Compensation considerations when an employee passes away

The death of an employee can trigger a cascade of administrative tasks around final wage payments, accelerated vesting and distribution of equity compensation and nonqualified deferred compensation, and other death benefits that may be payable to the employee’s beneficiaries.

Often, the questions of what payments are taxable, to whom the payments are taxable, and the timing of taxation are not top of mind when the compensation and benefits structure is implemented, but they become critical considerations once the employee has passed and payments are triggered.

When thinking through the various tax impacts of payments made incident to an employee’s death, we can loosely group payments made by the employer into three categories:

1. Payments the employee would have received in the year of death

As a practical matter, there is often a small category of income paid within a few days after the employee’s death that is run through payroll (for example, if an employee dies partway through a payroll period, the payroll run for that period is generally already in place and the payroll is paid out accordingly). The entire amount of compensation earned prior to death but unpaid at death is considered income in respect of a decedent (IRD) under section 691(a). These amounts generally appear on the final Form W-2 (and are subject to all the usual payroll tax reporting and withholding).

Any payments made after that first post-death run are generally made from the employer to a beneficiary (usually a surviving spouse) or estate. Revenue Ruling 86-109, which addresses salary or wages paid after the employee’s death, provides that these amounts are taxable income to the beneficiaries and/or estate. These amounts are reported on Form 1099-MISC Box 3 (Other Income).

These payments often include accrued wages or upcoming accrued bonuses, vacation pay, nonqualified deferred compensation, and compensatory equity awards. The terms of various compensation plans will generally address when and to whom payments will be made after an employee passes away. Where there are plan terms, employers should follow the plan terms when making payments or other distributions.

As a general rule, if amounts to which the employee had a right before death (see above list, for example) are paid by the employer in the year of death, they are subject to Federal Insurance Contributions Act (FICA) tax withholding (as applicable for that employee – if the employee already had wages during the year above the Social Security wage limit, only Medicare would be withheld). However, as noted above, even though the wages are subject to FICA withholding, these post-death wages are not reported as income on Form W-2 Box 1 and are not subject to federal income tax withholding, so the Form W-2 Boxes 1 and 2 wages will not be consistent with the Box 3 (Social Security) and Box 5 (Medicare) wages. The employer may have to pay Federal Unemployment Tax Act (FUTA) tax on these wages, if the FUTA limit for the employee, for the year, has not yet been reached.

If the amounts are paid after the end of the year in which the employee passed away (other than certain nonqualified deferred compensation amounts – see discussion below), the amounts are not generally subject to FICA withholding or FUTA treatment and are not reported on Form W-2.

One of the first steps employers should take after an employee passes away is to request Form W-9, Request for Taxpayer Identification Number and Certification, to obtain accurate information for the beneficiary or estate to be issued the Form 1099-MISC.

One exception is that life insurance payments to beneficiaries are generally not taxable, however, interest income received as a result of the life insurance proceeds might be taxable.

2. Payments that vest at death but are paid out after the year of death

Compensation or benefits that are vested in the year of death but because of the timing of death or because of plan terms are not paid out until after the year of death include wages earned in the year of death such as an annual bonus, nonqualified deferred compensation, or stock options that are vested but have yet to be exercised. These payments are made directly from the employer to a beneficiary or estate and, as above, are reported on Form 1099 MISC Box 3.

3. Other benefits that are paid to the surviving spouse or children, are sometimes decided upon by the employer after the death of the employee

An employer may wish to further assist a surviving spouse or children of a deceased employee, beyond the employer’s benefits programs.

Amounts paid by employers to the families of deceased employees are generally treated as ordinary income (Congress specifically repealed a $5,000 death benefit exclusion in 1996 with Public Law 104-188). It is generally difficult to argue that the payments to a family of a deceased employee are nontaxable gifts because they are generally not viewed as payments motivated by “disinterested generosity” (See, for example, Commissioner v. Duberstein, 363 U.S. 278, 80 S. Ct. 1190, 4 L. Ed. 2d 1218 (1960)). Thus, almost all death benefits are reported as Form 1099 MISC Box 3.

Employers may choose to contribute to a section 529 plan for the deceased employee’s children. Any contributions to a section 529 plan are taxable to either the child or the surviving parent. “Kiddie tax” rules may apply. Any amounts paid out to the surviving spouse or children are reported on Form 1099-MISC Box 3.

Additional common questions/topics

Qualified Retirement plan assets

The former employee’s account balance in a “qualified” retirement plan (such as a 401(k) plan) are payable to the beneficiary designated by the employee. Beneficiaries should be on file with the plan administrator and the beneficiary will need to work with the plan administrator to determine the choices available. The choices available may depend on whether the beneficiary is a spouse or a non-spouse beneficiary. Possible choices might include a lump-sum distribution, a rollover to another retirement account such as an IRA, or payments over a distribution period. Retirement plan distributions are reported on Form 1099-R.

COBRA group health coverage and notice after death

COBRA (Consolidated Omnibus Budget Reconciliation Act) continuation coverage allows certain former employees, retirees, spouses, former spouses, and dependent children the right to temporary continuation of their health coverage at group rates. Employers must notify the plan administrator of the employee’s death within 30 days and an election notice must be sent to the employee’s qualified beneficiaries within 14 days after the plan administrator has been notified. These rules do not apply to group health plans sponsored by employers with fewer than 20 employees.

It can be devastating when an employee passes away. Since this is not a common occurrence, the tax consequences can be unfamiliar to both the employer and the employee’s beneficiaries and estate. Employers should have operational plans in place to address the tax and reporting challenges caused by these tragic situations and reach out to their advisors as a best practice.