Give tax-protected raises to star employees

When you want to reward a rising star at your company, taxes can substantially dilute a well-deserved raise or bonus.

Strategy: Make the employee “whole” after a salary increase or bonus. Pay him or her enough to cover the raise or bonus plus the extra tax owed as a result.

Can’t you simply pay the employee’s share of taxes? You can, but the payment is treated as additional compensation to the employee. (IRS Revenue Procedure 81-48) This creates a pyramid effect where the employee owes “tax on the tax.”

Of course, you can keep recomputing the tax that will be due until you arrive at a negligible additional tax liability. But there’s a much easier way to do things. Use this formula: Total tax-protected raise or bonus = amount of original raise or bonus/1 minus the applicable tax rate.

Example: Currently, one of the up-and-comers at your company earns $50,000 a year. You’d like to reward her with a 20% raise, or $10,000. But she must pay income and employment taxes on that amount.

Assume the employee is a single filer in a combined 28% tax bracket for federal and state income taxes. Because her earnings fall below the Social Security tax wage ceiling of $128,400 for 2018, the entire $10,000 raise is also subject to FICA tax at the maximum 7.65% rate. So the combined income tax and employment tax rate is 35.65% (28% + 7.65%).

But let’s see what happens if you tax protect the raise by using the special tax formula. In that case, the original $10,000 raise is divided by 0.6435 (1 minus 0.3565). By paying the employee the result, or $15,540, you protect the employee from the extra tax hit.

Here’s the entire breakdown:

Payment: $15,540

Minus federal and state income taxes: $4,351

Minus federal employment taxes (7.65% of $15,540): $1,189

Net raise after taxes: $10,000

Note that an employment tax rate of 1.45% should be substituted for 7.65% if the employee’s wages for the year will exceed the Social Security tax wage ceiling of $128,400.

Tip: There’s no requirement to use this formula for raises for all your employees. Pick those you want to reward.