Withholding taxes from employee wages is all part of Payroll 101. But, what happens when an employee is exempt from withholding?
While rare, some of your employees might be exempt from taxes. And if an employee tells you that they are exempt, you need to know what to do. So, what does exempt mean, and how does it impact taxation?
What does tax exempt mean?
Tax exempt is when an individual or business is exempt from paying certain taxes. Employees who are exempt from withholding are exempt from federal withholding for income tax.
When an employee begins working for you, they fill out Form W-4, Employee’s Withholding Certificate. The W-4 purpose is to determine federal income tax withholding (FITW). Employees can lower their withholding through actions like claiming dependents.
An employee can also claim complete exemption from all federal income tax withholding on Form W-4. When you have a tax-exempt employee, do not withhold any federal income tax from their wages.
Claiming exempt on W-4 does not mean an employee is exempt from Social Security and Medicare taxes. It also does not mean that the employee should not have taxable wages on their W2 form. The employee is exempt from taxes, but not taxable wages. All wages earned by the employee should be reported on the W-2.
And, exempt on W-4 does not automatically apply to state and local income taxes. State W-4 forms vary, and only a handful of states use the federal W-4 for state withholding. A tax-exempt employee might need to fill out a different form for state or local withholding. Check your state and local laws for more information.
Who qualifies for tax-exempt status?
Now that we’ve gone over what does exemption from withholding mean?, it’s time to tackle who qualifies. Not everyone can claim exemption from withholding.
Your employee may be wondering: “Am I exempt from withholding?” An employee’s income must be low enough that they won’t owe income tax to qualify.
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
So, how much income results in “no tax liability?” In 2023, the employee’s annual income must be lower than:
- $13,850 (Single or Married Filing Separately)
- $20,800 (Head of Household)
- $27,700 (Married Filing Jointly or Qualifying Widow(er))
Examples of tax-exempt employees include students and other employees who work part time or seasonally.
Employees who are 65 or older or blind have different income thresholds than the ones listed above.
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.
How to know if an employee is exempt on W-4
Again, employees must use Form W-4 to tell you they are tax exempt.
To claim exemption, employees must:
- Write “Exempt” in the space below Step 4(c)
- Complete Steps 1(a), 1(b), and 5
- Leave the rest of the W-4 blank
If you see a W-4 with the word “Exempt,” you know not to withhold federal income tax from that employee’s wages. Keep the form in your records.
What if the employee falsely claims they’re exempt?
Generally, Form W-4 is for your records. You do not send it to the IRS. However, the IRS might require you to send a copy of an employee’s Form W-4 so it can review it for accuracy.
If the IRS does not think the employee is actually exempt, they will send you and the employee a notice saying the withholding arrangement 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, withhold employee earnings based on the IRS’s letter.
The employee can give you a new Form W-4 that results in more tax withholding. If the employee ever wants to lower their withholding or claim an exemption, the employee must dispute the determination with the IRS. Do not lower withholding or give the employee an exemption without IRS approval.
To learn more about lock-in letters, view Publication 505.
How long do exemptions from withholding last?
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.
An exemption from withholding is only good for one year. Employees must give you a new W-4 each year to keep or end the exemption.
Here’s a breakdown of exempt employees’ responsibilities:
- Employees expecting to owe federal income tax in the following year must fill out a new W-4 that does not claim exemption
- Deadline: December 1 of the current year
- Employees expecting to have no tax liability in the following year must fill out a new W-4 to claim exemption
- Deadline: February 15 of the following year
If the exemption expires, withhold federal income tax according to the employee’s Form W-4 information.
What are your employer responsibilities?
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, don’t withhold federal income taxes from their wages. Begin withholding federal income taxes again if an employee’s exemption expires.
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 to prevent owing money on their annual tax return.
Patriot Software’s online payroll makes payroll taxes easy. The software does all the tax calculations for you. If you have tax-exempt employees, you can indicate that in the software. And if you use the Full Service Payroll, Patriot’s payroll services will even file tax forms for you. Start your free trial now!
This article has been updated from its original publication date of January 30, 2017.This is not intended as legal advice; for more information, please click here.