While you’re likely exempt from backup withholding if there aren’t any issues with your tax identity number (TIN) and social security number, this type of tax can’t be overlooked. In simple terms, backup withholding is levied against your investment income when you make a withdrawal. As such, it’s a crucial consideration if you have diverse income streams.
In this blog, we’ll go over the various things you need to know about backup withholding – from its purpose, to compliance, and how to resolve potential issues.
Definition and Purpose of Backup Withholding
Generally, backup withholding is applied if you haven’t met the rules regarding your TIN. So, when you withdraw your investment income, a percentage of the amount is remitted to the IRS. And if you’re wondering why, it’s essentially an IRS safeguard against taxpayers who might need to resolve issues with their tax identification number, or who have previously underreported income. In other words, it’s a way for the IRS to avoid issues collecting these down the line.
Backup withholding is applied at a fixed rate. Currently, this is 24% for US citizens and resident aliens. And while it’s applied to withdrawn investments, several different types of income can trigger this kind of tax, if you are not exempt. These include:
- Broker payments
- Commissions and fees
- Dividends
- Gambling winnings
- Government transfers and some payments
- Interest
- Rent
- Royalties
Triggers for backup withholding
Having backup withholding levied against your income isn’t always a sign that you’ve done something wrong. However, there are a few common triggers that could lead the IRS to apply this tax.
The most common, as we’ve mentioned above, is an incorrect TIN. This includes your Social Security Number (SSN), employer identification number (EIN), Individual Taxpayer Identification Number (ITIN), Taxpayer Identification Number for Pending US Adoptions (ATIN), or your Preparer Taxpayer Identification Number (PTIN).
Being a foreign citizen, or not having the proper certifications, could also be a potential reason for this tax to be applied.
It could also be triggered if you or your broker haven’t reported dividends or interest income received from your investments. But keep in mind that this is a pretty uncommon occurrence, because most brokerage firms use automated reporting.
No matter the cause, if you are subject to backup withholding, you’ll be notified by the IRS. Their standard procedure is to inform you four times over 120 days, in writing. Also, if your Form 1099 indicates backup withholding, you can apply that amount as a credit against any income tax filing for that year.
Consequences and impact
If you are subject to this tax, you need to understand the practical implications. As mentioned above, affected income will be taxed at 24%. That means that if you earned $1,000 in interest from a savings account, you must withhold $240 for the IRS, so you receive only $760.
Of course, this can seriously impact your cash flow, as it leaves you with less money in your pocket. At the same time, if backup withholding was triggered by underreporting or underpaying in the past, you may also be subject to IRS penalties.
And as for how long you’ll be subject to this kind of tax – that comes down to how long it takes to resolve the issues that triggered it. In other words, the sooner you respond to any received notices from the IRS, the better.
Exceptions and Exemptions
While you won’t need to worry about backup withholding if your TIN is correct and you’ve not had any notice from the IRS, there are also other scenarios exempt from this tax. For instance, distributions from retirement accounts and unemployment income are exempted. And that’s not all – below is a list of payments that the IRS excludes:
- Canceled debts
- Distributions from Archer MSAs
- Distributions from an employee stock ownership plan
- Foreclosures and abandonments
- Long-term care benefits
- Qualified tuition program earnings
- Real estate transactions
- State or local income tax refunds
Also remember that if you are a foreign citizen, there is probably a tax treaty in place to ensure you’re not subject to backup withholding.
In addition to certain income types being exempt, the IRS also exempts certain entities from backup withholding. This includes corporations, tax-exempt organizations, and government entities.
Compliance and Reporting Requirements
As with anything to do with the IRS, non-compliance with backup withholding can cost you. This might include fines with steep interest for under-withholding or not withholding, potential criminal charges for willful non-compliance, and even audits.
Also remember that as far as the IRS is concerned, compliance is your responsibility. So to avoid these risks, we recommend doing everything you can to ensure you’re compliant. For instance, always provide the correct TIN when receiving payments, accurately report interest or dividend income on your tax return, and respond promptly to any notices about discrepancies.
Reporting on tax returns
Reporting backup withholding is crucial for both you and whoever pays income to you. You see, the IRS requires detailed documentation of all amounts withheld under their regulations.
This means you’ll need to review Form 1099 to double-check that all the information is correct. It also means you’ll need to provide whoever is paying you with a correct W-9, and a valid TIN.
But even if you’ve done all you can to prevent backup withholding, you may still face a few issues. So let’s chat about how to resolve them.
Procedures for Resolving Backup Withholding Issues
It’s possible to avoid backup withholding altogether if all your forms and documentation are correct, and you do not under-report or underpay any income on any of your tax returns. If you do have any payments to make or mistakes to rectify on returns, the sooner you take care of it, the sooner you’ll be free of this tax.
For example, if you are notified that your TIN is incorrect, you must remedy this as soon as possible. Here’s how to do that:
- Review the notice to verify the exact issue with your TIN.
- Contact whoever is making the payment to you and give them the correct TIN, so that they can update their records.
- Also, submit Form W-9 to them to certify the correct TIN.
- Keep copies of the corrected form and your re-submitted Form W-9 as proof.
When in doubt, ask for help
Remember that you don’t have to navigate tax compliance alone. With professional help from experts like the team at Fusion CPA, you can ensure that your tax filings are always compliant, and that if an issue crops up, it’ll be resolved quickly and accurately. Also, keep in mind that tax laws change all the time, and professionals will know exactly how this affects you and your taxes.
For help with backup withholding, or creating a tax strategy to avoid noncompliance, schedule a free Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
