Attention employers…what do you do when deferred compensation payments are due to a deceased employee’s beneficiary or estate? When an employee dies, the tax reporting and withholding requirements are a bit confusing, and it’s not always clear whether income tax and FICA tax withholdings are due from such payments. Let’s delve into these tricky questions.

What is deferred compensation?

Deferred compensation is a portion of an employee’s compensation that is earned in one year but is scheduled to be paid out in a later year. Deferred compensation plans can take on many different forms, including short and long term incentive arrangements and stock awards. Depending on the terms of the plan, either or both employers and employees can contribute to a deferred compensation plan.

What happens to compensation arrangements when an employee dies?

The terms of the plan or arrangement generally dictate when and how the future payments are to be made to the employee’s beneficiary or estate.

Should employers withhold income taxes on payments made to beneficiaries or estates?

IRS Revenue Rulings 71-146 and 86-109 outline the proper income tax treatment in this situation. Essentially, for income tax purposes, compensation earned preceding death (unpaid at time of death) and paid to a beneficiary or the estate of the deceased employee is not considered “wages”. Hence, employers should not withhold income taxes on the amounts paid to a beneficiary or estate.

What about FICA taxes?

This is where is gets confusing.

Federal Insurance Contributions Act (FICA) taxes may still need to be withheld. If compensation amounts are paid in the calendar year of the employee’s death, such amounts will constitute FICA wages and will therefore be subject to FICA (social security and Medicare) tax withholding.

On the other hand, if the amounts are paid in years after the year in which the employee died, the amounts will not constitute wages for FICA purposes and will not be subject to withholding.

What tax reporting forms are required?

Depending on the timing of payments made after the employee’s death, the following forms should be used to report payments made to beneficiaries or estates.

Form 1099- According to IRS Revenue Ruling 64-150, all amounts earned (but unpaid at an employee’s death) received by an estate or beneficiary should be reported as non-employee compensation on a Form 1099-MISC. The amounts reported here must factor in FICA tax withholding, so they will depend on whether the compensation payments are made in the calendar year of the employee’s death or in later calendar years.

Form W-2- For payments made in the same calendar year as the death of the employee, the payments are not subject to income tax withholding, but ARE subject to FICA withholding. In this case, employers should issue a Form W-2 for that year in the name of the deceased employee.

If you report on W-2, here is how you would report gross plan distributions and withholdings:

• Box 3- Social security wages
• Box 4- Employee’s social security tax withheld
• Box 5- Medicare wages and tips
• Box 6- Medicare tax withheld

What about payments made in the calendar year(s) after the employee dies?

In this case, no income tax or FICA taxes should be withheld and the W-2 is not required. The full amount should be reported instead on a Form 1099-MISC (box 3- Other income, issued to the beneficiary/estate).

Questions about tax reporting issues following an employee’s death? Contact us.