Relocation costs are those incident to a permanent change of assigned work location of an existing employee or upon recruitment of a new employee. FAR 31.205-35 lists the type of relocation costs that are allowable under Government contracts and the limitations on some of the costs. One restriction that is sometimes forgotten is that the relocation must be for a period of twelve months or more. If shorter than 12 months, the costs are unallowable and if not excluded from billings or incurred cost proposals, are subject to penalties.
One of the items specifically allowable under the relocation provisions are payments for increased employee income taxes incident to allowable reimbursed relocation costs (see FAR 31.205-35(a)(10). Relocation reimbursements are taxable to the employee and the intent of the provision is to make the employee whole so that he/she won't owe additional income tax as a result of the relocation. These payments for increased taxes are commonly referred to as "gross-up" although you won't find that term in the FAR.
The Gross-Up calculation is not as obvious as one might expect. Suppose for example that relocation reimbursement is $50 thousand and the employee is in the 25 percent tax bracket. The additional taxes would be $12,000 ($50,000 times 25%). But wait a minute. The $12,000 is also taxable so you need to add tax on that amount - $12,000 times 25% = $4,000. But that's not enough. The $4,000 is also taxable so you need to add tax on that amount. And on and on.
There is a common two-step method of calculating tax gross-up. Step one is to calculate the tax gross-up factor. Step two is to apply the factor to reimbursed relocation costs. Here's an example:
1. Tax gross-up factor = employee marginal tax rate divided by 1 minus the marginal tax rate. Assuming a marginal income tax rate of 25 percent per the above example, the tax gross-up factor is 0.25/(1.0-0.25) or 0.3333.
2 Tax gross-up amount = reimbursed relocation costs times tax gross up factor. Assuming reimbursed relocation costs total $50,000, the tax gross-up amount is $16,997 ($50,000 times 0.3333).
One final note. Marginal tax rates are going to vary from employee to employee based on other non-employee features like spousal income, investments, and retirement distributions. The marginal tax rate used for gross-up calculations should be based solely on the employee's compensation from the contractor employer. In most cases, under current tax law, this will be 24 percent.