something on your taxes depending on your other deductions, but probably not as much as the credit. 

For state income tax, you will have to research your state, there is probably a similar Claim of Right procedure.

For social security and Medicare tax, the employer could issue a refund of that tax, and issue a corrected W-2 that would change box 3-6 (social security and medicare wages and tax paid) but not change box 1 (gross wages).   If they don't, you can request a refund using IRS form 843.  You will need a letter from your employer verifying that you were required to repay wages and also verifying that the company will not be making the refund themselves.

Remember, you file a 2019 return using the 2019 information which is correct as to what you actually were paid in 2019.  If you make the repayment in 2020, any deduction or credit is claimed on your 2020 tax return. 

However, as I indicated, you probably don't have a Claim of Right in your case since you knew you were being overpaid, so professional legal and tax advice may be in order.  If you explain this to the company you might be able to negotiate a reduced repayment to account for the lost taxes.  

[Carl]

This is not complicated - though some get the false impression that it is. The key here is "PROOF" that will stand up in a court of law should that become necessary. When it comes to repayment of an over payment of wages, I've never heard of it ending up in tax court - much less seen it.

If you were "IN FACT" over paid in 2019 and did not pay the money back in 2019, then the W-2 is correct. It's a fact that you *WERE* paid the amount reported on the W-2. Period. End of Story. Further discussion on that is an absolute waste of your time. You *WERE* paid the amount in 2019, reported on the 2019 W-2. You will report the W-2 exactly as printed and you *WILL* pay taxes on the entire amount. There is "NOTHING" that "ANY" lawyer can do to change that fact, unless they know something about time travel that you and I don't.

If you pay back the over payment amount in 2020, the payer your reimburse needs to provide you *PROOF* that you paid it back, and they need to provide that proof *IN WRITING*. Then it will be no problem for you to report the repayment on your 2020 tax return under "Right of Claim" to reduce your taxable income in 2020. The TurboTax program can handle this Right of Claim just fine under the "Other Tax Situations" tab.

I would suggest that you pay it back with a personal check, so that if proof is not provided, then your cancelled check is all the proof you need. The check needs to be made payable to the employer using the same thing on the "Pay TO" line, as is identified on the W-2 as they payer. That removes any and all doubt once the check clears.

[Opus 17]

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@Carl wrote:

This is not complicated - though some get the false impression that it is. The key here is "PROOF" that will stand up in a court of law should that become necessary. When it comes to repayment of an over payment of wages, I've never heard of it ending up in tax court - much less seen it.

---

There are several claim of right tax court cases although they mostly involve corporations and much larger amounts than we are talking about here.  

This is what the Journal of Accountancy Says:

Sec. 1341 allows a taxpayer to take a deduction or a credit if he or she repays an amount exceeding $3,000 that the taxpayer had reported as income in a prior tax year because he or she appeared to have had an unrestricted right to the item, but it is determined in a later tax year that the taxpayer did not actually have that unrestricted right. The repayment must also be deductible under some other Code provision. Taxpayers who know that they have improperly acquired income cannot have an unrestricted right to it. In the later tax year, to show that there was no unrestricted right to the income, the taxpayer must demonstrate that the reported amount was involuntarily given away because of some obligation and the obligation had a substantive nexus to the original receipt of the income. [https://www.journalofaccountancy.com/issues/2019/sep/irs-sec-1341-claim-of-right.html] [emphasis added]

• Did it appear you had an unrestricted right?  It seems no.
• Did you improperly acquire the money, that would bar the credit?  That seems a no as well, and we don't need to pursue that further, but it is something you should be aware of that could be used against you.
• Did you involuntarily give up the money in 2020?  You might want to get the company to send you a demand letter so you have it all on paper.

Interestingly, in another case the Journal of Accountancy writes:

This case joins others in which the courts took a very broad view of section 1341. The outcome is due, in part, to the general rule that remedial provisions should be interpreted broadly and all doubts resolved in the taxpayer’s favor. If this trend continues, more companies should be eligible to use the relief provision contained in section 1341.

Most individual taxpayers aren't audited, so you can probably use the Claim of Right credit without worry.  But I am not a tax expert, and no one on this board will stand with you at any audit.  Educate yourself, and decide if it's worth the risk, and whether you want additional professional help. 

[csedayski]

Thanks for the thoughtful responses @Opus 17  and @Carl ! The total refund here is above $22,000. I genuinely did not realize until 2020 that I had been overpaid. I brought up the overpayment issue on my own with the company after I realized this. I have emails to show that I brought it up with the company. They did send me a demand letter after my emails and advised that their confirmation email, combined with a copy of my cancelled check, should be enough to prove when repayment was received.

1. Do you think this is enough to establish unrestricted right should that become an issue? To clarify, the demand letter does not specifically say that I brought up the overpayment on my own.
2. Do you think I could/should request any documentation which can establish unrestricted right?

[Carl]

1. Do you think this is enough to establish unrestricted right should that become an issue? To clarify, the demand letter does not specifically say that I brought up the overpayment on my own.

Doesn't matter. Keep both the demand letter and the cancelled check for at least 3 years (though I recommend 5).
2. Do you think I could/should request any documentation which can establish unrestricted right?

Nope. You have all you need with the demand letter and cancelled check.

The total refund here is above $22,000

Shouldn't be an issue, so long as you have taxable income in excess of that amount, from which to deduct the amount you paid back. Otherwise, the deduction may not help that much. I don't know how it works if say for example, you only have $10,000 of taxable income *before* the right of claim. While I've never heard details or experienced an amount that large, I would fully expect you to be audited by the IRS on this. But this should not be an issue.

Generally and audit of this type is what is referred to as a "paper audit" where the IRS sends you a letter asking for proof. The demand letter and cancelled check are all the proof you need. You send a copy of each to the IRS and the issue "goes away".

[Opus 17]

@Carl seems to think the credit is a gimme.  Maybe that's the voice of practical experience.  I tend to assume that when people put things in writing, they more or less mean what they say.  

I can't judge the legal merits of your situation but it seems like a fair case and I don't have any reason to argue with Carl other than my own natural skepticism.

I do want to make two final points, though.  First, the itemized deduction method is available for any repaid wages, even if the claim of right method was disallowed by an auditor, you could claim the repayment as an itemized deduction and claim at least some tax benefit.  Second, you should not assume that the tax credit method gives you a better recovery.  You are allowed to figure the tax effects of the repayment both ways (as a credit applied to 2020, calculated from 2019; or as a deduction in 2020) and use the method that gives the largest recovery.  I could create hypothetical situations on both sides, so the only way to know for sure in your case is for you to test it both ways.  (None of this affects how you must first file your 2019 return, of course.)

[Carl]

seems to think the credit is a gimme.

Actually, no I don't. Basically because of the large amount in this case. I would fully expect an audit regardless of which years tax return is affected. I don't know all the aspects as they apply to this specific case, nor do I claim to know all the options available. But I do know that paying back a 2019 over payment in 2020 affects the 2020 taxable income regardless of why year tax return one claims or takes the credit on. I feel it's safer to assume that claiming the credit either way, will not be the last time it's dealt with, with the IRS.

Perhaps it would be best to seek the advice of a local tax professional? Especially if state taxes are involved.