What Is An IRS Lock In Letter?

Uh oh…a “Love Letter” for the IRS!

The IRS uses information reported on Form W-2 to identify employees with potential withholding compliance problems. What this means is that if a taxpayer chronically claims too many withholding allowances, and generates significant tax balances when they file their return, the IRS may “flag” them. In some cases, if a serious under withholding problem is found to exist for a particular employee, the IRS may issue a lock-in letter to the employer.

How employees get in trouble.  While rare, some employees may actually qualify to be “exempt” from having federal income tax withheld from their checks. Unfortunately, most people who indicate to their employer that they are exempt from withholding, usually do so based upon the poor advice of fellow employees, friends or family members.

Form W-4, Employee’s Withholding Allowance Certificate, is used to indicate to your employer how much federal income tax you would like withheld from your paychecks. The greater the number on the W-4, the smaller the amount of taxes they will withhold. If you claim to be exempt, then no federal income taxes are taken out.

Steps the IRS will take. If the IRS does not think an employee should be exempt (or is withholding too little) they may send them a 2802C Letter. This is basically a “warning” letter to tell you that you need to self-correct the matter before the IRS acts. One way to do this is to use the IRS Withholding Calculator to ensure you are claiming the correct number of allowances.

If you don’t make changes, then the IRS will send you (and your employer) a 2801C Letter. This letter basically states that the IRS has determined that you’re not entitled to claim exempt status. You will be given a telephone number to call the IRS within 60 days for a modification. After that date, your employer must withhold income tax from your wages at a single rate with zero allowances. Once a lock-in rate is effective, an employer can not decrease withholding unless approved by the IRS.

Can a lock in letter decision be reversed? The short answer is yes. Here are the steps that one would take:

  • Call the IRS at 855-839-2235 within 30 days from the date of the letter.
  • When you call, have the following information available:
    • Form W-4 and worksheets. (You must complete the “Two Earners Multiple Jobs Worksheet” on the back of the Form W-4, if you have more than one job or your spouse works.)
    • Most current pay stubs for all jobs.
    • Number of withholding allowances you (and your spouse) are claiming on your Form(s) W-4.
    • The social security number and date of birth for any dependent you are entitled to claim.
    • A copy of the current tax return due, including all schedules, forms, and attachments.

The IRS will then consider your explanation of why you believe you are entitled to a different withholding rate or number of withholding allowances (or exempt status). If they agree with the information provided, then the lock in letter will be reversed.

Are you receiving letters from the IRS? If so, just know that help is available. Feel free to give us a call and we can discuss your situation. Whether it is adjusting your withholding, filing those unfiled tax returns or dealing with an outstanding tax debt, we can help you address the matter and put it behind you!

How Does Form W4 Work?

After tax season, many people find themselves in the position where their tax preparer/accountant recommends that they change their withholdings.  This typically happens when a person has prepared their return and either has a large refund or balance due.  The rule of thumb most will use is that if either of the above is roughly 3% or more of your gross annual salary, you may need to make some changes.

How Form W4 Works
Form W4 is used to tell your payroll department how much you would like taken out of your pay for Federal Income Taxes. You will also have to fill out this form in you live in one of the 41 states that impose an income tax.  The simple way to think of this form is that every number listed on the form (called an allowance) is supposed to represent a member of your household.  So the greater the number of allowances on the W4, the smaller the amount of taxes withheld becomes.   The smaller the number is on the W4, the greater the amount of taxes taken out becomes.

What Are Allowances?
As mentioned above, a withholding allowance is generally meant to represent each member of your family that will be claimed on your tax return. Just you by yourself?  Claim 1 allowance. Are you married? Maybe you will claim 2, one for each spouse. Have 3 children? Then it could be 5, one for each spouse and 1 for each child.

Should I File Exempt From Withholding?
Generally speaking, there are very few individuals who should EVER claim that they are exempt from withholding. This is honestly one of the fastest was we see people get into trouble with the IRS and create mountains of tax debt.

The only people who should claim this status are 1) those who do not have a filing requirement and 2) those who were entitled to a full refund of ALL amounts withheld in the previous year. To learn more, take a look at Publication 505 and look at the section on  “Exemption From Withholding” and “Figure 1-A.”

What If I Am A Teenager?
If you are a student, you are not automatically exempt from having to pay taxes. If you work only part time or during the summer, you may qualify for exemption from withholding. Thus, if your total income was say $2,500 (which is less than your standard deduction) and you had $375 of income taxes withheld, it would be refunded to you. But if you earned say $8,500, you would have a filing requirement and want to have taxes taken out. At a minimum, you would probably claim 1 withholding allowance just to be safe.

How This All Comes Together At Pay Time and Tax Time
Every week that you are to be paid, your employer’s payroll department will use the number listed on your Form W4 to determine how much to take out. They do this via one of two methods listed in Publication 15, Employer’s Tax Guide.  If you go to the “How To Use the Income Tax Withholding Tables” you can see that the employer will take your withholding, look up the appropriate amount to take out based on your filing status, and then cut you a check for the rest.  Once again, the greater the number, the smaller the amount of taxes they will withhold.

Fast forward to income tax return time.  If you made $15,000 during the year and you were just fling for yourself, you would probably claim 1 exemption and the standard deduction.  For tax year 2014, the two amounts combined amounted to $10,150 with the exemption being $3,950.  Thus, you would have been taxed on $4,850.  But what if it was you and your two children?  Then your exemptions would have been $11,850.  Add this to your standard deduction (assuming the filing status is now head of household) and you would have been taxed on $0 ($15,000 income – $21,000 standard deduction and 3 exemptions).

As you can see, under the second scenario you would not have had a filing requirement.  Thus, if you only had 1 allowance on the W2, you would have had too much income tax taken out and it would have come back to you in the form of a refund.  This is why you would have possibly wanted to claim 3 allowances on the W4; so they would have taken less tax out based on the anticipated outcome on your income tax return.

Need Help?
If you need some assistance determining if you are having the correct amount of income taxes withheld, give us a call at the number in the upper right or shoot us an email via the link below.

You can also use the IRS Withholding Calculator to help you determine the correct number of allowances to claim.