It's said that death and taxes are the only certainties in life. I'll leave the answer to that question to the great philosophers. However, one thing is an absolute certainty: taxes are a fact of life.
This is particularly true in the employer, employee relationship. The government requires that the employer withhold taxes from the employee's paycheck. Some would call this wise on the government's part, others wouldn't be so kind. In the corporate world, practically everything is taxed, including aspects of relocation packages provided to employees. Most relocation expenses associated with a move, whether it is a reimbursement made to a transferee or a payment made to a vendor on the transferee’s behalf, is required to be reported as taxable income to the employee and is subject to IRS supplemental withholding regulations.
Can you imagine the look on your employee's face when you gently explain that the generous relocation benefits provided will increase his or her tax burden? It is a guarantee, the once happy employee's mood will change quickly and not for the better. Well, fortunately for these employees, a portion of the tax liability of the relocation package can be covered by tax assistance (gross up) paid by the employer. Unfortunately, grossing up can add 55% or more to taxable relocation costs. If you consider the obvious benefit to the employees’ long-term happiness, it is money well spent.
Basically a tax gross up occurs when the employer adds to the taxable relocation amount to assist with the tax liability of the addition of taxable relocation costs to an employee's income. For example, if the relocation costs include $5,000.00 taxable dollars, the employer may pay a total of $7,500.00 so that the employee gets the full benefit of the $5,000.00, as the estimated taxes of $2,500.00 are paid by the employer.
If you are in planning a relocation move, getting your hands on IRS Publication 521, "Moving Expenses" and Publication 523, "Selling Your Home," available at www.irs.gov would be a good place to start to fully understand IRS regulations regarding relocation expenses.
3 main ways to calculate a tax gross up
1. Flat Method
The flat method is a flat percentage calculated on the taxable expenses and then added to the income. For example, an employer will gross up at a rate of 25% for taxable expenses. If the transferee is paid $1,000, the gross up would be 25% of this, or $250, and therefore the transferee would receive a benefit of $1,250 total. Note that the gross up is also considered taxable income and may create an additional tax liability to the transferee.
It’s important to note that this method likely doesn't cover the employee's tax liability since the gross up is taxable income. Additionally, this method is not compliant with supplemental withholding regulations.
2. Supplemental/Inverse Method
This method is often used because not only are relocation expenses considered income, but the gross up is considered income too. Therefore employers will pay the gross up on the gross up. To determine the amount, add up all the tax rates (fed, state, OASDI, SS) and then divide the taxable expense by the sum of the tax rates. Take this number and subtract the taxable expense.
This methodology covers gross up on the gross up, but may not accurately reflect the tax bracket of the employee.
3. Marginal/Inverse Method
This method is typically handled by a CPA or full-service relocation companies and also incorporates the tax on tax calculation. The difference is this methodology takes into account employee income and IRS Form 1040 tax filing status. In most cases policy dictates that only company-earned income will be considered and other forms of income, such as spousal income or investment income, won't be taken into account.These three methods represent the nitty gritty of grossing up taxable relocation expenses to assist with the employee's relocation tax liability. While one can do the calculations, it is always wiser to seek the help of an experienced relocation experts.
Although this written communication may address tax issues, it is not a covered opinion as described in Circular 230. Therefore, to ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments), unless expressly stated otherwise, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.