Post-employment payments of compensation

Post-employment payments of compensation Every company employee will one day work his or her final day, either moving on to a new job or a new job search, or leaving the workforce in retirement or on a hiatus. Sometimes, sadly, disability or even death will be the cause. Whatever the reason, once that final day passes, a company’s obligations to that employee are far from over. In this story, we describe what issues will arise in a company’s handling of post-employment compensation.

Payout of accrued vacation and final pay Most businesses will, at some time, have to manage the difficult situation of the death of an employee. A business’s human resources department should, of course, have policies in place that acknowledge and accommodate the grief of fellow co-workers. But the business also must expect to provide answers to other questions related to this person’s terms of employment.

Our focus here will be on questions surrounding this employee’s compensation, and how it is to be paid to a deceased employee’s beneficiaries. Some of these questions include:

  1. How are uncashed paychecks handled?
  2. What accrued wages are paid in the year of death?
  3. What wages are paid in a year after death?

The factors that must be considered are whether a payment is for an uncashed paycheck or for unpaid accrued wages, vacation pay, taxable fringe benefits or other types of accrued compensation. Additionally, the business must determine whether any payments are made in the year of an employee’s death or in a following year.

In the event of a paycheck being issued to an employee who passes prior to cashing the check, a new paycheck, with same net amount of the original paycheck, has to be reissued to the employee’s beneficiary. Since the original paycheck was already issued, the necessary withholding of taxes has already been done, and the wages and taxes will be reported on the deceased employee’s Form W-2 at the end of the year.

Generally, any wage payments made to the beneficiary in the year of death are subject to Social Security and Medicare (FICA) taxes. These payments are not considered wages for federal income tax purposes. The reporting of the wage payments would go in Form W-2’s Box 3 (Social Security) and Box 5 (Medicare) with the applicable taxes reported in Boxes 4 and 6. No amount is reported in Box 1 (wages, tips and other compensation). The payment is also reported to the beneficiary on a 1099-MISC in Box 3 (other income).

For wages paid in a year after the employee’s death, IRS Revenue Ruling 86-109 states, “…these payments are not considered wages for the purposes of the collection of income tax at source.” Therefore, the payments are not subject to federal employment taxes and will not be reported on a Form W-2. Rather, the gross wages should be reported on a Form 1099-MISC in Box 3 in the name and Taxpayer Identification Number (TIN) of the former employee’s beneficiary.

Payments of death benefits A company may have either a formal (written) or informal (unwritten) death benefit plan for their employees. The IRS no longer allows for a non-taxable death benefit. An employer can treat a death benefit payment as a bonus (which would be a wage item), or as a death benefit. Depending on how it is treated determines the taxability and reporting requirements.

If the payment is considered a death benefit, which is made to the employee’s estate or to a person who acquired the right to receive the payments solely because of the death of the employee, different rules apply to the reporting of the payment. Death benefits are not considered wages and are not subject FICA tax, nor are they subject to income tax withholding. The entire amount of the payment is reported on a Form 1099-R rather than a 1099-MISC, and no amount of the payment is reported on the deceased employee’s W-2. The payment would be reported in Box 2a (taxable amount) using Code 4 (death) in the Box 7 distribution codes. As noted, the amount of the death benefit is taxable to the beneficiary.

Payments of deferred compensation Deferred compensation is generally defined as any payment of compensation made to an employee more than 2 ½ months after the calendar year in which the employee became vested in the payment.

Deferred compensation is treated as wages subject to income tax withholding and reported on Form W-2, and is normally included in the employee’s gross income when paid. This is so even if the employee is no longer employed at the time the payment is made.

Social Security and Medicare taxes are imposed under a special timing rule which provides that these payroll taxes apply when either a contribution is made to the deferred compensation plan or when the employee vests (and not when amounts are later paid to employees), whichever occurs later. For example, if a deferred compensation plan provides for immediate 100% vesting for all amounts contributed to the plan, Social Security and Medicare taxes apply immediately when contributions are made to the plan.

Payments of deferred compensation are also subject to a special deduction timing rule. Under this rule, the employer receives a compensation expense deduction on the last day of the employee’s taxable year in which deferred compensation was paid to the employee. Since individuals have a calendar tax year, this effectively means that the employer is entitled to the deduction on the first Dec. 31 following the date of the payment. For calendar-year taxpayers, this rule does not often affect the taxable year in which they may take the deduction. For non-calendar taxable year taxpayers, care should be exercised to make sure the deduction is booked for the correct year.

Payments to settle lawsuits Payments to employees under settlement agreements can include several types of payments:

  1. Payment of back wages or other pay claimed by the employee
  2. Payment of damages for physical injuries
  3. Payment for other types of damages such as mental distress
  4. Payment of the former employee’s legal expenses
  5. Interest on the preceding types of payment

With the exception of damages for physical injury, all of these types of payments are taxable to the former employee. The income tax reporting requirements vary depending upon which types of payments are involved and whether some or all payments are made to the former employee or some or all of the payments are made to the former employee’s attorney.

Here is a general summary of how the most common types of settlement payments are reported where the former employee receives back wages, damages for other than physical injury and attorney’s fees:

1. Total award paid to attorney

  1. Total amount on Form 1099-MISC to attorney in Box 14
  2. Wages portion on Form W-2 to employee
  3. Attorney’s fees and damages portion on Form 1099-MISC to employee in Box 3

2. Award paid by check jointly to employee and attorney

  1. Total amount on Form 1099-MISC to attorney in Box 14
  2. Wages portion on Form W-2 to employee
  3. Attorney’s fees and damages portion on Form 1099-MISC to employee in Box 3

3. Separate payments to attorney and employee

  1. Amount paid to attorney for fees on Form 1099-MISC to attorney in Box 14
  2. Wages portion paid to employee on Form W-2 to employee
  3. Attorney’s fees and damages portion on Form 1099-MISC to employee in Box 3

4. Total amount paid to employee

  1. No Form 1099-MISC to attorney
  2. Wages portion paid to employee on Form W-2 to employee
  3. Attorney’s fees and damages portion on Form 1099-MISC to employee in Box 3

As is clear from the above, employment legal settlements can have a certain amount of complexity when considering the income tax and reporting consequences of settlement payments. Employers should therefore pay close attention to the characterization of the component parts of a settlement. And, when payments are actually made, employers should consult with a professional to ensure that they fulfill their reporting obligations under the IRS’s rules.

Mark Ritter
Managing Director
Human Capital Services
T +1 404 704 0114

Bob Woodall
Human Capital Services
T +1 949 878 3350

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