The Union Cycliste Internationale (UCI) announced that it is standing behind a report previously published by the U.S. Anti-Doping Agency (USADA) alleging that seven-time Tour de France winner Lance Armstrong oversaw the most sophisticated doping program in the history of sport. If you took this news as an indication that the embattled cyclist has finally hit rock bottom, no one would think you foolish.
After all, in the two weeks since the USADA released nearly 1,000 pages of evidence -- including damning testimony from 15 former teammates -- fingering Armstrong as the mastermind behind the U.S. Postal Service team's systematic use of performance enhancing drugs, Armstrong has been banned from cycling for life, stripped of his seven tour titles, and fired from endorsement deals with Nike, Trek, and Anheuser Busch that some pundits have estimated will cost Armstrong $150 million over the remainder of his life.
Oh yes it can. The UCI's decision was more than ceremonial, as the organization was the only one with the power to formally strip Armstrong of his Tour titles. And while Armstrong is likely to continue to profess his innocence -- his legendary oversized ego barring him from admitting guilt until someone can produce a picture of him ascending the Alpe d'Huez with an IV bag full of tiger blood dangling from his femoral artery -- his adamant denials are no longer enough to protect him. With his victories wiped clean from the record books, race organizers and former sponsors can now begin the process of recovering payments previously made to Armstrong for winning those events.
For illustrative purposes, let's look to Armstrong's most notable achievement: his consecutive Tour titles spanning from 1999 to 2005. During this run of dominance, Armstrong received bonuses from Tour officials for each stage win, each day he wore the leader's yellow jersey, and of course, each overall victory. These payments are rumored to have totaled nearly $5 million over the seven-year period.
Armstrong's compensation wasn't limited to race winnings, however. The U.S. Postal Service, Armstrong's team sponsor during each of his tour victories, paid Armstrong over $12 million in performance bonuses during that span. Particularly worthy of note was a $5 million reward the USPS agreed to pay Armstrong upon winning his fifth consecutive title in 2004. The payment was covered by an insurance policy the Postal Service had taken out with SCA Promotions, who initially balked at paying the bonus amidst rumors that Armstrong's victories had been fueled by drug use. The case eventually went to arbitration, where SCA was forced to pay $7.5 million to Armstrong, representing the original $5 million bonus and $2.5 million in interest and attorney fees.
Now that Armstrong's titles have been officially vacated, it's extremely likely that Tour officials are placing hurried calls to their legal department to start the process of recovering the $5 million in winnings previously paid to Armstrong. For its part, SCA Promotions will quickly stake their place in line, as they were angered during the arbitration process by what they viewed to be arrogant, dismissive behavior by the cyclist's legal team.
Should all of these claims come to fruition, Armstrong may be cutting a lot of checks in 2013. Which begs the question: What will be the tax consequence if Armstrong repays race winnings and bonus amounts that were previously included in his taxable income as compensation?
The issue is not one of deductibility. Because the bonuses were originally earned in Armstrong's trade or business of being a cyclist, any repaid compensation should be deductible as an ordinary and necessary business expense. Rather, the problem Armstrong faces is one of tax benefit.
If the doomsday predictions surrounding Armstrong's future income stream are to be believed, it's possible Armstrong may pay out more in bonus restitution during 2013 than he takes in as income. As a result, he may not be able to reap the full tax benefit of the deductions related to his repayments. And even in the event Armstrong is able to fully utilize his deductions in the current year, he may have been subject to a higher tax rate when the bonuses were originally earned -- particularly during the pre-Bush tax cut years of 1999-2001 -- than he is today. In either scenario, Armstrong would likely enjoy a larger tax benefit if he could travel back in time, exclude the bonus payments from income in the year they were received, and redetermine his prior years' tax liability.
