In your company’s payroll process, you may occasionally have an employee who wants to claim exemption from withholding. Having the facts will help you deal with this process.
The retention process
Withholding is a general term for amounts deducted from employee pay for federal and state income taxes, and for FICA (Social Security and Medicare) taxes. Some employees may not be required to have federal income taxes deducted from their pay if their earnings are below a certain level.
The IRS allows employees to claim an exemption from income tax withholding in a specific year if both situations apply:
- In the prior year, they were entitled to a refund of all federal income taxes withheld because they had no tax liability.
- For the current year, they expect a refund of all federal income taxes withheld because they expect to have no tax liability
Some types of employees may be exempt: students, part-time workers, people over 65, and blind employees.
Any exemption from withholding applies only to federal income taxes, not state taxes or FICA (Social Security/Medicare) taxes.
Claim of exemption from withholding as of January 1, 2020
A new W-4 form is now in effect, effective January 1, 2020, for all new hires and employees who want to change their W-4 forms. If an employee wants to claim an exemption, they must write “Exempt” on Form W-4 in the space below Step 4(c) and complete Steps 1 and 5.
An employee who wants an exemption for one year must give you the new W-4 by February 15 of that year. If an employee who currently receives a tax exemption expects to owe taxes for the next year, they must change their W-4 by December 10 of the current year.
How to know if an employee is exempt from withholding
You can only change withholding based on documentation provided by the employee. Until the employee gives you the correct form(s), you must continue to withhold federal, state, and local income taxes based on the most recent forms completed by the employee. You cannot take the employee’s word for the exemption claim.
If the employee claims an exemption, this is what the W-4 form should look like:
- Line 5 – Total number of concessions – will be blank
- Line 6 – Additional amount to withhold – will be blank
- Line 7 – The exemption claim – will show the word “Exempt”.
You (the employer) may need to submit the W-4 to the IRS for review of the claim. You do not need to submit the form unless the IRS specifically sends you a letter asking you to do so.
More About Withholding Exemptions
A claim of exemption from withholding does not exempt the employee from paying their portion of the FICA taxes, including the additional Medicare tax. All FICA taxes must be paid by both you as the employer and the employee. Employee withholding for Social Security stops at the Social Security maximum, but your employer Social Security contribution continues for all payments.
If you think an employee’s W-4 withholding exemption is incorrect, you can’t change it, but you can tell the employee that the IRS may challenge the exemption. Regardless of what the employee claims, you should use only the signed W-4 form to withhold from the employee’s pay.
The federal income tax exemption claim has nothing to do with the employee’s state income tax and local tax withholding. The employee should check with state and local taxing agencies to find out how this exemption works in those jurisdictions. As stated above, until the employee gives you the signed documents for the state or local tax exemption claim, you must continue to withhold these taxes.
If the employee wants to claim the withholding exemption but his salary has already been deducted during the year, he cannot return this money. At tax time, you will notify the employee of the withholding on their W-2 form for the year. The employee can then claim the amount withheld.
For example, Carlton comes to you in February and says that he wants to claim exemption from withholding for this year. You complete a new W-4 form claiming the exemption, but you already withheld $276 in federal income tax from your payment in January. You’ll have to wait to file your tax return and claim the $276.
Don’t assume that a student, part-timer, or temporary worker will be exempt from withholding. All employees must complete a W-4 form at the time of hire, and this form is what the employee must use to claim an exemption.
Your attorney will tell you not to help employees fill out forms. But if an employee asks, you can give them information to help them make the decision on their own. IRS Publication 505 has a flowchart (page 8) that may help an employee see if they can claim exemption from withholding.
If you receive a block letter from the IRS
You are not required to submit Forms W-4 to the IRS, but they may review an employee’s exemption claim and may ask you to submit an employee’s Form W-4. In some cases, if the IRS finds the exemption claim invalid, they may send a “block letter” to your business, along with a copy for the employee. A block letter blocks the employee’s withholding based on IRS review.
This letter specifies the maximum number of holds allowed for the employee. Once you receive this block letter, you must begin using this information to withhold federal income taxes from the employee’s pay, beginning on the date set by the IRS. You cannot change the withholding amount until you receive permission from the IRS; cannot accept a new W-4 from the employee to change the withholding amount.
You will also receive a copy of this employee letter that explains how to provide additional information to the IRS. You can encourage the employee to contact the IRS to request a lock change.
If you don’t change the employee’s withholding based on the withholding in the block letter, your business is responsible for paying the additional amount of tax that should have been withheld.