Lump Sum and Cap Administration

In today’s competitive environment, it is critical that employee assistance programs meet the needs of their employees and families while remaining cost effective and aligned with the company’s culture, which includes Relocation Assistance Programs.

Over the years, two approaches have been selectively implemented in relocation policies primarily for cost containment reasons: Lump Sum Allowances and Capped Assistance.

A “Lump Sum Allowance” is a set amount of money paid to the employee to cover the costs of defined assistance. A “Cap” can be placed on assistance to limit the costs of the entire relocation or specific policy components. Caps can be placed on many policy areas or on the total relocation costs.

Some companies have taken this approach to the extreme and adopted lump sums as a way to deliver all relocation benefits. That is, a single lump sum designed to cover both deductible and nondeductible expenses, including costs of disposing of the home. Such a program has a very significant adverse tax impact.

If deductible moving expenses are included in a Lump Sum, the benefit of the exclusion mechanism described above is lost. That is, the entire Lump Sum is included in the employee’s income as wages, including the costs of moving household goods and final move travel.

Because the employer cannot develop a reasonable belief as to what amount might be deductible as moving expenses by the employee out of the Lump Sum, withholding and payroll taxes are required on the entire Lump Sum, and the employer must pay its own share of payroll taxes, which can amount to as much as 7.65% of the entire Lump Sum.

Likewise, an overall Lump Sum approach is completely incompatible with a tax-protected home purchase program.

In order for the substantial costs incurred in a home purchase program to be excludable from the employee’s income, the employer must incur the costs itself, on its own sale to an outside buyer. The employer is a seller, responsible for the seller costs on the HUD-1 between itself and a buyer. The employer cannot just give the employee a sum of money and allocate part of it to these home sale expenses.

If home sale expenses are included in the Lump Sum, they too will be fully taxable to the employee, with the undesirable consequences previously described. In fact, the consequences are even more undesirable than they are with moving expenses, because the employee is not allowed a deduction for the expenses. Consequently, the employer will find itself with significant additional employment taxes, causing substantial additional tax liability for the employee, and will have to confront the issue of whether it should be grossing up those costs to reduce the tax impact for the employee.

For these reasons, companies typically do not include home sale expenses in a Lump Sum, but try to implement a form of the Lump Sum approach by operating a home purchase program with a cap on home sale expenses. In doing so, they seek to combine the benefit of the exclusion for costs that is available in a home sale program with the cost control inherent in a Lump Sum. For the reasons discussed below, this approach is unacceptable.

There are many possible ways to structure a cap on home sale expenses.

The employer might impose an overall Cap on all relocation expenses, including home sale expenses. Or, the employer might adopt specific limitations on specific categories of expenses. Or, the employer might limit specific components of cost within a specific category of expense.
Each of these approaches is acceptable from a tax perspective if the employer is merely reimbursing the employee’s own costs of home sale. All such reimbursements are taxable in any event, so the Cap does not affect the tax treatment.

All are unacceptable and highly inadvisable, however, if the employer seeks to combine them with a tax-protected home sale program. The Cap may well cause the program to lose its tax-protected status.

That is because the Cap will shift part of the risk of the home sale costs back to the employee, and also tie the employee to the second sale. The IRS will view this as strong evidence that the employee was the real seller, with the employer merely paying part of the costs. The IRS will conclude there was only one sale, from employee to outside buyer, not two separate, independent sales.

One of the basic risks and burdens assumed by a homeowner is liability for costs incurred in disposing of the home. This aspect of ownership burden is particularly important in a relocation home sale program, because the employer generally will not own the home for very long and is not exposed to long-term risks such as price depreciation or home deterioration. The risk that disposal expenses will be significant is a risk that the employer must be expected to bear if it wants to be treated as the owner.

Furthermore, if the employee is bearing a significant portion of the expenses of the employer’s sale, it links the employee inexorably to that sale. The employee has a continuing interest in the costs incurred, and an interest in minimizing them. The employee therefore has a financial interest in the second sale that is inconsistent with the full assumption of ownership risk by the company.

Turning back to the possible Cap structures discussed earlier, it is plain that neither a limitation on the real estate broker commission, nor an overall limit on the home sale expenses (whether by amount or percentage) is acceptable. The inevitable result is to make the employee liable for part of the home sale expenses in either all or most cases. As described, that is likely to result in the home sale program failing, and all costs becoming taxable to the employee. The employer and the employee will be liable for withholding and their share of payroll taxes. None of the costs incurred will be deductible by the employee, so the employee will fully bear the income tax burden of the failure. The employer will have to consider whether to gross up the expenses, which will be a substantial additional cost.

