It is inevitable for any business that at one point in time or another, one of its employees will pass away. During this difficult time, employers are not only faced with trying to be helpful to grieving family members but they are confronted with the difficult legal and tax questions of who is actually entitled to receive the deceased employee's unpaid wages and how should such wages be paid.
In California, employers should first inquire of the deceased employee's family of the deceased’s estate will be subject to probate. If the estate will be probated (either due to the size of the estate or nature of assets), then the employer can issue the final paycheck to the estate of the deceased employee. However, in most case, it is likely that no probate will be needed. In that case, the person or persons entitled to receive the assets of the deceased employee can fill out and furnish an Affidavit of Small Estate to the employer. Because the heirs sign the affidavit under penalty of perjury, employers are generally protected from claims brought by other heirs who may have a superior interest.
Once it is resolved who the final check should be issued to, the harder question is how should taxes be withhold and reported.
If an employee dies during the year, you must report the accrued wages, vacation pay, and other compensation paid after the date of death. You must withhold social security and Medicare taxes on the payment and report them only as social security and Medicare wages on the employee's Form W-2 to ensure that proper social security and Medicare credit is received. On the Form W-2, show the payment as social security wages (box 3) and Medicare wages and tips (box 5) and the social security and Medicare taxes withheld in boxes 4 and 6; do not show the payment in box 1 of Form W-2.
Also, you also must report the payment to the estate or beneficiary on Form 1099-MISC. Report the payment in box 3. Enter the name and TIN of the payment recipient on Form 1099-MISC. For example, if the recipient is an individual beneficiary, enter the name and social security number of the individual; if the recipient is the estate, enter the name and employer identification number of the estate. The general backup withholding rules apply to this payment.
An actual example of how this is to work is set forth below (which is from the instruction booklet to from 1099-Mis):
Example. Before Employee A's death on June 15, 2016, A was employed by Employer X and received $10,000 in wages on which federal income tax of $1,500 was withheld. When A died, X owed A $2,000 in wages and $1,000 in accrued vacation pay. The total of $3,000 (less the social security and Medicare taxes withheld) was paid to A's estate on July 20, 2016. Because X made the payment during the year of death, X must withhold social security and Medicare taxes on the $3,000 payment and must complete Form W-2 as follows:
Box 1—10000.00 (does not include the $3,000 accrued wages and vacation pay)
Box 3—13000.00 (includes the $3,000 accrued wages and vacation pay)
Employer X also must complete Form 1099-MISC as follows:
Boxes for recipient's name, address, and TIN—the estate's name, address, and TIN.
Box 3—3000.00 (Even though amounts were withheld for social security and Medicare taxes, the gross amount is reported here.)
If Employer X made the payment after the year of death, the $3,000 would not be subject to social security and Medicare taxes and would not be shown on Form W-2. However, the employer would still file Form 1099-MISC.