Grossing up one-time employee payouts, such as bonuses or relocation costs, is a juicy benefit you can offer your team. But, it is both complicated and expensive. In this article, we demystify the process so you understand:
- What a payroll gross-up is, and when it's most appropriate
- The tax implications of using this method and how to do so without incurring an unnecessary tax burden
- How to calculate a gross-up
- The pros and cons of grossing up a one-time payment
By the end, you'll have all the important information you need to decide whether offering this perk is a good fit for your business and its budget.
What Is a Payroll Gross-Up?
A payroll gross-up is when a business pays an employee an increased amount to offset the cost of the employee's payroll taxes.
So if you promise to pay a $1,000 bonus to an employee, you would issue a check for an additional sum so that the employee's taxes are taken care of and their net pay is $1,000.
The additional amount added to their paycheck covers:
- Federal Income Tax
- FICA (Social Security and Medicare taxes)
- Local Taxes (when applicable)
The employer must report the grossed-up amount as the total amount paid to the employee, including the taxes paid on the employee's behalf.
Include it in the appropriate boxes on Form 941 or Form 944 (but always speak with a tax professional if you are new to grossing up).
What Is the Purpose of a Payroll Tax Gross-Up?
Payroll gross-ups ensure that when an employee gets a large sum of money, like an end-of-year bonus, they'll receive the full amount promised. Otherwise, a big portion of their bonus will go toward taxes, and the bonus will come out to a lot less than it initially seemed.
Can it Help You Attract New Employees?
Yes, a gross-up allows you to offer more competitive pay, which makes you more attractive on the job market. In other words, when a job candidate is looking at their total compensation package, they'll get to add a considerable amount more to their net pay. In such a competitive job market, that can certainly tip the scales in your favor.
You may rightly be thinking, "Won't this become a never-ending spiral of taxes owed?" But, the IRS has accounted for this and allows employers to use an approved gross-up calculation.
Let's go over that next.
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How to Calculate a Payroll Gross-Up
The formula is fairly simple. The main task is calculating the total percentage of taxes owed, including federal, state, and FICA taxes.
To calculate, you simply divide the desired net pay by the inverse of the net percentage of taxes (i.e., the total tax rate). The formula looks like this:
Total Gross Pay = Desired Net Pay / (100% - Total % Tax Paid)
A Tennessee employer offers $6,500 in relocation expenses to a newly hired employee. That money is counted as income, so it is subject to the following tax withholding.
- Federal: 22%
- State and local: Does not apply in Tennessee*
- FICA (Social Security + Medicare): 7.65%
That brings the total percentage paid in taxes to 29.65%. Let's plug our figures into the formula:
Total Gross Pay = $6,500 / (100% - 29.65%)
= $6,500 / 70.35%
So the employer would cut a check for $9,239.52 to account for the additional taxes and ensure the new employee receives the full benefit of their moving expenses.
*Other states that don't withhold state income taxes include: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
It Isn't Always So Simple
We're simplifying the process to ensure the information is clear. Grossing-up can become more complicated under some circumstances. For example, issuing a bonus may push an employee over the FICA wage limit threshold ($147,000 for 2022).
In this instance, you'd need to count FICA toward any wages below that threshold but not above it.
When To Gross-Up Payroll
This is most appropriate when offering large sums, most commonly bonuses and relocation packages. The process is optional.
But employers can use it to their advantage. Offering to cover taxes builds trust between employers and employees, showing you care about your employee's compensation.
This is especially true when the additional income pushes an employee into a higher tax bracket, as more of that additional income will be 'lost' to taxes.
If grossing up payroll puts your budget out of whack, consider grossing up a smaller amount to stay within the business budget while covering employees' wages and added tax liability.
Pros and Cons
Everything is a trade-off in the small business world, and grossing up one-time payments is no different. Let's take a closer look at the advantages and disadvantages.
- Builds trust with employees and increases satisfaction by showing you care
- Allows you to offer more competitive pay to your employees, which can give you an edge in the job market
- Can offset costs for additional benefits your company can't currently offer, but larger companies can (like covering health insurance premiums, gym memberships, childcare, etc.)
- Employees pay less of their tax burden and have less stress, which should help them be more productive at work
- Additional cost for the employer, both in terms of money and time
- If offered once, employees will expect them with every bonus check, so ensure you're ready to foot that bill for the long run.
- If used to offset health insurance premiums, it's often more expensive in the long run and is not the most effective way to attract new employees.
The process for submitting these payments may vary depending on your specific circumstances, the applicable tax rules, and an employee's taxable income. It's always a good idea to consult with a tax professional or the IRS for guidance on how to handle them properly.
How to Make Payroll Gross-Ups Work for Your Business
Grossing-up payroll is an effective way to attract and retain employees by offering more competitive compensation packages. Here's how to use it to your advantage:
Being clear about bonuses can help employees feel valued and appreciated since they'll know to expect some extra compensation for good work.
Communicating about bonuses also helps manage employee expectations and prevents misunderstandings or conflicts. When employees understand the criteria for receiving a bonus, how it is calculated, and when it will be paid, they're less likely to be surprised or disappointed by the outcome.
If you're unsure that grossing-up can become a permanent fixture in your business policy, let your employees know. This can be as simple as the statement, "While we are overjoyed to be able to cover the cost of taxes with this bonus, that may not be possible in the future."
Finally, don't forget to work with your payroll team and CPA about your plans. They can help you through the process and may have additional ideas about how to make things work.
Keep Accurate Records
Like all things with business, secure and accurate bookkeeping is one of the keys to success. This will help you to stay compliant with tax laws and regulations—and avoid any potential penalties or fines.
Can you give an employee a bonus without taxes?
No, it is not possible to legally award bonus compensation to an employee without owing taxes.
For bonuses under $1 million, you can withhold taxes based on an employee's W-4 at a flat rate of 22% or with a more complicated method called the aggregate method.
Employers may also be required to withhold state and local taxes on supplemental wages, depending on the state.
What is the gross-up rate?
This is the cost of taxes an employee would pay on a (typically) one-time payout.
Rates vary depending on the employee's income bracket and their applicable taxes—federal, state, local, Social Security, and Medicare taxes.
And, because some taxes no longer apply after certain income thresholds, some compensation portions are subject to different tax rates than others.
Always consult a tax professional when navigating these calculations.
What's the difference between payroll gross-up and gross pay?
A payroll gross-up is additional compensation offered to an employee to offset taxes. Essentially the employer pays the payroll taxes for the employee.
Gross pay is the total amount an employee receives before tax.
What is the difference between gross-up and net pay?
Gross-up pay and net pay are both terms used to describe an employee's earnings, but they represent different amounts.
The gross-up amount is additional compensation added to a bonus to offset taxes. It ensures an employee's net pay—i.e., take-home pay—equals the specific amount promised by the employer.
Your Employees Will Thank You
Ideally, all parts of your compensation plan should help create a positive work environment, which is why grossing-up can be so effective.
If you're interested in offering this benefit at your company, the next step would be to research and understand the tax laws and regulations in your jurisdiction.
It's also a good idea to reach out to a trusted business tax advisor. From there, you can figure out the best approach for implementing this perk, like how to communicate with your employees and stay compliant.
At the end of the day, your employees will thank you—and you'll have a program that works for them, and for you.