Your employees use the W-4 form to indicate their federal income tax withholding conditions; this helps you to determine the amount of tax to withhold from their pay. An employee may choose "Exempt" on the W-4 if she meets the Internal Revenue Service's requirements. Exempt status means the employee is not subject to federal income tax withholding.
Criteria for Exemptions
The criteria for claiming "Exempt" is included on the W-4 for the tax year in question. As of 2017-2018, an employee is exempt if she received – or had the right to – a full tax refund of all her federal income tax withheld in the past year, and if she anticipates receiving a full refund for the present year because she does not expect to owe any tax. An employee who is also a dependent on another person's tax return typically cannot claim exempt status if she will earn more than $950 for the year and if her unearned income will exceed $300, as of 2017-2018. If an employee claims "Exempt" on the W-4, but is actually subjected to the tax, she would owe the IRS when she files her tax return.
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If applicable, the employee writes "Exempt" on Line 7 of the W-4. She also fills in her personal data on Lines 1 and 2 and her filing status on Line 3. She signs and dates the form and submits it to you. During payroll processing, you would not take any federal income tax out of her wages. Claiming "Exempt" on the W-4 is good for one year. If an employee wants to claim exempt for the next year, she must fill out another form. If the IRS finds that an employee has erroneously claimed "Exempt," it would send you a lock-in letter to change her withholding conditions to the correct status.
Withholding exemptions on the W-4 are different from exempt status. Withholding exemptions are sometimes called personal allowances, which reduce an employee's taxable wages. An employee claims withholding exemptions on Lines A through G of the W-4 and puts the total on Line H. She transfers the total from Line H to Line 5. She also cannot claim exempt on Line 7 plus claim allowances on Line 5; it must be one or the other. An employee who claims allowances that she's not entitled would likely owe the IRS when she files her tax return. The IRS might also send you a lock-in letter to change her withholding exemptions to the appropriate number.
Exemption from State Tax
Many states have their own withholding form that an employee would complete to claim exemption from state income tax. This type of exemption means you would not withhold any state income tax from the employee's paychecks. The criteria for exemption from state income tax are often similar to federal income tax; however, on occasion, such as in California and Colorado, an employee would use her W-4 for state income tax purposes. For example, in California, an employee may claim exemption from state income tax withholding on the W-4 if she did not owe any federal income tax in the previous year and she does not anticipate owing any tax in the current year. Because state rules vary, check with the state revenue department for exempt regulations in your state.