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What is backup withholding?

The IRS has several tools at its disposal to ensure that taxes are accurately reported and paid. One of these is backup withholding. Here’s a closer look at the definition of backup withholding and when it’s typically applied.

Understanding backup withholding

Backup withholding is used by the IRS to withhold certain types of income. This federal tax applies to some income types that usually wouldn’t have taxes withheld. The method applies to those earning gambling, interest, or specific types of self-employment income who haven’t reported it accurately in the past.

When applied, this rule requires that applicable financial institutions or businesses withhold a flat percentage of 24% of income.

When is backup withholding applied?

Most US taxpayers will be exempt from backup withholding. Here are a few circumstances when it might be applied.

  • An incorrect taxpayer identification number (TIN) has been used when filing taxes. This is usually a Social Security Number but could also be another official ID that’s been used in error.

  • A taxpayer has underreported their dividends or interest payments. To make up the difference, future tax would be withheld.

  • The taxpayer has failed to prove their exemption from backup withholding.

Usually, backup withholding will only be applied to the types of income reported on Form 1099. Examples include:

  • Rental income

  • Gambling winnings

  • Interest

  • Dividends

  • Royalties

  • Independent contractor payments

  • Fishing boat operator payments

  • Stockbroker transaction payments

There are also multiple types of payments that backup withholding doesn’t apply to. For example, unemployment payments, retirement account payments, and real estate transactions are not subject to mandatory withholding.

How does backup withholding work?

The process for backup withholding will depend on the situation:

Incorrect information on tax forms

When a taxpayer submits an incorrect name or tax ID number on a W-9 form, this can trigger backup withholding. It’s easy to stop the process, in this case, by merely supplying the corrected information.

The IRS is required to send a warning before applying backup withholding. It will send a “B” notice to the payer of income first, alerting them that the identifying details don’t match IRS records. The payer should then forward this backup withholding notice to the individual. You can easily prevent this type of backup withholding by verifying all tax documents for accuracy before submitting them.

Unreported dividends or interest

Another situation when backup withholding is applied is when interest and dividends go unreported. As with the previous example, the IRS will send an advance warning before applying backup withholding. In this case, it sends out four backup withholding notices spread out over 210 days, giving the taxpayer time to make amends.

There are some circumstances when the taxpayer is exempt. If any of the following apply, you can request that the withholding be stopped:

  • You did not underreport your interest or dividends.

  • You have already been in contact with the IRS, but the issue has not yet been resolved.

  • Backup withholding will cause undue hardship.

  • You made an honest mistake and will not underreport in the future.

  • You’ve filed an amended return with the correct information and paid all penalties and interest.

What happens when backup withholding tax is overpaid?

As with any overpayment, your backup withholding tax can be refunded. When federal income tax is withheld from your income, it will be reported as such on Form 1099. This is then reported as taxes withheld at the end of the tax year when you file your federal return. If you’ve overpaid, you’ll receive a refund.

How is income withheld?

The IRS does not deduct income for tax payments itself. Business owners or payers are responsible for withholding these taxes on payments. Once the IRS has informed a business that backup withholding is required, the payer must deduct the flat fee of 24% from the payee’s income. Payers are responsible for filing Form 945 with the IRS, reporting all backup withholding each year. They must also provide individual payees with the amount that has been withheld.

Similar to a tax lien, backup withholding should not necessarily be seen as a penalty. These collection tools are used as a precautionary measure by the IRS to ensure that individuals pay all due taxes.

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