Backup withholding might seem unfamiliar, but many payers may encounter it when paying vendors or contractors. If a payee provides an incorrect TIN or is flagged by the IRS, a mandatory 24% tax must be withheld and sent to the IRS. This can create uncertainty about your obligations. Read ahead to understand backup withholding and how to
handle it properly.
Key Takeaways:
- Backup withholding is a federal tax requirement that applies to payments reported on forms like 1099 or W-2G.
- A 24% withholding rate may be enforced if a payee provides an incorrect Taxpayer Identification Number (TIN) or fails to report specific types of income.
- Payments subject to backup withholding include interest income, dividends, certain government payments, rents, royalties, nonemployee compensation, and certain gambling winnings.
- However, some exempt payments include real estate transactions, canceled debts, retirement distributions, and certain insurance benefits.
Table of Contents:
- What is backup withholding?
- When is backup withholding required?
- Why is backup withholding necessary?
- What payments are subject to backup withholding?
- What payments are excluded from backup withholding?
- How does your payee become subject to backup withholding?
- How to stop backup withholding that has already been started?
- What happens when the IRS Backup withholding tax is overpaid?
What is Backup Withholding?
As a business or bank, you may be required to withhold a 24% tax from certain payments made to your payees. This process, known as Backup Withholding (BWH), ensures the IRS receives the appropriate taxes on income, especially when there’s a risk of underreporting or missing information. Understanding when and why you must apply backup withholding is essential for maintaining accurate records and avoiding penalties.
When is Backup Withholding Required?
Backup withholding may be necessary in the following situations:
-
BWH-B Program: Incorrect TIN Provided
If your payee fails to provide a correct taxpayer identification number (TIN), which is usually requested using
Form W-9, to report on the required information return, you must withhold 24% of future payments to them. A TIN can be one of the following:- Social Security Number (SSN)
- Employer Identification Number (EIN)
- Individual Taxpayer Identification Number (ITIN)
The IRS mandates this withholding to ensure proper tax collection when the payee's details are inaccurate.
-
BWH-C Program: Underreporting of Interest or Dividend Income
Backup withholding is also required if your payee has:
- Failed to report or underreported interest or dividend income on their federal tax return
- Failed to certify that they are not subject to backup withholding for underreporting interest or dividends
If the IRS notifies you that a payee is subject to backup withholding, you must withhold 24% from any payments made to them.
Why is Backup Withholding Necessary?
Backup withholding is crucial in the IRS’s efforts to prevent tax fraud. It ensures taxes are correctly collected and paid, safeguarding the system from tax evasion, which could lead to significant revenue losses and threaten vital public services.
What Payments Are Subject to Backup Withholding?
Backup withholding applies to various types of income reported on Forms 1099 or W-2G, including:
- Interest income (reported on Form 1099-INT)
- Certain government payments (reported on Form 1099-G)
- Dividend distributions (reported on Form 1099-DIV)
- Patronage dividends (reported on Form 1099-PATR)
- Rents, royalties, and other income (reported on Form 1099-MISC)
- Nonemployee compensation (reported on Form 1099-NEC)
- Brokerage and barter exchange payments (reported on Form 1099-B)
- Payments through payment cards or third-party networks (reported on Form 1099-K)
- Gambling winnings (reported on Form W-2G)
What Payments Are Excluded from Backup Withholding?
Certain payments are not subject to backup withholding, including:
- Real estate transactions
- Foreclosures and abandonments
- Canceled debts
- Distributions from Archer Medical Savings Accounts (MSAs)
- Long-term care benefits
- Retirement account distributions
- Employee stock ownership plan distributions
- Cash purchases of fish
- Unemployment compensation
- State or local tax refunds
- Qualified tuition program earnings
How Does Your Payee Become Subject to Backup Withholding?
A payee may become subject to backup withholding if:
- They failed to provide a TIN when requested
- The TIN provided is incorrect or does not match IRS records
- They underreport interest or dividend income
As a payer, you will receive a CP2100 or CP2100A Notice from the IRS if the payee’s TIN is incorrect or missing, or if their TIN doesn’t match IRS records. This notice will inform you that you are responsible for initiating backup withholding.
How to Stop Backup Withholding Once It Has Started?
To stop backup withholding, the payee must resolve the issues that triggered it. Actions include:
- Providing the correct TIN via Form W-9
- Correcting underreported income by amending their tax return
- Filing any missing tax returns
Once these corrections are made, the payee can inform you to update their records, and you may stop the withholding process.
What Happens When the IRS Backup Withholding Tax is Overpaid?
If the backup withholding tax is overpaid, the excess can be refunded to the payee. Here’s how the process works:
- Reporting Backup Withholding: The payer reports the withheld amount on Form 1099, which shows both the total income paid and the federal tax withheld.
- Filing the Payee's Tax Return: The payer reports the withheld amount on Form 1099, which shows both the total income paid and the federal tax withheld.
- Refunding Overpayment: The payer reports the withheld amount on Form 1099, which shows both the total income paid and the federal tax withheld.
Accurate reporting and timely action ensure that any overpayment is refunded to the payee without complications.