An overall dollar Cap on all expenses will also be unacceptable if it is structured so that it actually limits home sale expenses. If the Cap is sufficiently generous, and it is applied first against home sale expenses, then this might not occur. But, the resulting administrative problems will be daunting, both for employer and employee.

The bottom line is fairly simple. Just about all forms of cost caps on home purchase programs are unacceptable from a tax perspective and will end up costing the company substantial tax dollars. Furthermore, administrative and policy difficulties make a Cap that includes home sale expenses, even if the home sale expenses themselves might be covered, unwise and counterproductive. If cost control is an objective in a home sale program, that control is better accomplished through policy exclusions and other policy provisions, rather than a Cap on the costs a company will pay.

Each employer has a number of factors to consider in the design of Lump Sum Allowances or Caps. There are not only tax implications, as previously discussed, but also factors that will ensure cultural consistency, financial amounts appropriate to meet the needs of the employee, and cost effectiveness. We recommend that every employer:

• Examine the historical profile (e.g., marital status, income, homeowner vs. renter, family size, locations, etc.) of employees utilizing the policy or policy level (e.g., tiered programs) to be covered by a Lump Sum or Cap.
• Consider historical costs (e.g., average temporary living expenses, average home finding cost, etc.) for the assistance being covered by a Lump Sum Allowance or limited by a Cap. (Many times clients do not have historical cost data and as a result, the determination of cost impact cannot be determined. If there is historical data, the design can be more effective and projected program impacts measured.)
• Compare administrative processes to confirm improved ease of use.
• Exclude tax gross-up from any Lump Sum Allowance calculation.
• Exclude home sale programs from any Lump Sum Allowance or Cap Program.

It is also recommended that the result of the analysis should:

• Help determine if Caps or Lump Sum Allowances should be used.
• Provide input into the allowance or cap related policy components.
• Determine the allowance or cap amount calculation formulas with flexibility by location and family circumstances.

Caps are sometimes put into place as a cost sharing method. To meet that objective, Lump Sums covering multiple cost categories, such as temporary living and home finding trips, are more effective than a defined assistance program (for example, temporary living not to exceed $6,000) with Caps. Lump Sum allowances provide the employer cost certainty but give the employee greater flexibility to effectively spend the money on his or her family and situational priorities.

Without case-by-case Cap flexibility or a determining formula, a hard Cap on total dollars, may provide a single employee with more money than needed while a family can be inadequately funded. Location variables like cost differentials for basic needs such as travel and hotels also need to be addressed. For example, transferring from Savannah, Georgia, to San Francisco, California, will require more assistance than a move from Dallas, Texas, to Houston, Texas.

Tax gross-up can adversely affect a cap by limiting the dollars allocated under the cap, for needed services, providing further reduction in overall benefit to the employee. Additionally, the amount of tax gross-up may be difficult to calculate early in the relocation process because the amount of gross-up is hard to determine until the dollars spent on taxable and non-taxable items is determined. The employee may assume they are getting "X" amount for home finding or final move expenses or for the total relocation, but if the cap includes tax gross-up they have less at their disposal. They may also get ‘surprised’ once they discover what has actually been spent on deductible, excludable and non-deductible expenses.

It is recommended that home sale programs and tax gross-up be excluded from the allowances or dollar amount capped assistance.

One of the attractions of Lump Sum Allowances and Caps is the ease of administration. It often appears that with only checks to cut, no other administrative support seems necessary. What is hidden is the work in initial design and then the ongoing adjustments required to keep the program features up to date with current costs and regional cost differences.

By looking at successful programs and based on our experience, we recommend and are willing to administer programs with the following characteristics.

• Service, cost and administrative benefit objectives are clearly identified, documented and tracked.
• Program design is done in detail, reflecting the culture, move patterns and historical costs (all actual costs and tax gross-up) of the company.
• Caps and allowances have situational flexibility built into a calculation formula that will allow for personal and location variables.
• Allowances, when used, cover areas that can be managed by employee choice or planning, such as temporary living or home finding.
• Caps are used in very limited ways and do not create a boxed-in employee with limited flexibility and do not have a negative impact on the tax viability of the program.
• Caps do not put the employer or relocation management company into a collection position.
• Allowances are used in place of Caps, where possible.
• Tax consequences are carefully considered and do not create administrative, cost or program burdens.
• Employees should not be left without professional resources that assist them in the management of allowances, selection and management of additional service providers (e.g., real estate, temporary living resources, household goods shippers, etc.).

The views expressed by Altair in this document are subject to change based on evolving industry trends. As such, Altair may update our position accordingly and will notify our readers in a timely manner.

© 2006. Altair Global Relocation. All rights reserved.