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When should an employee be marked as exempt from a tax?

It is almost never correct to remove a federal or state tax from an employee's record.

Many employers make the mistake of removing a tax from the employee record when they should not. Doing this incorrectly causes significant "downstream" problems that affect reports, tax forms, tax calculations, and liabilities due.

Critical things to know about employee payroll taxes

There are two kinds of taxes: company-paid and employee-paid.

  • Every tax that is calculated and tracked in QuickBooks is set up on the employee record and is added to employee paychecks, even when it is not included in the employees' gross-to-net-pay calculation.

  • All company-paid taxes are added to paychecks, but they don't impact net pay and are not printed on pay stubs. They do, however, appear in payroll reports.

  • Taxes that are set up on an employee's record are calculated on the employee's paychecks. These taxes are added to the balance to pay for both company and employee-paid taxes. If the tax is not set up on the employee record, it is not added to the paycheck. Even if you add it to the employee record later, it is not added on paychecks that have already been created.

    How can I correct the numbers if I've done this?

    If you have made this mistake and need to correct it, run Payroll Checkup to fix the "wage base" for this tax, and on the next payroll many straight-line percentage taxes (Medicare, SS, FUTA, SUI and SDI, but not FWH and SWH) will "catch up."
  • If you remove a tax from an employee, that employee will almost always be fully or partially excluded from any applicable tax forms including the 941, 940, and your state tax forms (if you use the Enhanced Payroll service).

Common reasons why employers mistakenly remove a tax from an employee's record:

  • The tax is company-paid: QuickBooks knows which taxes are company-paid and which are employee-paid. All are added to the employee record based on "state lived" and "state worked," but only those that the employee pays are deducted from gross pay.

  • The tax rate is 0%: Some employers confuse the case where the tax rate is 0% with being "not subject to" the tax. Typically, you are subject to a tax even when your rate is 0%, and you must report wages for the tax. If this is the case, you should include the tax on the employee's record, and set the rate to 0% on the Payroll Item list.

  • The employee claims "exempt" status: Typically this means that the employee is claiming that they will not owe federal or state withholding at year end due to hardship, high deductions, or low income status. This does not mean they are not subject to the tax. "Subject to" and "exempt from" are two different but confusing concepts. For example, if you live or work in the US, you are usually subject to federal tax. However, you may claim to be exempt from withholding. In this case, you should select "Do Not Withhold" as the withholding status.

  • My state doesn't collect this tax: In QuickBooks, all employees who live or work in the US should have a "state lived" and "state worked" selected, even when the state doesn't collect that particular tax. For Enhanced Payroll service customers, this means that employees are identified with a state and are included on the state forms. Employee mailing addresses are not used to determine an employee's locality.

  • The employee paid the tax while working for a previous employer this year: In this case you are almost always required to withhold the tax again and the employee must file for a refund at the end of the year. You would also have to withhold tax even if the employee met the SDI and SUI limits while working for a previous employer.

  • I don't think I owe this tax: For federal and state taxes, this is unlikely. Almost all employers owe the taxes QuickBooks suggests. Exceptions are noted in the next section.

  • The company has agreed to pay a tax that is usually paid by the employee: This is a rare case. Even if it's correct, it's not supported by QuickBooks and your tax forms will be incorrect.

When is it correct to omit a federal or state tax or a state selection on an employee's record?

  • The employee lives or works outside of the US: It's possible that the employee is subject to withholding in their home state, but since they work in another country the SUI and/or SDI taxes are not due on that employee. Check with your state agencies to be sure.

  • The employee has a special status: For example, they are not a U.S. citizen or are on a special visa. In this case, they are subject to some taxes and may be exempt from others. Read the rules carefully or get professional advice for this special situation.

  • The employee is working in a U.S. protectorate such as Guam: In this case, QuickBooks doesn't support any "state-level" taxes for the employee directly. Leave the "state worked" and "state lived" blank, but set up any applicable local taxes as custom taxes, whether employee- or company-paid. QuickBooks supports both types of custom taxes.

  • The employer has a special tax-exempt status: For example, a charity, church, or government organization may have a special status at the federal or state level. If you are sure you fall into this category, then deselecting some taxes may be appropriate.

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