Definition and Example of Backup Withholding
Backup withholding is a method the IRS uses when taxpayers who earn certain self-employment, gambling, or interest income haven't properly reported it in the past. Backup withholding applies mostly to certain types of 1099 income, including:
- 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 aren't subject to mandatory withholding include 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. It dropped by 4% effective January 1, 2018. It remains at 24% for future tax years through at least 2025, when the TCJA potentially expires.
How Does Backup Withholding Work?
Businesses and financial institutions withhold a flat 24% of income as backup withholding for those taxpayers who are subject to the rule. It might apply to you if:
- You failed to provide an accurate taxpayer identification number (TIN) to the payer. This is often a Social Security number.
- The IRS notifies the payer that the TIN you provided isn't correct.
- You under-reported interest or dividends on income tax returns in the past. You'll receive four warnings from the IRS before this applies to you.
- You fail to certify that you aren't subject to backup withholding due to under-reported interest or dividends.
The process for initiating backup withholding will depend on why the IRS is requiring that it be withheld.
Withholding Due to Incorrect Information
Backup withholding due to submitting an incorrect name or TIN on Form W-9 can be prevented or stopped by supplying your payer with corrected information on Form W-9 as soon as possible.
The IRS will send a notice, called a "B" notice, to the payer of income if it can't match the name and TIN information you provided on your W-9. The notice alerts them that the TIN or the SSN they're using doesn't coincide with IRS records. The payer should send a copy of the "B" notice to you before it begins backup withholding.
The payer is prohibited from calling you and requesting the correct information by phone. But they can request verification or proof of the correct information, such as a Social Security card or tax return bearing your name and number.
Supplying the correct information to the payer can stop backup withholding if it's already begun. Better yet, prevent any backup withholding before it happens by doublechecking all your tax documents before you submit them to anyone who will be paying you this type of income.
Withholding Due to Unreported Interest or Dividends
The IRS will notify you by mailing four notices over a period of 210 days to alert you of future backup withholding if you've failed to report or under-reported interest or dividends. 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 four acceptable circumstances exists:
- You did not under-report interest or dividends earned.
- You reached out to the IRS about whether an under-reporting actually occurred, but the matter has not been resolved yet.
- Backup withholding will create an undue hardship for you. It's unlikely that you will under-report interest and dividends in the future. It was an honest error. You need the money that would be withheld from you.
- You either filed an amended return that properly reports all interest and dividends (as well as paying taxes, penalties, and interests due), or you filed an original return reporting the income if you didn't previously file one.
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.
- Backup withholding is a tool used by the IRS to ensure that taxes on certain types of income are paid.
- You can be subject to backup withholding if the Social Security or taxpayer ID number that's listed as a payee doesn't match what the IRS has on file for you.
- You might also be subject to backup withholding if you underreported or failed to report interest or dividend income on a prior year's tax return.
- This type of withholding most often affects certain types of income, such as gambling winnings, royalties, and investment transactions.
- Retirement benefits and unemployment compensation are safe from backup withholding.
Frequently Asked Questions (FAQs)
Are there any penalties?
Backup withholding isn't so much a penalty as it is a way in which the IRS can ensure that you 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. You can then report the amount as taxes paid withheld when you file your tax return.
Do I need to pay backup withholding?
Most taxpayers are exempt from backup withholding. U.S. citizens and resident aliens are exempt as long as they properly report their names and Social Security numbers or TINs to the payer and 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.