Payroll in Practice: 11.25.19

Practitioners’ questions are answered by a payroll and tax consultant who also is an enrolled agent licensed to practice before the Internal Revenue Service.

Question: Our company is planning to give holiday bonuses. We would like the net amount to be the full bonus but realize that taxes must be withheld. We intend to gross up the bonuses. Does the gross-up make any difference in determining the supplemental rate for a bonus?

Answer: Your question implies that you are considering using the aggregate method to determine the income tax rate rather than using the optional flat rate of 22%. Because of the graduated income tax rates, the rate to use in the gross-up formula for federal income tax is a moving target. State tax rates and rates for the Federal Insurance Contributions Act and Social Security also have to be considered.

Unless the employer wants to gross up the regular pay with the bonus, which would be expensive, a separate rate to apply to the bonus must be determined. Determining a single rate is difficult because the average rate changes with each additional dollar of compensation.

Here is the gross-up formula: gross pay / [1 – (federal income tax rate + Social Security rate + Medicare rate + state income tax rate)] = grossed-up pay

For example, to gross-up taxes for a $500 bonus using the optional flat rate of 22% for federal, a state income tax rate of 5%, and a FICA rate of 7.65% when the employee’s cumulative pay for the year did not exceed the Social Security wage base, the filled-in formula is $500 / [1 – (0.22 + 0.0765 + 0.05)] = $765.11.

Computing the taxes on $765.11 yields $168.32, ($765.11 x 0.22); $58.53, ($765.11 x 0.0765); and $38.26, ($765.11 x 0.05). Subtracting the tax amounts from $765.11 leaves a net bonus of $500. Keep in mind the employer is paying $265.11, plus employer Social Security and Medicare taxes of $58.53 on top of the bonus.

If the graduated tables are used, the average tax rate for federal income tax changes when the gross pay changes. However, the gross-up amount can be computed by layering the regular pay and the bonus for each change in tax rates.

For example, assume a $1,500 semimonthly salary aggregated with a $500 bonus for a total of $2,000 for the pay period. The employee claims single with no allowances and no additional withholding. The portion of the bonus plus the grossed-up taxes on the bonus that falls within the 12% tax bracket is $303. This is the $1,803 maximum for the 12% rate minus the $1,500 regular pay.

Compute the taxes on $303 using 12% for federal income tax, 7.65% for FICA and 5% for state income tax. The taxes amount to $36.36 federal income tax, $23.18 FICA, and $15.15 state income tax. Subtracting the taxes from $303 leaves the after-tax amount of bonus attributable to the 12% bracket at $228.31.

Subtract the $228.31 bonus attributable to the 12% bracket from the total bonus of $500 to get $271.69. This is the amount of the bonus which falls within the 22% bracket.
The regular gross-up formula is used to compute the grossed-up taxes on this portion of the bonus. That is, $271.69 / [1 – (0.22 + 0.0765 + 0.05)] = $415.75.

The taxes amount to federal income tax of $91.47, FICA of $31.80, and state income tax of $20.79, which leaves a net bonus for the 22% bracket at $271.69.

We can check that this is correct by computing the withholding for the aggregate pay of $2,218.75 ($1,500 regular pay + $303 + $415.75) and comparing with the amount of taxes and net pay to the amounts calculated above for the bonus and the amounts of tax and net pay for the $1,500 regular pay.

The tax and net pay for the $1,500 regular pay are federal income tax of $152.94, FICA of 114.75, state income tax of $75, and net pay of $1,157.31. The totals on $2,218.75 in gross pay are $280.77 in federal income tax, $169.73 in FICA, and $110.94 state income tax. The net pay is $1,657.31 under either method.

By Patrick Haggerty

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.