If an employer chose to
reward several of his top salespersons with an all-expenses-paid
vacation, the vacation would be a non-cash reward, but the
employees would have to pay income tax on the fair value
of their trip. To eliminate the tax and cash burden on them,
the employer might agree to pay the additional income tax
that is owed on account of the trip.
This creates a “pyramiding” problem, because
any payment made to cover the tax is itself taxable income
and will require you to make an additional payment to make
the trip completely tax-free. While IRS doesn't concern itself
with how an employer and employee determine how much tax
the employer must pay, it insists that the employee include
in income the total tax that the employer does pay.
One way to deal with this problem is by making a cash payment
to cover the tax in the year after the bonus is received.
For example, say that the employee wins a trip valued at
$10,000 in Year 1. The employer can agree to pay the tax
due on the $10,000 in Year 2, after the employee has filed
his Year 1 return. At that point, the amount of tax owed
on the $10,000 trip will be known exactly.
However, the payment of that tax by the employer will lead
to additional tax that must be paid. Here, there are two
options. The employer can agree to pay the tax on the trip,
but not the tax on the tax. The tax on the tax is the employee's
responsibility. This has the advantage of putting an end
to the matter, although it means that the employee will have
to pay some tax out of his own pocket.
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Alternatively, the employer can agree
to pay the tax on the tax. This approach keeps the transaction
alive far into the future, as the employer pays a diminishing
amount of tax in each year. Eventually, the tax on a tax
will approach zero, but this may not happen for many years.
Employers may therefore prefer to dispose of the matter
in the year in which the trip is received by “grossing
up” the tax. The basic gross-up formula is a simple
one: i/(1 − r), where i represents the amount of income
on which the tax is to be paid and r represents the employee's
tax rate.
For example, if the trip is worth $10,000 and the employee
is taxed at a 33% rate, the formula yields $10,000/(1 − .33),
or $14,925. Therefore, the employee must be paid $4,925 in
cash to cover the tax on the $10,000 trip.
In the real world, things aren't that simple. Many factors
besides tax rate can affect the tax owed on the additional
income. For example, the extra income may cause the loss
of tax benefits, such as itemized deductions or personal
exemptions. Also, the trip and the cash may push the employee
into a higher tax bracket.
One way of handling this problem is to base the employer's
tax payment on reasonable assumptions about the tax situation
of the employee. The employee's actual situation may differ
from these assumptions, either to his advantage or disadvantage.
This arrangement has the advantage of resolving of the matter
once and for all in the year the trip is earned. Also, the
employee's privacy is protected, because he doesn't have to
disclose to the employer any facts about his actual tax return. |
