What is Backup Withholding Tax?

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Backup Withholding - An Overview

Updated on December 11, 2024 - 10:30 AM by Admin, TaxBandits

When you request Form W-9 from your payee to gather the necessary information for filing an information return with the IRS, there are times when things might not go as planned. If your payee fails to provide the requested information, gives you an incorrect Taxpayer Identification Number (TIN), or indicates that they are subject to backup withholding, it can create confusion about your next steps. Here is where backup withholding comes into play, and you need to understand your responsibilities to avoid complications down the line.

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?

Key Takeaways About Backup Withholding

Backup withholding is a federal tax withholding requirement when your payee receives payments reported on forms such as 1099 or W-2G.
Backup withholding at a rate of 24% may apply to payees who provide an incorrect taxpayer identification number or fail to report certain types of income.
Payments that may be subject to backup withholding include interest income, dividends, certain government payments, rents, royalties, nonemployee compensation, and specific gambling winnings.
Some payments are not subject to backup withholding, including real estate transactions, canceled debts, retirement distributions, and certain types of insurance benefits.

1. What is backup withholding?

As a business or bank, there are times when you may be required to withhold a 24% tax from certain payments made to your payees. This process, known as Backup Withholding (BWH), ensures that the IRS receives the appropriate taxes on income, mainly when there's a risk of underreporting or missing information. Understanding when and why you must apply backup withholding is essential for keeping your records accurate and avoiding penalties.

2. 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 requires this withholding to ensure proper tax collection when the payee's identification details
are inaccurate.
BWH-C Program: Underreporting of Interest or Dividend Income
You may also need to withhold if your payee has either:
- Failed to report or underreported interest or dividend income on their federal income tax return or
- Failed to certify that they are not subject to backup withholding for underreporting interest and dividends.
The IRS can notify you when a payee is subject to backup withholding due to these reasons, and you'll be responsible for ensuring that 24% is withheld from any payments made to them.

3. Why is backup withholding necessary?

Backup withholding is pivotal in the IRS's efforts to prevent tax fraud. Ensuring that taxes are correctly collected and paid on schedule acts as a safeguard, making sure that your payees fulfill their obligations reasonably. Tax evasion could lead to significant revenue losses without this measure, potentially threatening vital public services.

4. What payments are subject to backup withholding?

Backup withholding can apply to different kinds of income typically reported on Form 1099 or W-2G. These include:

Interest income (reported on Form 1099-INT)
Certain government payments (reported on Form 1099-G)
Dividend distributions (reported on Form 1099-DIV)
Patronage dividends, provided at least 50% of the payment is in cash (reported on Form 1099-PATR)
Rents, royalties, profits, other income, payments made to attorneys, payments from fishing boat operators, and other miscellaneous payments (reported on Form 1099-MISC)
Commissions, fees, or payments for services performed as an independent contractor (reported on
Form 1099-NEC)
Brokerage and barter exchange payments (reported on Form 1099-B)
Transactions made through payment cards or third-party networks (reported on Form 1099-K)
Original issue discount payments, limited to the cash amount paid (reported on Form 1099-OID)
Gambling winnings that aren't subject to standard gambling withholding (reported on Form W-2G)

5. What payments are excluded from backup withholding?

Certain payments are not subject to backup withholding, as they fall outside the IRS's tax withholding requirements. These exclusions help to ensure that specific types of payments are treated differently under tax regulations, such as:

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

These exclusions provide a clear roadmap, helping you understand which payments are not subject to the backup withholding rules.

6. How does your payee become subject to backup withholding?

To determine if your payee is subject to backup withholding, consider the following situations:

Failure to provide a TIN: Did not provide the TIN in the required manner when requested.
Incorrect TIN notification: Did not notify you that the TIN they provided is incorrect or that the TIN on the information return does not match the IRS records.
Underreporting of interest and dividend income: Failed to fully report all interest and dividend income on their
tax return.

Note: As a payer, you will receive a CP2100 or CP2100A Notice if the payee's TIN is missing or incorrect or if their name and TIN on the information return filed do not match the IRS’s records. This notice informs you that you may be responsible for initiating backup withholding if you have not done so already.

When you make a reportable payment to a payee who has either not provided their TIN or has provided an incorrect TIN, you are required to withhold backup withholding on that payment. If you failed to withhold backup withholding on the payment when you should've, you must start backup withholding immediately.

7. How to stop backup withholding that has already been started?

To stop backup withholding that has already been started, your payee must take specific actions to resolve the issues that led to this situation. These actions can include the following:

Providing the correct TIN: If your payee uses an incorrect TIN, they must provide Form W-9 with the correct TIN information. It’s crucial to ensure that the TIN matches the name on the tax return to avoid further withholding.
Resolving underreported income: If your payee is subject to backup withholding due to underreported income, amend the previously filed tax return to report the income accurately.
Filing missing tax returns: If your payee has not filed the required tax returns, they must promptly file them and report the correct income.

Once these corrections have been made, the payee can inform you to update their records and potentially stop the backup withholding process. You should keep copies of all documentation for their records and respond promptly to any IRS correspondence regarding this matter.

Note: If you are a payee, you can directly complete and share your W9s with your payers and avoid backup withholding. Click here to learn more information about Fillable W-9.

8. What happens when the IRS backup withholding tax is overpaid?

When you overpay backup withholding tax as a payer, the excess can be refunded to the payee, just like other federal income tax overpayments. Here's how the process works:

Reporting backup withholding on Form 1099
- As the payer, when you withhold backup withholding tax from your payee's income, you'll report the amount withheld on an information return, such as Form 1099 (e.g., Form 1099-INT for interest income or Form
  1099-MISC for miscellaneous income).
- This form provides the IRS and the payee with the total income paid and the federal income tax withheld during the year.
Ensuring accurate filing on the payee's Tax Return
- At the end of the tax year, your payee must file a federal income tax return, reporting all sources of income and any taxes withheld, including the backup withholding you reported on Form 1099.
- The amount you withheld and reported will be included as part of the total federal tax withheld for the year.
Checking for overpayment
- During the tax return review process, the IRS determines whether the payee's total tax liability has been covered by the amounts withheld throughout the year, including the backup withholding you handled.
- If the total tax withheld exceeds the payee's tax liability, the IRS considers it an overpayment.
Issuing a refund for overpayment
- When an overpayment is identified, your payee becomes eligible for a refund. The IRS will issue the refund, which includes any backup withholding that was more than what they owed in federal taxes.

By accurately managing backup withholding and reporting it correctly on Form 1099, you help ensure that any overpayments can be refunded to the payee without complications. The withheld amount serves as a credit toward their total tax obligation, and if more than necessary was withheld, the excess will be returned as a refund.