Common Gross-Up Mistake: Using a W-4 vs. Tax Filing Status

2.15.19 | In the early months of each new year, many global mobility departments revisit their gross-up policies only to find themselves facing a myriad of options and seeking guidance. If we were to offer two pieces of advice, they would be:

  • Use the marginal inverse rate to best predict an employee’s tax liability.
  • Base your gross-up on an employee’s 1040 and tax filing status, not their W-4.

The second piece of advice is often overlooked yet it is critical because most employees’ W-4 forms do not reflect their true tax situations. As a result, many employers inadvertently overpay or underpay their transferees. When tax time comes, these employees are surprised by a larger-than-expected refund or a larger-than-expected bill. The latter, of course, can leave employees confused and upset.

Example: W-4 vs. 1040 & Tax Filing Status

When Bill was hired, a W-4 was among the many forms he had to complete. Bill is married but in an effort to compensate for his spouse’s income, which places his household in a higher tax bracket, he claimed a “single” status.

Bill’s employer uses a marginal gross-up policy with an inverse rate. Here’s what it looks like when Bill’s gross-up is based on his W-4:

$220,000 salary and $20,000 taxable expense, and state of Illinois (flat 4.95% rate)

Single:

  • 35% Federal + 4.95% IL + 2.35% = 42.3%
  • Gross-up on gross-up percentage is 42.3/57.7 = 73.310%
  • Gross-up is $14,662.05

Here’s what it looks like when Bill’s gross-up is based on his actual tax filing status:

Married filing jointly:

  • 24% Federal + 4.95% IL + 2.35% = 31.3%
  • Gross-up on gross-up percentage is 31.3/68.7 = 45.560%
  • Gross-up is $9,112.08

The marginal inverse strategy used above is most recommended because it is based on the employee’s actual tax situation; it takes into account various factors, including filing status and earned income. It also accounts for the additional tax liability the gross-up creates, in other words, the tax on tax exposure. However, many employers are drawn to the supplemental approach because it’s the easiest to administer and simple to explain.

Here’s an overview of an employer’s four options:

  • Supplemental gross-up with a non-inverse calculation: Calculates transferees’ gross-up at the flat rate of 22%. This method using a non-inverse calculation with a flat rate of 22% only tax protects the transferee on their taxable expenses. The additional taxes owed on the gross-up included in their income are the responsibility of the transferee.
  • Supplemental gross-up with an inverse rate calculation: Calculates employees at the same flat rate of 22%, but considers the tax on tax gross-up for a more accurate calculation. This method using an inverse calculation with a flat rate of 22% protects the transferee on their taxable expenses and for the additional tax gross-up added to their income.
  • Marginal gross-up with a non-inverse calculation: Calculates each transferee’s gross-up based on their individual tax bracket based on their filing status and earned income. The rates range between 10% and 37%. This method using a non-inverse calculation with marginal tax rates only tax protects the transferee on their taxable expenses. The additional taxes owed on the gross-up included in their income are the responsibility of the transferee.
  • Marginal gross-up with an inverse rate: Calculates each transferee’s gross-up based on their individual tax bracket but considers the tax on tax gross-up for the most accurate calculation. This method using an inverse calculation with marginal tax rates protects the transferee on their taxable expenses and for the additional tax gross-up added to their income.

If you’re exploring a new gross-up strategy in the new year, do the math. Figure out how each approach will affect your bottom line and your employees.

Questions? Tap into our tax expertise and contact us.

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