Payroll in Practice: 1.17.2023

Question: An employee claimed exempt for 2022 on Form W-4. Does this mean the employer should not report any wages on the employee’s Form W-2?

Answer: No, an employee’s compensation must be reported on Form W-2 regardless of whether the employee claims an exemption on Form W-4. The classification “exempt” when applied to wage payments can have different meanings. When used on Form W-4, Employee’s Withholding Certificate, the term does not mean the wages are exempt from tax. The compensation is still reportable on Form W-2, Wage and Tax Statement, in Box 1 as income tax wages, Box 3 as Social Security wages, and Box 5 as Medicare wages, unless the compensation is otherwise exempt or excludable from gross income.

For Form W-4, “exempt” means the employee is claiming to be exempt from withholding on otherwise taxable compensation because the employee did not have an income tax liability during the previous calendar year and does not expect to have a tax liability for the current year. “Tax liability” should not be confused with “balance due.” Having no tax liability means that the tax amounts computed on the return are not greater than zero.

Using the exemption might save the employee from having to file a tax return, and the IRS from having to process it, for the sole reason of obtaining a refund of withheld tax. If the employee must file a tax return for other reasons, even if the employee does not expect to have a tax liability, the employee should not claim an exemption from withholding on Form W-4. This might happen if the employee is eligible for a refundable tax credit such as the Earned Income Credit. Rather than claiming an exemption from withholding, the employee should control the amount withheld by adjusting the tax credits (Step 3) or deductions (Step 4) on Form W-4 as appropriate.

There are other situations in which taxable compensation is exempt from income tax withholding. For example, the imputed premiums on excess employer provided group term life insurance is taxable income but is exempt from federal income tax withholding.

Other forms of compensation may be exempt from income tax. For example, qualified education expense reimbursements are excluded from gross income, by statute. Because the benefit is exempt from tax, it is also not subject to income tax withholding.

If the employee wishes to continue to claim exempt from withholding for 2023, the employee will have to submit a new Form W-4 to the employer by Feb.15, 2023. If the employee does not file a new W-4, the employer is to withhold tax on any payments made on or after Feb. 16. The instructions for the 2023 Form W-4 say that, to claim exemption, the employee is to complete Step 1a (name and address), Step 1b (Social Security number), write “Exempt” in the space below Step 4c, and complete Step 5 (signature) on the form.

An employee may claim exempt status any time during the calendar year. However, any withholding prior to filing the claim is not refundable by the employer. The employee must file a tax return to obtain a refund.

Question: An employer grants gift cards to employees as a holiday bonus. The cards are redeemable for merchandise from a catalog from an unrelated online store. The employer knows the cards are taxable income to the employees. Under constructive receipt, are the cards included in employee pay when the cards are given to the employees or when the employees use the cards?

Answer: Under the constructive-receipt rule, the gift cards are received and thus reportable whenever the cards become available to the employees, regardless of whether they take immediate possession of the cards.

This concept involves two separate issues. The first is whether the item given to the employee is taxable and the second is when the item becomes subject to tax. If the item is not taxable income, then the second issue does not apply.

For the second issue, the answer depends on the type of tax involved. For example, for income tax purposes, Treasury regulation 26 CFR 1.451-2 is primarily concerned with the tax year in which the item is to be reported as income.

However, for Social Security and Medicare reporting purposes, Section 1302 of the Social Security Handbook is a bit more specific as to when income is considered to be paid.

“Your wages are constructively paid when:

They have been credited or set aside for you, and you can get them at any time. It does not matter when or how you receive payment, just that you have access to your wages when you want them; or Your employer intends to pay, set apart, or credit the wages and is able to pay you when due, but fails to do so because of a clerical error or mistake in the mechanics of payment.”

Regarding the first issue, the value of the gift cards is taxable as wages, Also, the cards are considered a cash item rather than a noncash fringe benefit.

Regarding the second issue, the cards are income when the employees may take possession of them unless there are significant restrictions on when they may be redeemed. The employer need not know when or if the cards are used.

The cards are treated in the same manner as a paycheck. For example, a paycheck is issued to the employee, but the employee failed to cash the check. The employee had access to the funds and the income was reportable and subject to withholding when the check was issued. If the check is lost and replaced later, the new check is simply replacing the original check and the payroll records are not adjusted.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.