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Typically, employers are required to withhold income taxes from employees’ paychecks. However, if an employee is tax-exempt, employers should not withhold any of their pay for federal income taxes.
There are several reasons why an employee may receive an income-tax exemption. It could be because their earnings are below a certain threshold. Perhaps they’ve listed dependents on their personal tax returns, or they’re paying taxes in another country.
Importantly, just because an employee is exempt from federal income taxes, it doesn’t mean they’re exempt from other taxes. Employers must still withhold the employee’s portion of Social Security and Medicare taxes and pay for state income taxes.
Businesses can also receive tax exemption from federal income taxes in some cases. For example, many 501(c)(3) nonprofits are exempt from federal income taxes.
Withholding and Tax Exemption
When a business hires a new employee, that employee must file a W-4 form as part of the onboarding process.
Form W-4 tells the employer how much to withhold from the employee’s paycheck for federal income taxes. The W-4 form accounts for an employee’s expected income and deductions to estimate their tax bill for the year. Companies are then required to withhold the correct amount of money from that employee’s paychecks to meet their expected tax obligation.
However, some employees don’t have to pay federal income taxes. For example, single individuals with no dependents who make less than $12,950 per year—the standard deduction for 2022—won’t owe any federal income tax. Individuals who are claimed as a dependent on another person’s tax return won’t owe income tax if they make less than $1,100 per year.
If an employee didn’t pay federal income tax last year and expects not to have to this year, they can claim to be tax-exempt. These employees should fill out lines 1a, 1b, and 5 on form W-4, then write “Exempt” in the space below line 4(c).
If an employee submits a W-4 form with this notation, the employer should not withhold any federal income tax for that employee. The employer must still withhold state income taxes and federal Medicare and Social Security taxes. Employers are still responsible for paying all employer payroll taxes for that employee.
Re-submitting form W-4
Most employees never need to submit a new W-4 form. But if an employee claims tax-exempt status, they are required by the IRS to submit a new W-4 form by February 15 each year. They may still claim tax exemption on the new W-4 form or request withholding if their financial situation has changed.
If employees fail to submit a new W-4 form, employers are required to start withholding. The withholding amount should be calculated as if the employee is single and has no deductions.
Who Is Exempt from Federal Income Taxes?
Exemption from federal income taxes is usually claimed by a few types of individuals.
- Low-income individuals
- Individuals with a large number of deductions
- Heads of household with many dependents
- Individuals who are claimed as dependents, such as students
- Foreign citizens
To qualify, individuals mustn’t have paid federal income taxes during the prior year and aren’t expecting to owe any tax during the current year.
It’s up to individuals—not their employers—to determine whether they are tax-exempt. However, it’s helpful for HR managers to know how tax exemption works since employees may ask questions about how to correctly fill out form W-4.
Tax Exemptions for Businesses
Businesses can also be exempted from federal income taxes under certain circumstances. Most 501(c)(3) nonprofits, such as charities and religious organizations, qualify for tax-exempt status. Labor organizations, agricultural organizations, veteran’s organizations, and 501(c)(4) social welfare organizations can also qualify.
To claim tax exemption, organizations must apply with the IRS.
Corporations and other for-profit businesses may qualify for state and local tax exemptions. For example, a state may offer a state income tax exemption for businesses that relocate to a certain city. This type of exemption may apply only to a portion of a business’s income and does not impact its federal tax obligations.
If an individual didn’t pay income taxes last year and doesn’t expect to owe any taxes this year, they can claim an exemption from federal income tax.
If an employee submits a W-4 form claiming tax exemption, employers don’t need to withhold federal income taxes from their paycheck. However, employers must still withhold state income taxes and federal Medicare and Social Security taxes.
Businesses can also be tax-exempt. Federal income tax exemption for businesses is usually limited to nonprofits. For-profit businesses may receive state or local income tax exemptions under certain circumstances.