Relocation Tax Gross-Ups

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.

Relocation's "12-month" Rule

A contractor relocated an employee from one coast to the other. After a few months, the employee (and his family) became very unhappy with the new living situation. Since the employee was highly-valued, the contractor relocated him and his family back to their original location. Both of the relocations occurred within a nine month period. The cost of both relocations are unallowable under Government contracts.

Relocation costs are costs incident to the permanent change of assigned work location for a period of twelve months or more of an existing employee or upon recruitment of a new employee. Relocation costs are generally allowable but since it usually represents a significant cost to contractors, FAR 31.205-35 has caps and limitations on different components of relocation costs. One area where auditors are instructed to focus their efforts is on the "twelve-month" minimum relocation period rule. If relocation costs for an employee have been allowed either as an indirect or direct cost and the employee resigns with 12 months for reasons within the employee's control, contractors must refund or credit the relocation costs to the Government (see FAR 31.205-35(d)).

Government contractors should include recapture provisions in relocation agreements so that it can recover relocation payments from the employee if that employee does not fulfill his/her twelve month minimum. Contractors should also implement a follow-up system to collect refunds when appropriate and to ensure that the refunds are appropriately credited back to the Government. Regardless of whether a contractor can recover relocation payments from an employee, it is still required to make appropriate refunds to the Government.

Relocation Costs

Back in 2005, the FAR cost principle for Relocation Costs, FAR 331.205-35, was revised so that certain types of relocation costs could be reimbursed to employees based on a lump-sum basis in lieu of actual costs. Prior to this revision, only miscellaneous costs up to a ceiling of $5,000 could be reimbursed on a lump sum basis. These three new types of costs eligible for lump sum reimbursement are:

• costs of finding a new home
• costs of traveling to the new location, and
• costs of temporary lodging.

Companies that are still reimbursing employees based on actual costs, might want to consider whether it is more cost effective to switch to a lump sum basis. One contractor with a significant number of relocations because of its overseas work, believes it has saved money (and therefore saved the Government some money) by switching to the lump sum reimbursement. The lump-sum method significantly reduces the administrative effort required to review and process the claims. Record-keeping is minimized. The time it takes to support external audits of contract costs is reduced. And, here's a dirty little secret, it keeps employees from padding their claims.

There is a catch however to implementing a lump-sum reimbursement policy. FAR states that reimbursement on a lump-sum basis may be allowed when adequately supported by data on the individual elements (e.g., transportation, lodging, and meals) comprising the build-up of the lump-sum amount to be paid based on the circumstances of the particular employee’s relocation.

The new provision does not impose a ceiling amount for the additional three types of relocation costs reimbursed on a lump-sum basis. However, a lump-sum reimbursement is required to be adequately supported to be allowable. DCAA is instructing its auditors to question any portion of the lump-sum payment that is not adequately supported. According to DCAA,

adequate support should include detailed calculations of the individual cost elements (e.g., airfare, car rental, lodging, and meals) that reflect specific factors, such as the number of travelers involved, travel destination, and the estimated number of travel days required based on the particular employee’s circumstances. For example, the estimated number of days required for house hunting trips may vary depending on whether the employee is single or married with dependent children, buying a home or renting an apartment, and the availability of housing at the new location.

The choice to reimburse on lump-sum basis versus an actual cost basis comes down to the number of relocations that happen in your organization. Where sporadic, its probably more cost effective to use the actual cost method. Where frequent, regular, and recurring, it might be more cost effective to establish a lump-sum policy. Contractors who adopt a lump-sum reimbursement of these relocation costs should establish policies and procedures that identify the group/class of employees eligible for lump-sum reimbursements and provide guidelines or criteria for determining the estimated lump-sum amount.

Audit evaluations of lump-sum provisions will include a review of the contractor’s policies and procedures and the documentation that supports the calculation of the estimated lump-sum amount for the particular employee. The auditor will also ensure that the contractor’s practice is consistently followed and that lump-sum payments reflect the individual circumstances of the relocated employees.

Finally, the new lump-sum reimbursement provision envisions that the lump-sum amount will be established before the employee actually incurs the costs and it prohibits subsequent adjustments to reflect actual costs incurred by the employee.