Sorting out taxes and reporting for a deceased employee

While fortunately a rare circumstance, dealing with payroll for a recently deceased employee can be tricky. What pay is taxable? What do you do with their final paycheck? Are there special reporting requirements? Hopefully this isn’t an issue that comes up for your payroll department often, but it’s important to know what to do, and get it right, in the event that it does happen. So, let’s take a look at the unique circumstances related to a deceased employee’s payroll.

Immediate steps

First, reverse the deceased employee’s direct deposit or cancel their pay card immediately upon notification of an employee’s death. If they’re paid by check, the check must be returned to you and voided. That’s because you must wait until the executor (if they die with a will) or the administrator (if they don’t) settles the employee’s estate. This can take some time.

Even though you’re holding the deceased employee’s last paycheck, some states allow a spouse or dependent children to receive a portion of those wages before the will is probated. Payees must usually present an affidavit attesting they can receive the payment. Check with the company’s counsel if you get such a request and don’t disburse any funds without getting a receipt.

Once you’re notified by the executor/administrator, pay the final check on paper to the employee’s estate or beneficiary. Get a copy of the death certificate before you disburse anything.

And you probably shouldn’t pop the final check in the mail and forget about it; send it registered. People sometimes claim they never received the check. You’re then left in the uncomfortable position of not knowing whether to pay for a stop payment order and reissue the check.

More practically, cancel the deceased employee’s company email and security card, and retrieve their company-issued cell phone and laptop. You also need to dig out the employee’s 401(k) beneficiary form—401(k) assets move independently from the employee’s will, so you need to know who the beneficiaries are.

Determining what’s taxable

Next, determine what goes into and comes out of the final check. Out of the deceased employee’s final regular pay, deduct for all voluntary benefits (e.g., health, dental, vision, retirement) and involuntary deductions, like garnishments. Payouts for accrued vacation and other time off follow company policy on final pay.

The withholding rules, however, are tricky.

• Wages and accrued benefits paid in the same calendar year as death are exempt from income tax withholding, but are subject to FICA and FUTA. The final check, therefore, will be net of FICA taxes.
• Wages and accrued benefits paid to the beneficiary or estate after the calendar year of death are exempt from all federal withholding.

Accounts payable customarily makes these payments, but the check is usually processed through Payroll because you have to pick up the FICA withholding.

Internal Revenue Code § 132 excludes de minimis fringe benefits from taxation. Providing a flower arrangement or fruit basket to the bereaved family is a tax-free de minimis fringe benefit.

Reporting rules

Tricky withholding rules lead to tricky reporting rules. For the year the employee died, you file W-2 and 1099-MISC forms.

• On the final W-2, report all wages up until death. Report wages and accrued benefits paid after death only as Social Security and Medicare wages and taxes, since those were the only taxes you withheld.
• The gross amount of wages and accrued benefits paid after death are reported to the estate or beneficiary on the 1099-MISC, even though the final check was net of FICA taxes. To file the 1099-MISC, you must have the payee’s Taxpayer Identification Number. You can solicit this by sending the payee Form W-9.

If you must report income in the year after the employee died, report the gross amount to the estate or beneficiary on the 1099-MISC.

Most states follow the federal rules regarding taxation, withholding, and reporting.