Meaning
Contractual clauses in employment agreements require an employer to increase the size of a termination payment so the employee receives a specific net amount after taxes are deducted. Implementing a tax gross up statutory severance ensures that the recipient’s exit package is not eroded by high marginal income tax rates. It is commonly used for senior executives who negotiate net-of-tax severance packages to guarantee their post-termination liquidity.
Financial Calculation
Payroll departments must apply a formula that accounts for the progressive brackets of the tax system to determine the gross payout. For a tax gross up statutory severance to work, the calculation must be run in reverse, starting from the target net figure. This process results in a significantly higher total cost to the company than the nominal severance amount.
Corporate Risk
Board members must approve these commitments because they represent a significant open-ended liability during restructuring.
Judicial Interpretation
Disputes arise when the tax treatment of the payment changes between the date of the agreement and the date of termination. Courts will generally enforce the clear intent of the parties to deliver the net sum, regardless of how burdensome the resulting tax liability becomes for the employer. This potential escalation makes such clauses a target for restructuring professionals seeking to cut exit costs.
