A gross-up is an additional amount of money added to a payment to cover the income taxes the recipient will owe on the payment.
Gross-ups are commonly seen in executive compensation plans. For instance, a company may agree to pay an executive’s relocation expenses plus a gross-up to offset the expected income taxes that will be owed.
Key Insights:
- A gross-up is a financial tactic to ensure recipients cover their income taxes without impacting net pay.
- Commonly applied to one-time payments like relocation reimbursements or year-end bonuses.
- Can be controversial, especially when used in executive compensation, attracting media attention for extravagant payments.
The Mechanics of Grossing-Up
Grossing up a paycheck means calculating it ‘in reverse’. While employees usually receive a gross amount from which taxes and other withholdings are deducted, gross-up calculations start with a net pay goal and add the necessary amount to ensure taxes are covered, yielding the desired net pay.
This is particularly employed for one-time payments, covering relocation expenses or bonuses. The method varies among companies, and additional tax liability might still remain.
In essence, grossing up rephrases an employee’s offered salary in terms of take-home pay rather than gross pay before taxes. Some companies favor this method, especially for compensating high-level executives because it can partially obscure salary costs in financial reports.
Enhanced Example of Grossing-Up
Imagine an employee with a 20% income tax rate whose net annual salary is $100,000. Here’s the grossing-up formula:
- Gross pay = net pay / (1 - tax rate)
In this scenario, the company needs to adjust the employee’s salary to $125,000 to account for the taxes, ensuring $100,000 is netted by the employee:
1$125,000 x (1 - 0.20) = $100,000
The Gross-Up Dilemma
Increased scrutiny around executive compensation, especially post-2008 financial crisis, has brought the practice of grossing up into the spotlight. Companies can discreetly inflate executive salaries significantly, which may not be evident in financial reports showing net earnings alone.
Several companies have faced criticism for gross-up practices. A 2005 study revealed that 77% of companies provided gross-up severance packages for outgoing executives. Gillette, for instance, saw its CEO James Kilts receive $13 million in gross-up payments after Procter & Gamble’s acquisition in 2005.
Moreover, the rise of the gig economy and remote work complicates the gross-up process, given the diverse income streams individuals might have.
Other Related Terms
What Does It Mean to Gross Over?
Gross over refers to the total earnings before any taxes are deducted.
What Is Adjusted Gross Income?
Adjusted Gross Income (AGI) is used by the IRS to determine a taxpayer’s liability. It refers to the gross income minus specific deductions and income adjustments.
What Is Gross Profit Margin?
Gross profit margin is a metric reflecting a company’s operational efficiency. It represents the ratio of revenue after deducting the costs of goods and labor.
Conclusion:
Gross-up involves additional payments by employers to counteract the income taxes that an employee owes when benefiting from cash payments like relocation expenses or bonuses.
Gross-up payards are calculated by dividing an employee’s wages by the net tax rate, ensuring the employee’s take-home pay remains unaffected by the additional tax burden.
Related Terms: Tax Liability, Severance Package, Adjusted Gross Income, Gross Profit Margin.
