When you receive certain types of income, the Internal Revenue Service (IRS) mandates that the payer reports these payments to them via an information return. Typically, the payer does not withhold taxes from these payments upfront, operating under the assumption that you, as the taxpayer, will accurately report this income and pay the necessary taxes when you file your annual federal income tax return.
However, there are instances where the payer is legally obligated to withhold taxes from these payments at a flat rate of 24 percent. This is known as backup withholding. This measure ensures that the IRS receives the tax owed on this income by deducting 24% from any future payments made to you.
Backup withholding (BWH) may be necessary under the following circumstances:
Payments Subject to Backup Withholding
Backup withholding can be applied to a wide array of payments that are usually reported on Form 1099 and Form W-2G. These include, but are not limited to:
- Attorney’s Fees and Gross Proceeds: This includes fees paid to attorneys (reported on Form 1099-NEC) and gross proceeds, such as settlements, paid to an attorney (reported on Form 1099-MISC).
- Interest Payments: Interest income reported on Form 1099-INT.
- Dividends: Dividend payments reported on Form 1099-DIV.
- Payment Card and Third-Party Network Transactions: Transactions processed through payment cards or third-party networks, as reported on Form 1099-K.
- Patronage Dividends: These are dividends from cooperative organizations, but backup withholding applies only if at least half of the payment is in cash and reported on Form 1099-PATR.
- Rents, Profits, or Other Gains: Income from rents, profits, or other gains reported on Form 1099-MISC.
- Independent Contractor Income: Commissions, fees, or other payments for work performed as an independent contractor, reported on Form 1099-NEC.
- Broker and Barter Exchange Payments: Payments from brokers or barter exchanges, reported on Form 1099-B.
- Fishing Boat Operator Payments: Payments to fishing boat operators, but only the portion that is in money and represents a share of the proceeds from the catch, reported on Form 1099-MISC.
- Royalty Payments: Payments for royalties, reported on Form 1099-MISC.
- Gambling Winnings: Gambling winnings, reported on Form W-2G, may also be subject to backup withholding under certain conditions.
- Original Issue Discount: Original issue discount reportable on Form 1099-OID, but only if the payment is made in cash.
- Certain Government Payments: Specific government payments as reported on Form 1099-G.
Rules for Receiving Payments Reported on Form 1099
When you establish a new account, make an investment, or begin receiving payments that will be reported on Form 1099, you are required to provide your Taxpayer Identification Number (TIN) in writing to the financial institution or business. Furthermore, you must certify, under penalty of perjury, that your TIN is correct. Often, the bank or business will provide you with Form W-9, Request for Taxpayer Identification Number and Certification, or a similar form for this purpose.
If your account or investment is expected to generate interest or dividends, you must also certify that you are not subject to backup withholding due to past underreporting of interest and dividends. This certification is part of ensuring compliance with IRS regulations and avoiding backup withholding.
How to Prevent or Stop Backup Withholding
To avoid or stop backup withholding, it’s crucial to rectify the issue that triggered it. This typically involves:
- Providing the Correct TIN: Ensure the payer has your accurate Taxpayer Identification Number (TIN). This is often a Social Security number (SSN) for individuals or an Employer Identification Number (EIN) for businesses.
- Resolving Underreported Income: If backup withholding started because of underreported income from previous years, you need to resolve this with the IRS. This might involve filing any missing returns and paying any outstanding tax liabilities, including interest and penalties.
- Certifying Non-Exempt Status: Properly complete and submit Form W-9 to certify that you are not subject to backup withholding (if this is indeed the case and the reason for withholding is not due to IRS notification).
By addressing the underlying cause, you can prevent backup withholding from starting or stop it from continuing.
Credit for Backup Withholding
If you have experienced backup withholding, the amount withheld is not lost. It is essentially an advance payment of your federal income tax. You should report the federal income tax withheld (as indicated on Form 1099 or Form W-2G) on your federal income tax return for the year in which you received the income. This withheld amount will be credited against your total income tax liability when you file your return.
Payments Excluded from Backup Withholding
Certain types of payments are specifically excluded from backup withholding. These include:
- Real estate transactions
- Foreclosures and abandonments
- Cancelled debts
- Distributions from Archer MSAs (Medical Savings Accounts)
- Long-term care benefits
- Distributions from any retirement account
- Distributions from an employee stock ownership plan (ESOP)
- Fish purchases for cash
- Unemployment compensation
- State or local income tax refunds
- Qualified tuition program earnings
Understanding backup withholding is important for taxpayers receiving income reported on Forms 1099 and W-2G. By ensuring your information is correct with payers and addressing any potential underreporting issues, you can avoid or resolve backup withholding and ensure smooth tax compliance.
