Payroll in Practice: 7.17.2023

Question: When an employee dies, how should payment of wages and accrued benefits to survivors be processed and reported?

Answer: The death of an employee involves several issues related to payroll that must be handled correctly. While employee death may be a rare event for a particular employer, it is not unusual. It is best that payroll identify the issues and prepare a procedure for payroll personnel to follow in the event of an employee’s death.

This is particularly important with respect to the immediate release of funds to a spouse or other survivors. Most states have rules under wage and hour or probate law that specify when such payments are to be made, who may be paid, how much may be paid and whether certain documentation must be obtained before payment is made.

These laws vary by state, and some states do not have specific rules related to deceased employee wages. A best practice is for employers to determine the state laws that apply and establish procedures that comply with the relevant laws.

For example, Ohio allows an employer to pay earnings of up to $5,000 to a deceased employee’s survivors in order of preference – including a surviving spouse, children aged 18 or older, or a parent – without requiring a release from the estate’s executor or the Department of Taxation.

California, in contrast, allows employers to pay up to $16,625 net. However, the payments may be directed only to a surviving spouse, who must submit an affidavit as specified in the probate code. Payments made in the year of the employee’s death are not subject to Personal Income Tax withholding but are subject to withholding for State Disability Insurance and employer payments for Unemployment Insurance and Employment Training Tax.

For federal tax purposes, the payments of earnings are taxable income to either the decedent if constructively received prior to death, or to the payee if paid “in respect of” the deceased employee.

Any wages that were actually or constructively received by the decedent prior to death are reportable as income to the decedent for all tax purposes and reported in the employee’s Form W-2, Wage and Tax Statement.

Constructive receipt is a cash-basis concept that determines when cash is received for tax reporting purposes. A wage payment is deemed to be constructively received when the employer makes the funds available to the employee. Courts have interpreted this to include funds in a paycheck or direct deposit that is available or mailed to an employee on a scheduled date prior to death, even if the funds are not received by the employee on that date.

For example, an uncashed payroll check issued to an employee prior to death is considered constructively received regardless of whether the employee received it. The employer should void the check and issue a new one payable to the appropriate payee. The new check is for the same amount as the original check, usually the net pay. Since it is a replacement check, the payroll records are not adjusted, and the payment is not subject to withholding.

Wages that were not constructively received by an employee prior to the time of death are “wages in respect of a decedent.” These might include accrued wages and benefits such as unused vacation or sick pay. The employer must determine all wage amounts that should be paid out upon the death of the employee.

Wages in respect of a decedent are paid to the estate or to an appropriate person, such as a personal representative, executor, or designated beneficiary. To obtain the payee’s tax identification, the employer should use Form W-9, Request for Taxpayer Identification Number and Certification.

Wages in respect of a decedent paid during the calendar year the employee died are not subject to federal income tax withholding but are subject to withholding for Social Security and Medicare tax. Generally, these payments are not subject to state income tax withholding; however, some states, such as California, require that certain payroll taxes, such as State Disability Insurance, be withheld from all wages paid during the year of death.

Wages paid in a year after the year the employee died are not subject to Social Security and Medicare taxes, and employers should not withhold these taxes.

Employers should report all taxable compensation and constructively received compensation in Box 1 of Form W-2. The amount reported should not include wages in respect of the decedent.

Generally, Form W-2 is not required for federal tax purposes for a year after the year the employee died, because the wages are not subject to payroll taxes.

Whether paid in the year the employee died or a subsequent year, federal and state income tax liability for wages in respect of a decedent attaches to the payee. The payment is taxable to the payee for income tax purposes as general income in the same way it would have been taxable to the decedent. However, the payee is not receiving the funds as an employee.

The employer should obtain a Form W-9 from the payee. The employer is required to obtain the payee’s name, tax ID number, address, and entity type to avoid backup withholding of income tax as well as to obtain the information required to issue a correct and complete information return, usually a Form 1099-MISC, Miscellaneous Information.

If the employer does not have the payee’s name and tax ID number before making the payment, the employer is required to withhold 24% of the gross wages as backup withholding. Gross wages for this purpose include amounts of withheld Social Security and Medicare taxes and any other deductions. States may have similar backup withholding requirements. For example, California requires 7% withholding on amounts reported on Form 1099-MISC if federal backup withholding is required.

The employer should not issue a check payable to “the estate of decedent” using the employee’s Social Security number for the tax ID number. The estate should have an Employer ID number; however, the name control for Tax ID matching will be the same as that for the employee’s Social Security number. This might cause the IRS to match the income to the employee instead of the estate and propose underreported income penalties, which might also result in information return penalties for the employer.

If the payee information is obtained before payment, income tax should not be withheld.

The employer reports the gross amount of the wages in respect of the decedent on Form 1099-MISC, in Box 3, Other Income. As would be the case on the employee’s Form W-2, the gross amount is the taxable amount rather than the net pay after deductions. Backup withholding, if any, is reported on Form 1099-MISC in Box 4, Federal Income Tax Withheld, and Box 16, State Tax Withheld.

In summary, employers that paid a deceased employee’s wages in the year the employee died will issue two information returns – a Form W-2 made out to the decedent and a Form 1099-MISC made out to the payee.

The payee may be required to issue nominee information returns to the ultimate beneficiaries. For example, when the recipient is the employee’s estate or trust, the estate or trust is to issue Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., to each beneficiary showing each beneficiary’s share of the income.

There may be other benefits that are affected by the employee’s death. The employee’s health insurance may need to be cancelled or COBRA set up for the survivors, and there may be nontaxable amounts owed to the employee such as expense reimbursement, qualified tuition benefits or death benefits payable under a qualified retirement or life insurance plan.

Certain death benefits paid by employers are exempt from income tax. For example, death benefits paid by an employer to the survivor of an employee who died as a result of a terrorist attack are exempt, as are qualified disaster relief payments under Section 139 of the Internal Revenue Code.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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