Q&A #94 – How is a tax gross up calculated?

Question: I serve on the Board of a nonprofit that is hiring a new Executive Director. We will be providing a relocation payment intended to offset the new Executive Director’s costs of moving to the area where the organization is located. She is asking that this payment be “grossed up” for taxes, so that she does not have an additional tax burden from the payment. We have had some disagreement about how this gross up is calculated. What is the proper way to calculate a tax gross up?

Answer: Grossing up a payment to offset the taxes the employee will owe on the payment is a relatively rare practice among nonprofit organizations, but can be appropriate under certain circumstances usually involving one-time payments such as reimbursement of relocation expenses. These calculations can be confusing because when you increase a payment to cover taxes, there is also tax on that increased amount. Therefore, a formula must be used to figure out the amount that is sufficient to pay the taxes on the original (pre-gross up) amount as well as the taxes on the increased amount.

The basic formula for a tax gross up is relatively simple. To illustrate, suppose the intended relocation payment is $10,000, and the Executive Director’s total tax rate is 35% (including federal, state, and local taxes). The basic formula to calculate the total gross up payment would be:

Total grossed up payment = $10,000 divided by (100% minus 35%)

In other words:

Total grossed up payment = $10,000 / (1 - 0.35), or $10,000 / 0.65

In this case, the total grossed up payment would equal $15,384.62 (rounded). That is, at a tax rate of 35%, the Executive Director would pay $5,384.62 in taxes on the relocation payment, leaving her with exactly $10,000, the original intended payment amount. Many payroll administration platforms have features that can perform this calculation automatically based on the withholding information entered for the employee.  

Planning Tip – When hiring any new employee, be aware of the state and city from which the employee will be performing the work. In the case of an employee who will be working remotely, this could be the state and city where the employee lives. If your organization does not already have employees in this state and city, there may be significant new compliance obligations related to paid leave requirements, wage and hour laws, tax and unemployment registration, and other areas. Seek advice from your attorney, CPA, payroll administrator, and other advisors well in advance of the employee’s starting date to make sure the organization is in compliance and has made any needed changes to its employee handbook.

While the gross up formula is simple, it can be surprisingly complicated in practice to account for all taxes that might be owed by the payee. This is because it is hard to know exactly what the payee’s marginal tax rate will be, since this depends in part on the payee’s other sources of income, as well as other factors that could change during the year, such as filing status and state of residence. This is further complicated by the fact that the payee might or might not exceed the social security wage base limit for the year, which would affect the amount of payroll taxes due on the payment.

For these reasons, it is generally advisable for both parties to not dwell on finding the exact tax rate to reach a perfect gross up calculation. If a tax gross up is deemed appropriate under the circumstances, focus on finding an estimated tax rate for the calculation that both sides find fair and agreeable.

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