What is backup withholding (short definition)
– Backup withholding is a mandatory tax withholding on certain types of investment and reportable payments when the payee has not provided correct taxpayer identification or the IRS has directed the payer to withhold. The payer (bank, broker, or other payor) sends the withheld amount to the tax authority instead of paying it in cash to the recipient.
Key points (quick summary)
– Purpose: to make sure taxes on interest, dividends, and other reportable payments are collected even if the payee might not report the income.
– Typical trigger: incorrect or missing Taxpayer Identification Number (TIN) or a notice from the IRS saying the payee underreported income.
– Rate: the current statutory rate for backup withholding is 24% of the reportable payment.
– Credit: amounts withheld are credited against the payee’s income tax liability for the year when they file their return.
Definitions (short)
– TIN (Taxpayer Identification Number): a number the tax authority uses to identify taxpayers (in the U.S., commonly a Social Security number or an Employer Identification Number).
– Form W-9: the U.S. IRS form used by U.S. persons to provide their correct TIN and certification to a payor.
– Form 1099 (family of forms): the series of forms payors use to report various types of non-wage income (e.g., interest, dividends, independent contractor payments). Form 1099-PATR reports patronage dividends.
How backup withholding works — step by step
1. Payor asks the payee for a TIN (usually via Form W-9 for U.S. persons).
2. If the payee fails to provide a correct TIN, or the IRS notifies the payor that the payee underreported interest/dividends, the payor must begin backup withholding.
3. The payor withholds 24% of reportable payments (interest, dividends, some contractor and royalty payments, certain patronage dividends, and other reportable items).
4. The payor remits the withheld amount to the tax authority and reports the payment and withholding on the appropriate 1099 form.
5. The taxpayer claims the withheld amount as a credit on their annual tax return; any excess withheld may be refunded after filing.
Payments commonly subject to backup withholding
– Interest and dividend payments.
– Patronage dividends reported on Form 1099-PATR.
– Rents, royalties, profits, commissions, fees, and other payments for independent contractor services (when reportable on Form 1099).
– Some gambling winnings if they were not already subject to standard withholding.
Note: retirement distributions and unemployment compensation are typically exempt from backup withholding.
Who is exempt from backup withholding
– U.S. persons who have provided a correct TIN and certification (e.g., completed Form W-9) and have not been flagged by the IRS for underreporting.
– Certain payments such as many retirement plan distributions and unemployment benefits are not subject to backup withholding.
Who may be subject to backup withholding
– Payees who fail to provide a correct TIN to the payor.
– Payees who have underreported interest or dividend income and have been notified by the IRS.
– Nonresident aliens and foreign entities generally have different withholding rules and may be subject if proper documentation is not provided.
What the IRS does before starting withholding
– The IRS normally notifies the taxpayer multiple times before directing payors to begin backup withholding. These notifications give the taxpayer opportunities to correct the TIN or address reporting issues.
What happens on your tax return
– Any backup withholding taken during the year appears on the 1099 the payor issues. The taxpayer reports their total income and claims the withheld amount as a payment or credit on their annual income tax return. If too much was withheld relative to the tax owed, the taxpayer will receive a refund.
Checklist — how to avoid or stop backup withholding
– Provide a correct and legible TIN to any payor that requests it (use Form W-9 for U.S. persons).
– Make sure the name you give the payor matches the name associated with your TIN.
– Report interest and dividend income accurately on your tax returns.
– If you receive IRS notices about underreporting, respond
promptly and provide any requested documentation. If the notice alleges a tax-reporting mismatch (for example, the payor reported payments using a TIN or name that doesn’t match IRS records), take these concrete steps:
– Contact the payor (the person or firm that issued the 1099) and ask what information they reported. Request a corrected Form 1099 if they find an error.
– Furnish a corrected and signed Form W-9 (Request for Taxpayer Identification Number and Certification) to the payor so future payments use the right name/TIN.
– Keep copies of communications and any corrected forms you send or receive. Document dates, names, and what changed.
– If backup withholding has already been taken, file your annual tax return reporting the full income and claim the backup withholding as tax paid (it appears on your 1099 and reduces your tax liability or increases your refund).
– If you believe withholding was taken in error and the payor will not correct it, you can still claim the withholding on your return; if that does not resolve the problem, consider contacting the IRS or a tax professional for next steps.
Worked numeric example (simple)
– You receive $1,000 of interest. The payor withheld 24% backup withholding = $240. Your 1099 shows $1,000 interest and $240 federal income tax withheld.
– On your tax return you report $1,000 interest as income and enter $240 on the line for federal income tax withheld.
– The $240 reduces your total tax owed for the year or increases your refund. If your total tax on all income is $1,000, then after crediting the $240 withholding you owe $760; if your total tax is $200, you would receive a $40 refund (because $240 paid minus $200 tax = $40 refund).
Quick checklist to stop or minimize future backup withholding
1. Verify the name/TIN combination with the Social Security Administration (for individuals) or the IRS (for businesses) before giving it to payors.
2. Give payors a signed and accurate Form W-9 when requested.
3. If the IRS notifies you of underreporting, respond quickly and provide supporting documents.
4. Ask payors to issue corrected 1099 forms when errors are confirmed.
5. Keep records of all correspondence and filings related to the dispute.
When to consult a professional
– The rules can be technical when underreporting involves third parties, trusts, estates, or international payors. If the amounts are large, notices are unclear, or the payor refuses to correct forms, consult a certified tax professional or the IRS for guidance.
Educational disclaimer
This explanation is for educational purposes only and is not individualized tax advice. For personal tax questions or complex cases, consult a qualified tax professional or the IRS.
References
– Investopedia — Backup Withholding: https://www.investopedia.com/terms/b/backupwithholding.asp
– IRS — Backup Withholding: https://www.irs.gov/businesses/small-businesses-self-employed/backup-withholding
– IRS — About Form W-9, Request for Taxpayer Identification Number and Certification: https://www.irs.gov/forms-pubs/about-form-w-9