Navigating Payroll Complications After a Deceased Employee’s Tax Filing: A Guide for Business Owners

The unfortunate passing of an employee can lead to unexpected complexities, especially when it comes to processing payroll and tax documentation. Recently, I encountered a challenging situation regarding the W2 amendment for a deceased employee, which has resulted in a negative payroll liability. Here’s an account of the issue along with potential solutions.

The Dilemma

At the end of December 2023, one of our business partners sadly passed away. The payroll for the corresponding pay period fell into 2024, resulting in the issuance of a paycheck that included deductions for a 401k loan and other regular withholdings. In January 2024, a W2 was generated for the deceased employee, a practice that is generally not permitted, as he was no longer living.

As I joined the company after this incident, I was involved when the estate was preparing to file the 2023 tax returns. To rectify the W2 issuance, I needed to contact our payroll service provider to amend the W2 and instead issue a 1099 to comply with the regulation.

However, this amendment produced a journal entry from the payroll service that created a negative liability within both the loan and withholding accounts, complicating our financial records.

Understanding the Consequences

Typically, when an adjustment like this occurs promptly, the amount owed would be refunded to the estate. However, due to the elapsed time since the employee’s passing and the tax filing, the estate had already relocated the funds from the employee’s 401k to another account. Consequently, both the loan repayment and standard withholdings have also been affected.

The pressing question now is: how do I resolve this negative liability issue?

Solutions to Consider

One potential solution could involve creating a journal entry (JE) to transfer these amounts from the payroll liability accounts to payroll expenses. However, it’s crucial to understand how this adjustment will impact our financial statements:

1. Effect on Balance Sheet: By moving the amounts from liabilities to expenses, you would effectively clear out the negative liability, improving the accuracy of your financial statements.

2. Impact on Financial Reporting: This shift will also reflect a more realistic picture of your payroll expenses for the period. While it may correct your immediate liabilities, consider how these adjustments will affect your profit and loss statements in the long term.

3. Consult with an Accountant: Given the complexity of