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Backup Withholding Tax – Who Has To Pay It?

What Is Backup Withholding Tax?

Backup WithholdingBackup withholding tax is an IRS requirement used to collect taxes on certain types of income payments that are not subject to regular tax withholding. Investors should know that backup withholding is a tax that is levied on investment income.  The withholding is at an established tax rate – usually, 24-28%.  It is applied as the investor withdraws the funds. Payers are obligated to withhold the tax on payments that are not subject to other withholding requirements. Backup withholding ensures that government tax-collecting agencies, such as the Internal Revenue Service (IRS) or the Canada Revenue Agency, get income taxes owed to them from the earnings of investors. The method is used to make sure the government collects taxes on income that an investor may otherwise spend before his or her tax bill comes due.

Backup withholding may also be used if an investor fails to meet the requirements for taxpayer-identification numbers (TIN). When an investor withdraws investment income, the amount stipulated by the backup withholding tax is transferred to the government.  This provides the tax-collecting agency with the necessary monies instantly but leaves the investor with less short-term cash flow.  If you are a taxpayer receiving certain types of income payments, the IRS requires the payer of these payments to report them.

Backup Withholding Tax – A Closer Look

Investors frequently generate income from the assets in which they have invested.  For example, interest payments, dividends, and capital gains. This income is potentially taxable at the time it is received.  However, taxes on investment income earned in a calendar year are only due once a year, during tax season. There is a risk that investors may spend all of their investment income before paying their annual income taxes. As a result, they may be unable to pay their taxes.  This leaves the IRS with the laborious and costly task of collecting the back taxes owed. This risk is essentially what drives the government to occasionally mandate backup withholding taxes.  This reporting and withholding requirement is assessed by financial institutions when investment income is realized.

Backup withholding is not required for all taxpayers. You may be exempt if you have provided your name and SSN to the payer using Form W-9.  However, your information must match the IRS documentation on file. The IRS will usually alert you when you are subject to required backup withholding.

Withholding rules: When you open a new account, make an investment, or begin to receive payments reportable on Form 1099, you must provide your TIN (taxpayer identification number). For certain types of payments, you must provide the TIN in writing and certify under penalties of perjury that it’s correct. In those cases, the bank or business will give you Form W-9, Request for Taxpayer Identification Number and Certification or a similar form. If your account or investment will earn interest or dividends, you must also certify that you’re not subject to backup withholding due to previous underreporting of interest and dividends. (Source: irs.gov)

When is Backup Withholding Required?

Backup withholding may apply if a taxpayer fails to give the accurate TIN.  Or, if he fails to report dividend, interest, or patronage dividend income to the IRS in a previous tax year. Rents, royalties payments, earnings, commissions, fees, and other payments for employment as an independent contractor are also subject to backup withholding. If gambling gains were not subject to standard gambling withholding, they may be subject to backup withholding. In these situations, the payer is required to withhold at the current rate of 24 percent. This 24 percent tax is taken from any future payments to ensure the IRS receives the tax due on this income. If a tax filer’s 1099 shows backup withholding, that amount can be used to offset any income tax filing for that year.

Backup Withholding Tax (BWH) may be required:

  • Under the BWH-B program – you failed to give the payer an accurate taxpayer identification number (TIN) for reporting on the mandatory information submitted. A TIN might be your social security number (SSN), employer identification number (EIN), or individual taxpayer identification number (ITIN).  Or, it may be any combination of these.
  • Under the BWH-C program  – Either you omitted to disclose or underreported interest and dividend income on your federal income tax return.  Or, you failed to attest that you are not subject to BWH for underreporting interest and dividends.

How to Stop Backup Withholding Taxes

When you open a new brokerage account, make an investment, or begin receiving payments reportable on Form 1099, you must provide your TIN in writing to the bank or other firm.  Further, you may be required to certify that it is correct under penalty of perjury. Document W-9, Request for Taxpayer Identification Number and Certification PDF (PDF), or a similar form may be provided by the bank or business. If your account or investment will earn interest or dividends, you must also attest that you are not subject to backup withholding owing to underreporting of income and dividends in the past.  The person or business paying you doesn’t necessarily withhold taxes from these types of payments.  It is assumed you will report and pay taxes on this income when you file your federal income tax return.

To discontinue backup withholding, you must first address the cause of your backup withholding requirement. This can include giving the payer the right TIN.  Or, by resolving the underreported income and paying any outstanding tax amount owing.  Or, by submitting the missing tax return(s), if applicable.

Frequently Asked Questions

Is this withholding tax a form of punishment?

Backup withholding isn’t meant as a punishment.  It is simply a means for the IRS to ensure that you pay all taxes owed. Any federal income tax withheld from your earnings as a result of backup withholding will be reported.  Both you and the IRS receive a copy of the appropriate Form 1099. When you file your tax return, you can list the amount as taxes paid.  This amount can be applied to any taxes you might owe for the year, or be taken as a refund if one is due.

Are all taxpayers required to pay backup withholding taxes?

The vast majority of taxpayers are exempt from backup withholding. US residents and resident aliens are exempt.  However, they must properly provide their names, Social Security numbers, or TINs to the payer.  Also, that information must match IRS records. They are also exempt if the IRS has informed them that they are not subject to obligatory backup withholding.  This can occur when the initial reason for backup withholding is properly addressed and resolved.

Up Next: What Is a Quiet Title Action?

Quiet TitleA quiet title action is a type of legal proceeding used to identify who owns real property, fix a title error, or settle an ownership dispute. A party having a claim to land can bring an action to quiet title.  Simply put, it is essentially a lawsuit against everyone else who has a claim to the land. If the owner wins the quiet title action, no further title challenges can be filed.

A quiet title action is a circuit court lawsuit.  It is filed to establish or resolve the title to a piece of property. Quiet title proceedings are common when there is a dispute over the title.  The litigation is intended to remove, or “quiet,” a claim or objection to the title. When real estate passes from one owner to another, a new link is added to the chain of title. When this chain of title is questioned, a quiet title suit may be required. There are other reasons for bringing a quiet title action besides title claims.  They might include resolving tax difficulties with a property, boundary disputes between private parties, surveying errors, and fraudulent conveyance of the property.

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