What is a withholding allowance?
Once an employee starts working for you and fills out the Form W-4, you’ll withhold a certain amount according to your tax obligations and allowances when completing payroll. This amount is based largely on the employee’s income, as the employee’s income determines the appropriate withholding allowances. For more guidance on how to pay an employee, explore the different payment options and their pros and cons.
Some individuals may opt to withhold an additional amount to avoid owing to the Internal Revenue Service (IRS) or get a larger refund at the end of the tax year. The amount of taxes withheld from each paycheck is determined by the information provided on the Form W-4 and the employee’s income.
Who can claim tax exempt status?
According to the IRS, individuals must meet all of the following criteria to be eligible for tax exempt status:
- The employee must have had no tax liability for the previous year
- The employee must expect to have no tax liability for the current year
Other factors also determine eligibility for tax exempt status. Those who are claimed by other individuals as dependents may request an exemption if one of the following is true:
- The employee’s income will be less than $1,100
- The employee’s income will include more than $350 of unearned income, such as interests or dividends, and be less than $12,550
For more details on 401(k) contribution limits and employer match, see our 2024 guide.
For others not claimed as dependents, tax withholding exemptions depend on their total annual income. As of 2021, the amount they earn must not exceed the limits listed below, and employees must meet a minimum amount of income to qualify for exemption:
- $12,550 for single individuals
- $18,800 for a head of household
- $12,550 for married individuals filing separately
- $25,100 for married individuals filing jointly
- $25,100 for qualifying widowed individuals
Eligibility for exemption is based on the employee’s pay and total annual income.
Tax exemptions are generally applicable to:
- Students
- Foreign citizens
- Taxpayers with dependents
- Taxpayers with income deductions
- Dependents
- Low-income taxpayers
- Part time employee, if their pay and hours meet exemption criteria
- Hourly workers, depending on how their compensation and timekeeping are structured
- Highly compensated employees, who may be exempt depending on their total compensation and how it is calculated
Individuals may refer to this guide from the IRS to help determine if they meet tax withholding eligibility criteria.
Form W-4 for tax exempt employees
If some of your staff members are exempt, they should indicate so on the Form W-4 once they begin working for your company. To claim exemption from withholding, your employees will follow these steps:
- Write “Exempt” on Form W-4 in the space below Step 4(c)
- Complete Steps 1(a), 1(b) and 5
- Leave the rest of the form blank
By following these steps, employees can claim complete exemption from withholding federal income tax. This means they are requesting not to have federal income tax withheld from their paycheck, based on their completed tax forms.
If an employee claims an exemption, the employer won’t be withholding federal income tax from the employee’s paycheck, although other taxes such as Social Security and Medicare may still be withheld. This exemption directly affects the amount of federal income tax withheld from the employee’s paycheck.
On the other hand, if these employees don’t meet the criteria to qualify for exceptions when they file their next tax return, they may end up owing taxes and penalties. This form doesn’t need to be sent to the IRS, but they may request a hard copy for review. It should be kept in your records for at least four years to make sure you’ve withheld taxes according to the employee’s request.
What if there is an error, change or dispute with Form W-4?
If an employee’s personal or financial situation changes, they may be required to complete a new Form W-4, which is also known as the employee’s withholding certificate. These changes include tax deduction eligibility, variations in salary or wage, and adding or removing dependents.
Unauthorized changes to Form W-4, such as defacement or adding form entries that were not requested, will make it invalid. The form is likewise invalid if the employee informs you that they’ve included any false information.
In these cases, employers should withhold taxes as if the employee were a single individual with no deductions or exemptions. If the employee had a previous W-4 form, you can use it to determine the amount to withhold until the employee provides you with a valid Form W-4.
Should the IRS have a dispute with the requested withholding amount, it may send both the employee and employer lock in letters, which specify the minimum tax withholding amount and determine a new withholding agreement. The IRS allows the employee a period of time to dispute the new withholding amount before it takes effect.
When do employees need to resubmit Form W-4?
The Form W-4 does not expire, so employees don’t need to resubmit it. Exempt employees, however, need to provide a new Form W-4 by February 15 of the following year. If employees are expecting to owe federal tax the following year, they will complete a new form by December 1st of the current year. For related information on federal tax documents, such as when W-2s are distributed, it’s important for employers to be aware of all relevant deadlines.
Consequences of Misclassification
Misclassifying employees as exempt or nonexempt can create significant challenges for employers, especially when it comes to federal income tax withholding and compliance with wage and hour laws. If an employee is incorrectly classified as exempt, an employer may fail to withhold federal income taxes properly, which can result in unexpected tax liability for both the business and the employee. This misstep can also affect the correct withholding of Medicare taxes and other payroll taxes, leading to further complications.
Beyond tax withholding, misclassification can violate the Fair Labor Standards Act (FLSA) by denying nonexempt employees their right to minimum wage and overtime pay. Nonexempt employees must be paid at least the federal minimum wage and receive overtime pay for hours worked over 40 in a workweek. Exempt employees, on the other hand, are not entitled to these protections. Failing to classify employees correctly based on their job duties, salary basis, and hourly wage can result in disputes, back wages owed, and even lawsuits.
Employers who do not comply with FLSA provisions or who ignore state and local laws risk facing penalties, fines, and costly legal action. The IRS may also intervene by issuing a lock-in letter, which requires the employer to implement a specific withholding arrangement for the affected employee. Ignoring a lock-in letter or failing to withhold federal income taxes as directed can increase tax liability and lead to further enforcement actions.
It’s also important to distinguish between employees and independent contractors. Independent contractors are not subject to the same tax withholding rules as employees, but misclassifying a worker as an independent contractor when they should be an employee can result in additional taxes, penalties, and interest.
To avoid these risks, employers should regularly review their employee classification practices, ensuring they are classifying employees correctly according to FLSA guidelines, salary basis, and job duties. Staying informed about state and local regulations is equally important, as these may impose additional requirements beyond federal law. Providing clear tax advice and guidance to employees about their withholding options can also help prevent misunderstandings and ensure taxes are withheld correctly.
In summary, the consequences of misclassifying employees can be severe, including tax liability, back wages, penalties, and legal disputes. By classifying employees correctly, following FLSA provisions, and complying with both federal and state/local regulations, employers can protect their business and ensure they are meeting all tax withholding obligations.
