What Happens When You Claim Exempt On Your Payroll?

Michael Lodge

By Michael Lodge

This week in our tax office we have had three clients come in to have us prepare their tax returns and they were not happy with their results.  Why?  Because they claimed exempt on their W-4 and owed a bundle in taxes.  Not a tiny bit of taxes – but a bundle.  And they owed taxes not for this year but for the three prior years.  Why?  Because they claimed exempt on their W-4 and now they have to sit down with the IRS and State and work out an installment plan to pay back more then $50,000 in taxes.  They made a bad move and did not follow the rules, and their HR / Payroll department did not follow the rules.

Let’s go over the rules on filing exempt on your payroll.

Your employer determines what to withhold by what you put on your W-4.  Social Security and Medicare taxes that is deducted at a flat percentage of your pay, federal income tax is a multi-layer system.  Your employer determines your withholding status from your W-4.  If you meet certain requirements you will be able to claim to be exempt from federal income tax on the W-4.  Withholding amounts vary by each employee, but the exempt category has the same effect on all employees who claim exempt.

The IRS has very strict regulations on claiming the exempt status on your W-4.  The general rules are stated on the W-4 for the respective tax year.  Let’s examine line 7 of the W-4, which says:

7.  I claim exemption from withholding for 2016, and I certify that I meet both of the following conditions for exemption.

  • Last year I had a right to a refund of all federal income tax withheld because I had no tax liability, and
  • This year I expect a refund of all federal income tax withheld because I expect to have no tax liability

Now if you have not met any of item 7 you are in trouble.  First you lied about your tax status, and secondly you have just set yourself up for a big tax bill.

One other rule – you may not claim exempt if someone else claims you as a dependent on their tax return and if your wages or non-wage income will exceed $1,000 for the year.

It is so tempting once a taxpayer finds out they can claim exempt and have no taxes taken out of their payroll.  They feel there is more money in the pocket and they can pay down their expenses.  However, there is a big impact if you had no taxes taken out and not enough deductions to offset the taxes and they get that look at the line on the tax return that say how much they owe.  Wheat we have seen is that people are still willing to take the risk with the IRS and do it again and again.  Soon, they have several years of taxes that they owe and now their problem has become a stress related problem because the IRS becomes very aggressive in their collection process if you don’t settle or arrange to settle the tax debt.

Risks – filing exempt comes with big risks.  If you don’t qualify for the exempt status, you will owe the IRS when you file your tax return.  The IRS imposes penalties for providing false information on a W-4.  This includes a fee for making statements or claiming allowances to lower withholding and for having no reasonable basis for taking such action when you filled out the form.  If you are convicted of an actual crime, penalties may include imprisonment for up to one year.  Penalties are effective only if you purposely falsified your W-4.  A simple mistake, such as an honest calculation error – DOE NOT COUNT.  The risk is big if you intentionally fill out the W-4 in a manner not to pay taxes.

FINAL NOTE – don’t take risks when it come to dealing with taxes and the IRS.  Make the right claim on your W-4.  Consult with your tax accountant and make sure you are in compliance with the IRS regulations as it relates to your payroll withholding’s – the risk is not worth it.

If you have any questions please submit them to:  tax@icontaxgroup.com