Are Nonprofits Exempt From Backup Withholding?

Backup withholding is an IRS mechanism designed to ensure tax compliance on certain payments. Generally, nonprofit organizations are exempt from backup withholding on payments they receive. This article clarifies when and why nonprofits typically enjoy this exemption, along with specific circumstances where they might still be involved in backup withholding as a payee or a payer.

Understanding Backup Withholding

Backup withholding is a federal income tax collection method applied to certain payments not typically subject to income tax withholding. Its main purpose is to ensure the Internal Revenue Service (IRS) receives taxes on income when there is a risk of underreporting or missing information from the payee. This mechanism applies if the payee’s Taxpayer Identification Number (TIN) is incorrect, missing, or if the IRS has notified the payer that the payee is subject to backup withholding due to underreported interest or dividends.

Common types of payments generally subject to backup withholding include interest, dividends, royalties, rents, commissions, and payments for services performed by independent contractors. The standard rate for backup withholding is 24% of the gross payment. This withholding ensures that the IRS collects taxes owed, especially when an individual might otherwise spend income before their annual tax bill is due.

Nonprofit Exemption from Backup Withholding

Most tax-exempt organizations, particularly those recognized under IRS Code Section 501(c)(3), are exempt from backup withholding on payments they receive. This exemption exists because their income is generally not subject to federal income tax.

To claim this exemption as a payee, a nonprofit must provide a properly completed IRS Form W-9, “Request for Taxpayer Identification Number and Certification,” to the payer. On Form W-9, the nonprofit should indicate its exempt status by checking the appropriate box for “Exempt payee” and stating the specific reason for exemption, such as “501(c)(3).”

Providing the correct Taxpayer Identification Number (TIN), which for most nonprofits is their Employer Identification Number (EIN), is also a requirement. The certification on Form W-9 confirms that the TIN is correct and that the organization is not subject to backup withholding. Submitting a complete and accurate Form W-9 to the entity making the payment is crucial for a nonprofit to avoid having backup withholding applied to its incoming funds.

Specific Scenarios for Nonprofits and Backup Withholding

While nonprofits are generally exempt from backup withholding as payees, certain situations can lead to them being subject to it. A nonprofit receiving payments may still face backup withholding if it fails to provide any TIN, provides an incorrect TIN, or if the IRS notifies the payer that the nonprofit’s TIN is incorrect and the issue is not resolved. This typically occurs due to procedural errors rather than a loss of tax-exempt status. If the IRS issues a “B” notice because of an incorrect TIN, the payer is required to send this notice to the payee within 15 business days.

Nonprofits also have responsibilities when they act as payers themselves. If a nonprofit makes certain reportable payments to individuals or entities that are not exempt, it may be required to perform backup withholding. This applies to payments such as those made to independent contractors, certain prize winners, or individuals receiving specific grants, especially if the payee does not provide a correct TIN or is subject to backup withholding for other reasons.

In these instances, the nonprofit, as the payer, must withhold 24% of the payment and remit it to the IRS. The nonprofit is also responsible for reporting these withheld federal income taxes on IRS Form 945, “Annual Return of Withheld Federal Income Tax.” This form consolidates all federal income tax withheld from nonpayroll payments throughout the year. The nonprofit must also make regular deposits of the withheld taxes, typically via electronic funds transfer.