ITG FAQ #2 Answer-Can an employee claim “exempt” on Form W-4? What are my responsibilities as an employer when an employee has claimed “exempt” ?
Generally, an employee may claim exemption from income tax withholding because he or she had no income tax liability last year and expects none this year. The Form W-4 Instructions state that you cannot claim exemption from withholding if (1) your income exceeds a certain dollar threshold and includes more than a certain dollar amount of unearned income (e.g., interest and dividends) and (2) another person can claim you as a dependent on their tax return. Please refer to the current year Form W-4 Instructions for these dollar amounts.
Whenever an employer receives an invalid Form W-4 and does not receive a corrected one upon request, the employer is to withhold taxes as if the employee were single and claiming no withholding allowances. However, if there was a valid W-4 on file previously, withholding may be based on that form.
The Publication 15, Circular E, Employer's Tax Guide, gives complete instructions as to how to handle Forms W-4.