What is a Tax Gross-Up?

A tax gross-up or simply, gross-up, is compensation paid to an employee, in addition to his salary, to cover the tax liability for perquisites, or "perks." Perquisites may include the use of a corporate car or aircraft, relocation expenses, leases, memberships, and insurance. Because the Internal Revenue Service (IRS) views perquisites as other income, employees who receive perks must pay taxes on the fair market value of the goods or services received.

Of large United States companies, roughly 77 percent offer tax gross-ups or tax reimbursements. For example, in 2004, Home Depot gave outgoing chief executive officer Robert Nardelli an extra $3.3 million US Dollars (USD)to take care of his personal taxes on various perquisites. In Nardelli's case these included forgiveness of a personal debt and family travel on the corporate jet.

Begun in the 1980s, tax gross-ups grew after the United States Congress imposed a 20 percent excise tax, on top of regular income tax, on severance packages of executives who merged or sold their companies. The excise tax applies when the severance exceeds an amount that is triple the executive's median earnings over the past five years. Standard severance packages are typically three times the salary and bonus, and restricted stock and outstanding options vest immediately, making the potential tax bill extremely expensive. Companies can end up paying millions in gross-up taxes to the IRS to provide employees only a few hundred thousand dollars in additional severance. A tax gross-up can be the most costly part of a golden parachute for the company.

Supporters of tax gross-ups argue that the tax reimbursement is an effective mechanism for recruiting, hiring, and retaining experienced executives. Another advantage is that executives are able to hold larger equity stakes in their companies if they do not have to pay taxes on restricted stock. Executives who have increased equity will most likely align their management goals with that of shareholders. Opponents of tax gross-ups suggest that companies use the tool to beef up executive compensation while concealing this fact from shareholders. An expensive tax gross-up can be an inefficient use of shareholder money.

Prior to 2006, perquisites had to be included in the Summary Compensation Table of the annual proxy statement only if the total perquisite value exceeded 10 percent of the employee's total annual salary and bonus or $50,000 USD. Furthermore, specific details of a tax gross-up, or any other perk, had to be delineated in a separate summary only if it exceeded 25 percent of the total perks for that employee. After the financial catastrophes of Tyco, WorldCom, and Enron, the SEC issued new regulations, "Executive Compensation and Related Party Disclosure," which applied to proxy statements submitted after 15 December 2006. The threshold for disclosure dropped from $50,000 USD to $10,000 USD for the aggregate perquisites with detailed disclosure required for any perk that exceeds $25,000 USD or makes up 10 percent of the total perks for an employee.

Using data from proxy statements of Fortune 500 companies, the tax gross-up is the most widely used perquisite. From proxy statements pertaining to 2006, 755 executives accepted tax gross-ups, with the median gross-up approximately $34,000 USD. Although the tax reimbursement is the most commonly employed perk, it is not the most exorbitant. For example, during 2006, Fortune 500 companies provided airplane or corporate jet use as a benefit to 432 executives, with an average perk value of $82,203 USD. Nonetheless, shareholder and media criticism over excessive executive pay packages, including bonuses and perks, has made the implementation of tax gross-ups a controversial issue.