Definition, Rules, and Requirements for Backup Withholding
Backup withholding can be avoided and possibly recovered at tax time
Backup withholding is a type of federal tax withholding on certain types of income, and it's mandatory in certain circumstances. Federal income tax can be withheld from an individual's pay at a flat rate of 24% on the following types of income:
- Patronage dividends
- Gambling winnings
- Commissions and fees paid to independent contractors
- Payments from brokers on stock and bond transactions
- Payments from fishing boat operators
Payments that are not subject to mandatory withholding include cancelled debts, real estate transactions, retirement account distributions, and unemployment compensation.
The backup withholding rate was 28% before the Tax Cuts and Jobs Act went into effect in 2018. It dropped by 4% effective Jan. 1, 2018.
When the IRS Requires Backup Withholding
The IRS requires businesses and financial institutions to withhold a flat 24% of income as backup withholding when taxpayers:
- Fail to provide an accurate taxpayer identification number (TIN) to the payer. This is often a Social Security number. Backup withholding will be required when the IRS notifies the payer that the number isn't correct.
- Have underreported interest or dividends on their income tax returns. The tax is withheld from future interest and dividends.
- Fail to certify that they're not subject to backup withholding due to underreported interest or dividends.
Most taxpayers are exempt from backup withholding.
These rules apply to two separate backup withholding programs: BWH-B, which applies to taxpayer identifying information, and BWH-C, which applies to underreported interest or dividends.
Who's Exempt from Backup Withholding
It follows then that U.S. citizens and resident aliens are exempt from backup withholding if they properly report their names and Social Security numbers or TINs to the payer using Form W-9, and if that information matches IRS records.
They're also exempt if they've been notified by the IRS that they're not subject to mandatory backup withholding for some reason.
Withholding Due to Incorrect Information
Backup withholding due to an incorrect name or TIN on Form W-9 can be prevented or stopped by supplying the payer of income with your correct information on Form W-9 as immediately as possible.
The IRS will send a notice—called a "B" notice—to the payer of income alerting them that the TIN or the SSN they're using doesn't coincide with IRS records. The payer of income should send a copy of the "B" notice to the recipient of the income.
The payer is prohibited from simply calling the taxpayer and requesting the correct information by phone. The payer might also request verification of the correct information, such as a Social Security card.
Supplying the correct information to the payer can stop backup withholding once if it's already begun, but you must additionally certify that the TIN you give is correct.
Perhaps the easiest way to avoid this dilemma is to check and recheck all tax documents before you submit them, both tax returns and supporting documents to the IRS and reporting documents such as W-4s and W-9s submitted to employers and other payers.
If You Receive a Second Notice
You'll have to reach out to the Social Security Administration (SSA) if your information still doesn't line up after you've submitted it a second time. The SSA can provide verification of your TIN either to you or directly to the IRS.
Withholding Due to Unreported Interest or Dividends
The IRS will require backup withholding on interest income and dividends if a taxpayer previously underreported the amount of interest income or dividend income they've earned on their tax return.
In such cases, the IRS will notify the taxpayer by mailing four notices over 120 days to alert the taxpayer to future backup withholding. You can ask the IRS not to resort to backup withholding or to stop it after it's begun, but you must establish that one of five acceptable circumstances exists:
- You did not underreport interest or dividends earned.
- You've reached out to the IRS about whether an underreporting actually occurred but the matter has not been resolved yet.
- Backup withholding will create an undue hardship for you.
- You're unlikely to underreport interest and dividends in the future—in other words, it was an honest error.
- You've filed an original return reporting the income if you didn't previously file one, or you've filed an amended return, this time reporting all interest and dividends and paying all taxes associated with that income as well as any penalties or interest due.
The IRS will provide you with certification and will notify any payers who were sent notices if it determines that backup withholding isn't required or that it should stop if it's already begun.
You must also certify that you're not subject to backup withholding.
You Can Recover Backup Withholding
Backup withholding is a precaution, as the name suggests. It's not so much a penalty as it is a way in which the IRS can ensure that you ultimately pay all taxes that are due.
Any federal income tax withheld from your income due to backup withholding will be reported to you and to the IRS on the appropriate Form 1099, such as 1099-INT for interest income, or on a Form W-2 when income from employment is subject to backup withholding. You can then report the amount as taxes withheld when you file your tax return. You'll receive a refund if you've ended up paying in more than what you actually owe at year's end.
Partnerships and S corporations cannot claim a refund for overpaid backup withholding. The refunds must be claimed by the partners or shareholders in this case.
IRS. "Backup Withholding." Accessed Jan. 22, 2020.
IRS. "Topic No. 307 Backup Withholding." Accessed Jan. 22, 2020.
IRS. "Backup Withholding for Missing and Incorrect Names/TINs," Page 13. Accessed Jan. 22, 2020.
IRS. "Publication 505 (2019), Tax Withholding and Estimated Tax." Accessed Jan. 22, 2020.