Section 1341, In General
Fortunately for Armstrong, there is an Internal Revenue Code provision that contemplates such a dilemma. Section 1341 provides that if the facts are right, a taxpayer like Armstrong who is required to repay amounts previously included in income can compute their tax consequences on a "best case scenario" basis. The statute permits the taxpayer to either:
1. Deduct the payment in the year of repayment, or
2. Compute the hypothetical reduction in tax that would have resulted from excluding the repaid income in the year it was originally received before applying that reduction to decrease the current year's tax bill (without deducting the repayment in the current year).
To illustrate, assume Armstrong repays $20 million in race winnings during 2013 and deducts the payment on his 2013 tax return, yielding $3 million in tax benefit. If he qualifies to use Section 1341, Armstrong opt instead to go back to the years he received the payments and perform a hypothetical computation (he does not actually amend the previous years' returns, which are closed by statute) in which he redetermines the tax liability for each year by excluding the amount of income that has subsequently been repaid. If the result of these computations is a total decrease in previous years' tax of $5 million, Armstrong may opt to forego the current year deduction related to the repayment, and instead reduce his 2013 tax liability by the $5 million in tax savings that would have resulted from excluding the income in the year originally received.
Unfortunately for Armstrong, Section 1341 is rife with requirements that must be met before a taxpayer can take advantage of the retroactive reach of the provision. While Armstrong will satisfy the majority of these hurdles with ease, there is one that poses a potentially fatal challenge.
Requirements of Section 1341
The repayments must be involuntary. While Armstrong clearly subscribes to the George Costanza formula for convincing fibbing -- It's not a lie if you believe it -- and will likely go to his grave convinced he's been wrongly persecuted, the Code does not look to the taxpayer's mindset to determine if a repayment is voluntary or involuntary. Rather, the taxpayer must be required, as a result of a discovery made after the payment was originally included in income, to have not had a right to the income when received.
In Armstrong's case, although the repayment of prior bonuses wouldn't take place until 2013, a full eight years after Armstrong's last Tour victory, because both the Tour's race rules and Armstrong's sponsorship contracts contained provisions barring Armstrong from using performance enhancing drugs while competing, the repayments are required due to a condition that was present prior to Armstrong's initial receipt of the bonus payment. This should serve to make Armstrong's repayment involuntary.
The deduction must be allowable under another Internal Revenue Code provision. Section 1341 is not a deduction granting provision; rather, it simply allows for an alternative tax benefit analysis in certain situations provided the deduction is otherwise allowable. As discussed above, in Armstrong's case, since the payments in question relate to previous compensation, repayment of the compensation should be allowable as an ordinary and necessary business deduction under Section162.
The deduction must exceed $3,000. That's not going to be a problem.
The income must have been originally included in the taxpayer's income because the taxpayer believed he had an unrestricted right to the income. This requirement poses a significant threat to Armstrong's ability to use Section 1341 to obtain the most advantageous result from any bonus repayments. Because Armstrong has been accused of knowingly violating race rules and the terms of his sponsorship contracts by doping throughout his seven Tour victories, it is difficult to envision the IRS concluding that Armstrong could have believed he had an unrestricted right to his bonus money. Stated in another way, because Armstrong knew his doping was against the rules, he couldn't have believed he had an "unrestricted right" to the bonus payments. Rather, he would have accepted the bonus money knowing that a subsequent failed drug test -- or as it happened, an investigation eight years after his last race -- could result in his being forced to forfeit the bonuses.
Previous case law would support this theory, as the courts have made clear that Section 1341 does not apply to any "ill gotten gains," such as embezzled income, smuggled goods, or illegal kickbacks [See Perez v. U.S., 553 F. Supp 558 (M.D. Fla. 1982]. Armstrong's PED use poses a similar problem in that his bonus payments appear to have been earned through "fraud or deceit," precluding him from using Section 1341 to achieve the most beneficial tax result of any subsequent repayments.
Should Armstrong be unable to utilize Section 1341, he would be limited to merely deducting any bonus repayments in the year they are made, with the tax benefit of those deductions being dictated by the law -- and Armstrong's specific tax picture -- in the year of repayment. Of course, given all that Armstrong has been through over the past two weeks, his future tax returns are likely the least of his worries.