Reporting of payments following employee's death.
When an employee dies, the employer will often owe the employee for accrued current wages, vacation accruals, bonuses earned, etc. Since these amounts are earned by the employee before death but paid to his estate or beneficiary, the payments are income in respect of a decedent under Sec. 691(a). The payments are taxable to the estate or beneficiary and not to the decedent. The amounts were earned, however, for services rendered by the decedent, who should, therefore, receive credit for those earnings for Social Security and Medicare purposes. Thus, if the payments of accrued compensation are made in the year the employee died, the employer must withhold Social Security and Medicare taxes and pay any applicable FUTA tax.
Rev. Rul. 86-109 is the cited authority on reporting death benefits and compensation payments made after an employee's death, and the instructions for Forms W-2 and 1099 provide further detail on how to report such payments. If the accrued compensation payments are made in the year of death, the applicable amounts should be reported as Social Security wages (box 3) and Medicare wages (box 5) on the decedent's final W-2, so that proper credit for those earnings is received. The wages are not taxable to the deceased employee, however, and, thus, not subject to Federal income tax withholding and not included in total wages (box 1) on Form W-2. The gross compensation amount is reported to the estate or beneficiary on Form 1099-MISC in box 3 as "Other Income."
If payments of a deceased employee's earned compensation are made after the year of death, the amounts are not subject to FICA (Social Security and Medicare) or Federal income tax withholding. Thus, the payments in years after death are reported to the estate or beneficiary on Form 1099-MISC, but not on Form W-2. The instructions for Forms W-2 and 1099-MISC provide both an explanation and an example of the appropriate reporting.
Death benefits and distributions from both qualified and nonqualified plans, including gratuitous post-death salary continuation payments, are reported on Form 1099-R. Death benefits and other distributions from qualified plans are not subject to FICA and FUTA taxes (Sec. 3121(a)(13)). If the death benefits or distributions are paid out of a qualified plan, the payments are subject to Federal income tax withholding under Sec. 3405; see Rev. Proc. 86-109.
Post-death distributions from nonqualified deferred compensation plans are generally treated as taxable wages but, like post-death payments of accrued current compensation, are not subject to income tax withholding. The timing of the distributions and whether the plan is a "nonqualified deferred compensation plan" under Secs. 3121(v)(2) and 3306(r)(2) determine whether FICA and FUTA taxes will apply to the distributions. Death benefits paid under a nonqualified plan, such as gratuitous post-death salary continuation payments, are exempt from FICA and FUTA taxes.
In general, amounts deferred under certain nonqualified deferred compensation plans are subject to FICA and FUTA taxes at the later of when the services are performed or when there is no substantial risk of forfeiture (Secs. 3121(v)(2) and 3306(r)(2)). Thus, in many cases, Social Security and other payroll taxes will have been paid long before distributions are made from the plan. Like payments for accrued current compensation, distributions made in the year of the employee's death will be subject to FICA and FUTA taxes if the distributions are either from a plan or arrangement that is not a "nonqualified deferred compensation plan" under Secs. 3121(v)(2) and 3306(r)(2) or from a nonqualified deferred compensation plan under which the amounts were not properly subjected to FICA and FUTA taxes in earlier years. Nonqualified plan distributions in years after the employee's death are not subject to Social Security, Medicare and Federal unemployment taxes.
Distributions from both qualified and nonqualified plans are reported on Form 1099-R, with distribution code "4" (indicating that the amount is paid to a decedent's beneficiary). If any of the distribution amounts are subject to Social Security and Medicare taxes, the Social Security and Medicare wages will be included on the decedent's final W-2, like post-death current compensation payments.
Income from stock options exercised after death and from the vesting of restricted stock at the time of death are generally taxed and reported in the same manner as compensation payments after death. The taxable amounts are not subject to Federal income tax withholding and are reported on Form 1099-MISC in box 3. Income from the vesting of restricted stock at death, and income from the exercise of stock options in the year of death, will generally be subject to FICA and FUTA taxation, and reported as Social Security wages and Medicare wages on the employee's final W-2. There is an exception from FICA and FUTA taxation, however, if the employer for pre-1998 years had treated vested options as nonqualified deferred compensation and subject to payroll taxes at that time. Income from the exercise of stock options in years following death is not subject to Social Security or Medicare taxes.
In summary, taxable compensation and plan distributions will be reported as taxable income to the payee beneficiary on either Form 1099-MISC or Form 1099-R. Payments of compensation earned by the decedent and paid in the year of death (except for most plan distributions) are subject to Social Security and Medicare withholding and will be reported as Social Security and Medicare wages on the employee's final W-2, but will not be included in taxable wages on the W-2 (as those amounts are reported to the payee beneficiary on Form 1099).
Editor's note: Mark Ely is former chair of the AICPA Relations with the IRS Committee. Deborah J. Pflieger is the current chair. Ms. Barners, Ms. Hyde and Messrs. DeGeorgio, VanDeveer and Goldstein are members of that committee.
FROM CAROL T. BARNES, CPA, COLE, EVANS & PETERSON, CPAs, SHREVEPORT, LA, AND DEBORAH J. PFLIEGER, PRICEWATERHOUSECOOPERS LLP, WASHINGTON, DC