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An Explanation of Tax Gross-Up Payments

Posted on by bentakis

In today’s edition of Paul Streckfus’ fabulous publication, the EO Tax Journal, he discusses a recent article in the Chronicle of Higher Education about the hefty compensation packages of some private college presidents. The article focuses on one politically sensitive piece of compensation: the tax gross-up. This refers to an extra payment to an executive to cover the taxes the executive owes on his/her base compensation. The practice is so politically sensitive that many public companies have stopped making gross-up payments to their executives for fear of angering shareholders. But gross-ups are apparently still prevalent among private colleges.

This prompted Paul to ask: “If a college pays the tax on a bonus to its president, isn’t the president liable for the tax on the tax payment, or does the college pay that, too, and if so, doesn’t that go on ad infinitum?”

I sent Paul the following explanation:

You are correct that when you increase someone’s pay to cover taxes there is also tax on that increased amount. When you gross up, you need to use algebra to find the amount of extra payment that is enough to pay the taxes on the original (pre-gross-up) amount as well as the taxes on the extra payment. The end result should be that, after taxes, the employee ends up with exactly the pre-gross-up amount.

The algebraic equation we use for this is: tax rate (pre-gross-up amount + x) = x, where x equals the gross-up amount. I am fairly math illiterate, so there may be better ways to do this, but this is what has worked for me in my employee benefits practice.

So, for example, if the executive’s base compensation is $300,000, and her tax rate is exactly 30%, the equation would look like this:

.30(300,000 + x) = x.

I won’t embarrass myself by attempting to show you how I worked out the algebra (there are algebra solving applications online), but in this example x equals $128,571.43.

Thus, if you add $128,571.43 to the executive’s base compensation, you pay her a total of $428,571.43. Her tax rate in this example is 30%, so when she pays taxes on $428,571.43, she ends up with after tax compensation of exactly $300,000.

Of course, when you take into account the different rates for state and local taxes and employment taxes, it gets more complicated, but this is basically how you figure out the gross-up amount.

UPDATE: Paul Streckfus graciously reprinted my email in the following day’s edition of EO Tax Journal.

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