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Tax Man Cometh: Tax Gross-Ups and Other Certainties in Life

February 4, 2015

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Tax Season

The start of any new year marks the rapid onset of the less macabre of Benjamin Franklin’s two certainties. For most Americans, filing taxes is complicated enough to spawn an entire industry dedicated to the assistance thereof. For recipients of corporate perquisites, the calculations are even muddier. There is another perquisite for these individuals – one referred to by numerous monikers, but best known as the tax gross-up.

Tax Gross-Ups

Tax gross-ups, while often obscured in footnotes to the summary compensation table, are conceptually quite simple. Corporate perquisites are treated as income by the Internal Revenue Service (IRS) and, as such, require taxes to be paid on the value realized by any executive who receives them. For items such as salary or bonus, the taxable amount is calculated from the initial value, and the net value realized by the individual is thus less.

This simple interaction does not hold, however, when the compensation is in the form of a perquisite such as a company car or home security, where there is no liquid capital to be readily paid to the IRS. To ameliorate and prevent employees from functionally having to pay for complimentary perquisites, companies will provide a supplementary lump sum of cash commensurate with the perquisite value to cover any taxes. This achieves a net-after-tax effect for the executive.

Historically, this perquisite has been frowned upon by proxy advisory firms and shareholders alike. The gross amount paid by companies must be upped—hence the name—by a larger amount than the recipient takes home, a practice regarded as inefficient use of company and shareholder capital. As such, tax gross-ups have gradually declined in prevalence over the last five years. In 2009, they were disclosed by half of the Fortune 100. By 2013, this number had declined to 18.1%, an annualized rate of decline of 18.4%.

Despite this waning popularity, median tax gross-ups have continued to rise in value among companies that continue to use the perquisite in executive compensation programs.