Unless you’re a tax expert, mistakes are bound to happen when preparing documents and filing returns, such as a discrepancy with the SSN or TIN that you or your employer provided to the IRS. Unfortunately, these issues could be costly and take some time to resolve.
Case in point: backup withholding. It results from errors, understated or omitted information related to 1099 or W2-G income. Backup withholding could be initiated if the Internal Revenue Service (IRS) spots an issue and sends a notice to the payer.
What is a Backup Withholding Tax?
Do you receive income payments that don’t have taxes withheld before distribution? If so, future compensation could be subject to tax backup withholding at a rate of 24 percent to cover the amount of tax due to the IRS.
When is Backup Withholding Required?
Backup withholding generally applies to specific forms of 1099 income. The following instances warrant backup withholding:
- The taxpayer provided an incorrect taxpayer identification number (TIN) to the payer. Consequently, the TIN relayed to the IRS was invalid. (Please note that a TIN refers to the taxpayer’s Social Security number, individual taxpayer identification number (ITIN), or their employer identification number (EIN).
- The taxpayer underreported or omitted dividend income from their federal return. Backup withholding could also be required if the taxpayer did not certify that they’re not subject to backup withholding for underreporting dividends and interest.
Consult with a tax professional if you believe you may be subject to backup withholding.
How Backup Withholding Works
It depends on what prompted the IRS to require backup withholding.
Withholding Due to Incorrect Information
Suppose there’s a discrepancy between your correct name or TIN and what you provided to the payer via tax documents. In that case, the IRS will send a “B” notice to the payer. This notice will alert the payer of the variance. They should forward the notice to you and reach out to correct the information before initiating backup withholding.
The payer must file Form 945 (Annual Return of Withheld Federal Income Tax) with the IRS annually, per federal law, and notify payees of amounts withheld.
Withholding Due to Unreported Interest or Dividends
Did you fail to report dividends or interest income? Or maybe you under-reported the actual amount? Either way, the IRS will send four notices to you over a 210-day window to alert you of backup withholding in the future. However, you can stop backup withholding from occurring by filing a return that reflects the income or amending an existing return to rectify any errors.
You can also plead your case and possibly avoid backup withholding if the IRS determines it will create an undue financial hardship for you (and you make the same mistake going forward). Or you can contact the IRS to argue against under-reporting and await a response to possibly prevent or stop backup withholding.
Payments Subject to Backup Withholding
These payments could be subject to backup withholding:
- Certain Gambling Winnings (Form W-2G)
- Certain Government Payments (Form 1099-G)
- Commissions, fees, or other payments for performed by independent contractors (Form 1099-MISC)
- Dividends (Form 1099-DIV)
- Interest payments (Form 1099-INT)
- Original Issue Discount (Form 1099-OID)
- Payments by fishing boat operators (limited to the earnings that represent a share of catch proceeds (Form 1099-MISC)
- Payment Card and Third Party Network Transactions (Form 1099-K)
- Patronage dividends (if at least half of the earnings are in currency) (Form 1099-PATR)
- Proceeds from Broker and Barter Exchange (Form 1099-B)
- Rents, profits, or other gains (Form 1099-MISC)
- Royalty payments (Form 1099-MISC)
Payments Excluded from Backup Withholding
Some income payments are excluded from backup withholding, including:
- Canceled debts
- Distributions from any retirement account
- Distributions from an employee stock ownership plan
- Distributions from Archer MSAs
- Fish purchases for cash
- Foreclosures and abandonments
- Long term care benefits
- Qualified tuition program earnings
- Real estate transactions
- State or local income tax refunds
- Unemployment compensation
Prevent or Stop Backup Withholding
It’s possible to be proactive and prevent backup withholding by:
- Providing a valid TIN to the payer(s) when completing payroll forms
- Accurately reporting dividend income on your federal tax returns
- Remitting the amount owed for income tax on dividend income
Suppose you are already subject to backup withholding. In that case, you can remedy the situation by correcting the issue that led up to backup withholding.
