While not common, some of your employees might be tax exempt. If an employee tells you that they are exempt, can you answer the question, “What does tax exempt mean?” Do you know how to adjust that employee’s payroll?
What does tax exempt mean?
When an employee begins working for you, they should fill out Form W-4 using the form’s personal allowances worksheet. Employees use this form to claim personal allowances (aka exemptions). Each allowance reduces the amount of federal income tax that you will withhold from the employee’s wages. You can provide W-4 Form help if an employee needs assistance.
The employee can also claim complete exemption from all federal income tax withholding (FITW). When an employee is tax exempt, you will not withhold any federal income tax from their wages.
What about other exemptions?
The tax exemption on Form W-4 does not apply to Medicare or Social Security taxes. Even if an employee is exempt from federal income taxes, you should still withhold Medicare and Social Security taxes.
What does claiming exempt mean for an employee’s state and local tax liabilities? The federal income tax exemption does not automatically exempt the employee from state or local income taxes. In some states, Form W-4 might or might not exempt the employee from state or local income taxes. The employee might need to fill out a different form for state or local withholding. Because the laws are different everywhere, you should check with your state and local laws.
Who can be tax exempt?
Not everyone can claim exemption from federal income tax withholding. Employees must meet specific qualifications to be exempt.
Employees can claim exemption if both of the following situations apply:
In the previous year, the employee had the right to a refund of all federal income tax withheld from their wages because they had no tax liability.In the current year, the employee expects a refund of all federal income tax withheld because they plan to have no tax liability.
There are also some other factors that help decide if an employee can be exempt from federal income taxes. If an employee needs help determining if they are exempt from taxes, direct them to IRS Publication 505. The publication has a flow chart and worksheets that can help employees decide if they are exempt.
A note about students, part-time, and seasonal help
If you hire students, part-time, or seasonal help, those workers are not automatically exempt from federal income taxes. You need to withhold federal income taxes from their wages unless they indicate that they are exempt from withholding.
How do you know if an employee is tax exempt?
Employees must use Form W-4 to tell you that they are tax exempt. If an employee is tax exempt, they must still fill out the Employee’s Withholding Allowance Certificate portion of the worksheet, like all employees should. An exempt employee will not complete line 5 (total number of allowances) nor line 6 (additional withholding amounts). Instead, the employee will write “Exempt” on line 7 of the form.
What if the employee falsely claims they are exempt?
You will not usually send an employee’s Form W-4 to the IRS. However, the IRS can require you to send a copy of an employee’s Form W-4 so it can review the form’s accuracy. If an employee claimed exemption, the IRS will determine if the employee really does qualify for the exemption.
If the IRS does not think the employee is exempt, the IRS will send you and the employee a notice saying the maximum withholding allowances the employee can have. This notice is called a “lock-in letter.”
The IRS provides a period for the employee to dispute the determination. If the employee does not dispute the lock-in letter or if the IRS thinks the dispute is inadequate, you should withhold employee earnings based on the IRS permitted allowances.
The employee can give you a new Form W-4 that claims fewer allowances than the IRS permits. If the employee ever wants to claim more than the permitted allowances or an exemption, the employee must dispute the determination with the IRS. You should not increase the employee’s allowances or give an exemption without IRS approval.
To learn more about lock-in letters, view Publication 505.
When is the deadline to be tax exempt?
Normally, Form W-4 does not expire. But, if an employee claims they are exempt from federal income tax, they need to give you a new Form W-4 each year to keep the exemption.
The Form W-4 deadline for exemptions is February 15. If the employee does not give you a new Form W-4 by the deadline, the exemption expires.
After the exemption expires, you should then use the employee’s last valid Form W-4 that had withholding allowances. You will withhold federal income taxes based on the number of withholding allowances claimed on the old Form W-4.
If you do not have a previous Form W-4 with allowances for an employee, you can withhold federal income taxes from the employee’s wages as if they claimed zero allowances.
What are your responsibilities as an employer?
As an employer, it is your job to withhold taxes from employee wages.
If an employee gives you a Form W-4 that says they are exempt, make sure you don’t withhold federal income taxes. If an employee’s exemption expires, it is your responsibility to begin withholding federal income taxes again.
If you are not withholding federal income tax from an employee and that employee did not claim exemption on their Form W-4, you may have made an error. You might have accidentally checked an exemption box in your payroll software. Correct your error as soon as possible. The employee might need to adjust their withholding allowances to prevent owing money on their annual tax return.
PayNortheast's online payroll software makes payroll taxes easy. The software will do all the tax calculations for you and automatically file payments with the federal, state and local agencies. If you have tax-exempt employees, you can indicate that in the software. Start your free trial now.
This is not intended as legal advice.