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Summary: Gross-up is additional money an employer pays an employee to offset any additional income taxes, often used for one-off payments like bonuses.
Understanding gross-up is important to ensure intended financial rewards for employees. Here we explain benefits and how to calculate.
Gross-up
A gross-up is an additional amount of money added to an employee’s compensation to cover the taxes owed on that compensation. This ensures the employee receives a specific net amount after taxes. While grossing up can be done with regular salary payments, it’s not very common. Instead, gross-ups are normally applied to one-off payments like reimbursing a relocation or giving an annual bonus.
The rationale for grossing up comes from historically rounding up rewards to make administration easier. For example, if an organization’s 200 employees were all given a $50 bonus, it might be easier for administration to simply pay everyone an even $50 instead of deducting taxes and subtracting them to create odd totals. The taxes would simply be paid afterward on all of these payments together, greatly simplifying the process. These days, however, gross-ups are more common as incentives for highly compensated employees like those in C-suite positions. Grossing up ensures them they get the actual take-home pay they’re looking for.
Benefits of Gross-ups
Gross-ups can create benefits for both employees and employers. Employees essentially get to keep their awards at their gross totals, thereby avoiding any losses due to taxes. For employers, the benefits of grossing up include:
- Keeping things round: Paying bonuses and other awards can simply look nice and neat when they’re grossed up. Like the $50 bonus example, if it costs relatively little to gross up awards, it may be worth it for employees’ satisfaction.
- Ensuring net pay expectations: Employees are used to having portions of their salaries withheld for tax payments. They know that a $100,000 annual salary is actually about $76,000, and that’s just after federal taxes. However, most people calculate their budgets on how much they need to take in. Grossing up their salaries and rewards can make their calculations a lot easier.
- Attracting and retaining talent: When one firm offers $250,000 gross per year and the other offers $250,000 net, the net amount is far more attractive. When things like bonuses and moving expenses are stated, employees are often mistaken in assuming these are their net and not gross amounts. So, when compensation is clearly stated in net amounts, it can be incredibly enticing for top talent.
Challenges and Considerations in Gross-ups
Gross-ups are not always easy to manage. They can be hard to calculate and can be seen as not being open and transparent in many circumstances. The challenges of gross-ups include:
- Calculating accurate gross-up amounts: Calculating gross-ups can be challenging on their own. Consider a $95,000 salary offered to a manager as net income instead of gross. Here’s how to calculate the gross-up for this salary:
Take the net amount and divide by 1 minus the grossing up rate, then subtract the net amount.
Calculate the taxes to be paid on $95,000:
– Income tax: 22%
– Social Security and Medicare deductions: 7.65%
– State income tax: 7%Total taxes: 36.75% (equal to 0.3675)
Divide $95,000 by (1 – 0.3675):
$95,000 / 0.6325 = $150, 197
Subtract the net amount:
$150,197 – 95,000 = $55,197 gross-up
To pay an employee a net salary of $95,000, it would cost an organization an extra $55,197.
While receiving $95,000 net seems to keep them in the 22% income tax bracket, the gross-up on this salary pushes their earnings over the $95,375 threshold into the 24% bracket. This means that most of the gross-up would actually have to be paid at a 24% tax rate, further complicating the calculation.
Tax implications and compliance: Organizations sometimes report only the gross amount of a cash award to monitoring agencies. If the amounts awarded are grossed up so the net is equal to the reported gross, they’re reporting in error. This kind of accounting could cause a firm to be penalized if later discovered and especially fined for avoiding taxes.
- Budgeting: To return to the earlier example, if someone in an organization recommends paying each of the 200 employees a small $50 reward, the person responsible may approve this $10,000 expenditure. However, if it’s not clear whether the awards are being paid gross or net, this approval may not be given appropriately. If the net amount was stated, not the gross, this expenditure would cost thousands more and may not have been approved.
- Internal reporting: Internal reporting can become confusing when gross-ups are added to rewards or salaries. Net amounts are often reported incorrectly as gross, while the real gross values are a lot higher. This can lead to accounting errors, incorrect reports for shareholders, and even negatively affect budgeting and other planning.
Best Practices for Implementing Gross-ups
If organizations want to implement gross-ups, they should be clear in all of their procedures. They should calculate these gross-ups accurately and make sure that they’re properly reported both internally and to tax authorities to avoid penalties and other negative repercussions.
Grossing Up for Employees’ Benefits
Grossing up is performed so that employees end up with the full net amounts they are promised. In this way, they don’t lose anything to taxes, and this makes grossed-up salaries and benefits highly attractive.
FAQ
Gross pay is calculated by dividing the net pay promised by one minus the tax rate. The difference between this new gross pay and the net pay is the gross-up.
If an organization promises to pay a set net amount for salary, relocation expenses, bonuses, or other awards, it will have to perform gross-ups to calculate the total amounts it will need to pay.