Is an Employee Exempt From Federal Withholding?

When an employee asks you, “Am I exempt from federal withholding?” here are some points to keep in mind when determining employee exemptions:

Did the employee have a tax liability in the previous year? If he or she received a refund of all federal income tax paid (or had a right to a refund), the employee had no liability and can claim to be exempt.

Does the employee expect to have a tax liability this year or expect to qualify for a refund of all federal income tax paid? To make this determination, the W-4 worksheet asks:

1. Can the employee be claimed on someone else’s income tax return this year (such as a parent)?

2. What level of income does the employee expect this year?

3. In addition to earned income, does the employee expect to receive more than $250 in unearned income (such as interest or dividends) this year?

Note: An “exempt” W-4 is only valid for one year. If your payroll includes employees who claim to be exempt, require them to see you every January to fill out new W-4s to reflect changes in their situations.

Current Procedures: Years ago, employers were required to send copies of questionable W-4s to the IRS for evaluation. However, this requirement was dropped years ago. The IRS may still determine that an employee is under-withholding based on information reported on W-2s. If your employee is found to have a serious under-withholding problem, your payroll department may be contacted and instructed to withhold at a more appropriate rate. (IR 2005-45)

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© 2014 Thomson Reuters/Tax & Accounting