Taxation of Employee Death Benefits

How are death benefits provided by an employer taxed upon an employees death?

It is getting to be common that an employer makes payments (death benefits) to a deceased employee’s surviving spouse, children, or other beneficiaries if an employee dies when they are employed by the company. These payments will help the family adjust to the loss of income caused by the employees death, but families must be aware of the tax consequences related to such payments. Once you receive your death benefit, you’ll need to be familiar with your state’s tax laws. In most cases, life insurance benefits are exempt from state and federal taxation but other benefits may be taxable.  This exemption applies to the death benefits on virtually all forms of traditional life insurance and most forms of life assurance.

 

What is a Taxable Death Benefit?

Generally, if the decedent had a non- forfeitable right to the payments received from the employer (e.g., the decedent’s accrued salary), the amounts are generally taxable to the recipient just the same as if the employee had lived and collected the payments. These amounts would not have any special tax treatment because they are just like receiving regular wages from working and will be reported on the deceased W-2 form when mailed in January.

 

IRS Death Benefit Tax Law

However, when the employer makes voluntary payments when an employee dies, the gift issue arises. Generally, the IRS considers such payments to be compensation for prior services rendered by the deceased employee. However, there are some interpretations of the death benefit tax law that indicate that payments to an employee’s surviving spouse or other beneficiaries are gifts if the following are true:

 

Taxation of Employee Death Benefits

  • The payments were made to the surviving spouse and children rather than to the employee or the employee’s estate.
  • The employer derived no benefit from the payments.
  • The surviving spouse and children performed no services for the employer.
  • The decedent had been fully compensated before death
  • Payments were made pursuant to a board of directors’ resolution that followed a general company policy of providing payments for families of deceased employees.

When all of the above conditions are satisfied, the payment is presumed to have been made as an act of affection or charity. These payments would not be treated as regular wage income and are a non-table death benefit. When one or more of these conditions is not satisfied, the surviving spouse and children may still be deemed the recipients of a gift if the payment is made in light of the survivors’ financial needs.