A gross-up refers to an extra sum of money added to a payment to account for the income taxes the recipient will need to pay on that payment. This is commonly seen when employees get cash benefits, such as severance packages, relocation costs, and cash bonuses.
This practice is also found in executive compensation plans. For instance, a company might agree to cover an executive’s relocation costs, along with a gross-up to balance out the anticipated income taxes that will be due on this payment (as well as on their salary). Gross-ups can sometimes stir up controversy, especially when they lead to excessive executive pay.
Learn more about Gross-Up
At first, employees get their gross pay, which is the full amount before any deductions like taxes, retirement contributions, or Social Security. Once those deductions are taken out, what employees actually take home is called “net pay” or “take-home pay.”
To gross up a payment, you need to figure out the net pay you want, then bump up the gross pay enough to account for tax withholdings so that the net amount comes out right.
Typically, grossing up is used for one-off payments, like reimbursements for moving costs or year-end bonuses. Depending on how a company calculates it, which might be their best guess at an employee’s tax burden, that employee could still end up with extra tax to pay.
Some companies like to use grossing up to show the compensation of their top executives and other high earners. One reason for this is to somewhat obscure salary costs in their financial statements.
Example of Calculation
For instance, think about a company that gives an employee a net salary (take-home pay) of $100,000 each year. This employee faces an income tax rate of 20%. The formula to calculate the gross salary is as follows:
Gross pay = net pay / (1 - tax rate)The employer needs to increase the employee’s salary to $125,000 to cover the 20% tax on income—since $125,000 × (1 – 0.20) equals $100,000.
Conclusion
Gross-up is basically extra money that an employer gives to an employee to help cover any extra income taxes that might come from that payment.
Typically, this grossing up happens when an employee gets a one-time cash benefit from the company, like relocation costs or a bonus. To figure out the gross-up amount, you take the employee’s wages and divide them by the net tax percentage that would apply.
Using gross-ups can be a bit controversial, especially for executive pay, because they might hide costs in financial reports. Companies that go this route should be ready for some extra scrutiny regarding this practice.