An employee put in years of service with your company, or is an exemplary worker, but circumstances now lead to his or her departure. You have agreed to pay the employee severance, but you want him or her to receive the full amount, with no taxes taken out. To accomplish this, you will need to do a “gross-up.”
Here are five things to keep in mind when performing this transaction.
1. What payments can be grossed up?
A gross-up can be done on all types of wages. However, it’s typically used for one-time or infrequent payments, such as severance pay, a special bonus or a recognition award.
2. Which taxes must come out of severance?
For tax purposes, severance pay is treated as supplemental wages — which are subject to federal income tax, applicable state and local income taxes, Social Security tax, and Medicare tax.
3. How is a gross-up on severance done?
Let’s say the severance is for a lump-sum amount of $30,000 and the employee works in Pennsylvania.
(a) Add the tax rates together: 22 percent for federal income tax supplemental rate + 6.2 percent for Social Security tax + 1.45 percent for Medicare tax + 3.07 percent for Pennsylvania supplemental tax = 32.72 percent.
(b) Make the 32.72 percent a decimal by dividing it by 100, which comes to 0.3272.
(c) Subtract the decimal amount from 1 (1 – 0.3272 = 0.6728).
(d) Divide the severance of $30,000 by the decimal amount of 0.6728 to arrive at $44,589.77, which is the total gross amount that you would need to pay the employee in order for him or her to receive a net severance amount of $30,000.
- If the employee’s wages exceed the annual wage limit for Social Security tax ($128,400 for 2018), no Social Security tax should come out of the excess wages.
- If the employee’s wages go over the IRS-mandated threshold, you will need to withhold additional Medicare tax of 0.9 percent.
- If the severance exceeds $1 million, federal income tax should be calculated on the extra amount at the highest tax bracket of 37 percent.
- The IRS has different formulas for calculating federal income tax on supplemental wages, so make sure you’re using the right one for the severance payment.
4. Will I owe employer taxes as well?
Yes, you’re liable for employer taxes on severance payments — including federal unemployment tax and state unemployment tax plus your own share of Social Security and Medicare taxes.
5. Do I need to report the severance payment if I grossed up the taxes?
Even though you’re assuming the employee’s severance pay taxes, the payment itself is taxable compensation. Therefore, you must report the severance as taxable wages on the employee’s W-2 and on your federal and state employment tax returns.
Your payroll provider can help you properly execute a gross-up on severance or other types of wages.