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"Don’t Get Caught Paying Your Employees’ Taxes"
Wily employees claim 25 exemptions on their W4 forms and the IRS holds business owner liable for paying over $100,000 dollars of his employees’ income taxes. Can this be possible?

Prior to starting to work, every employee is required to complete a withholding exemption certificate - Form W-4 - stating how many exemptions he or she is claiming for purposes of income tax withholding. Of course, the more exemptions claimed, the less income tax withheld from the paycheck. Normally, the number of exemptions the employee claims is his concern. However, if an employee claims more than ten exemptions then it becomes the employer’s problem. Many business owners have no idea this shift in responsibility can occur, and withholding tax exemptions have become a frequent source of trouble for business owners.

Here is a prime example of how bizarre and devastating this problem can become.

Recently, a construction materials supply company unknowingly employed a group of tax protestors. The problem all started when just one employee mentioned over lunch that he had surfed onto a very interesting Web site. The fraudulent information on the Web site included such myths as "an income tax on wages is unconstitutional." Upon further investigation, he explained, the site offered a practical solution. The way to prevent wages from being unconstitutionally taxed, was to claim twenty-five exemptions (the maximum allowed by law) on your Form W-4 so there would be virtually no withholding of income tax.

Within a few weeks the word was out. One could increase their take-home pay by 25 percent by claiming twenty-five exemptions on their Form W-4. Twelve employees took advantage of this remarkable tax loophole by slowly submitting new W4s to the accounting clerk. The business owner was totally unaware of the consequences about to befall him.

The IRS became aware of the situation about sixteen months later, when the participating employees started filing their tax returns. Then, since the employer had not obtained IRS approval for W-4 forms claiming more than ten exemptions, it received an IRS bill for more than $100,000 dollars! This was the total amount of the income taxes that were not withheld, plus interest.

If one does not submit the Form W-4 to the IRS and it later turns out that excessive underwithholding occurred, then the employer is liable for the difference between what was actually withheld and the income taxes of employee that should have been withheld from his paycheck, based on the correct number of exemptions. Yes, unfortunately the company owner, not the employee, must pay the employee’s income taxes. (This liability is not personal if you run your business through a corporation.)

Why this magic number of 10 exemptions, and a system of approval, and shift in responsibility? Well, the IRS fears that an employee who claims that many exemptions is intentionally causing his income taxes to be underwithheld, and the agency wants to verify that the taxpayer is entitled to such a small withholding.

Can the business owner recover from his employees the taxes he had to pay on their behalf? Perhaps by deducting the taxes from future paychecks? After all, he did pay their taxes for them. The answer is NO. The tax laws prohibit anyone from attempting to recover from their employees the taxes that they were required to pay on their behalf. An employer is obligated to make sure that their employees don’t significantly underwithhold. If one fails to do so, then unfortunately the responsible party is stuck with the bill. For the proper methods of avoiding this devastating situation, contact us or your tax professional.