Deceased employee W2 amendment created negative payroll liability – Help?

Navigating Payroll Challenges After an Employee’s Passing: A Guide for Small Business Owners

Losing an employee is undoubtedly one of the most challenging events a company can face. Unfortunately, the complications that arise do not always end with the loss itself—especially when it comes to payroll matters. A recent situation highlights an important issue related to tax reporting for deceased employees that we’ll discuss today.

The Scenario

Imagine a company grappling with the passing of one of its owners at the close of 2023. Although the owner was no longer with us, a payroll cycle ran into 2024, resulting in a paycheck being issued that included deductions for a 401(k) loan and standard payroll withholdings. Subsequently, the deceased received a W-2 in January 2024. The tax implications of this situation are profound as issuing a W-2 posthumously can lead to compliance issues with IRS regulations.

The company, which had experienced a transition in staff, needed to file the deceased owner’s taxes. In pursuit of accuracy, a request was made to amend the W-2 and switch to a 1099 form, which is generally more appropriate for handling income after a person’s passing. However, this amendment inadvertently generated a journal entry (JE) from the payroll service that resulted in a negative liability in both the loan and withholding accounts.

Understanding the Implications

Typically, if this process had moved more swiftly, the business could have refunded the deducted amounts directly to the estate. Unfortunately, due to the delay between the owner’s death and tax filing, the estate had already transferred the funds out of the owner’s 401(k), leading to complications with the associated 401(k) loan payments and withholdings.

This scenario raises the critical question: How do you resolve the negative payroll liabilities that have emerged from this situation?

Potential Solutions

1. Adjusting Journal Entries (JEs): One straightforward approach might be to create an adjusting journal entry to move these amounts from payroll liabilities to payroll expenses. This adjustment can help clear out the negative liabilities from your balance sheet.

2. Impact on Financial Statements: It is essential to consider the effects of such an adjustment. Although it may eliminate the negative liability, moving these amounts to expenses could impact your net income for the period. It’s crucial to evaluate how this adjustment aligns with your overall financial health and forecasting.

3. Seeking Professional Advice: Given the complexity of this issue, particularly with IRS guidelines surrounding