Section 3406 a: What Is Backup Withholding?

Backup withholding is a tax collection method used by the Internal Revenue Service (IRS). When certain conditions are met, a payer, such as a bank or business, is required to withhold a flat 24% from payments made to you. This process ensures the IRS can collect income tax on money that might otherwise not be reported. It is not an additional tax or a penalty, but a way of paying income tax in advance, similar to how an employer withholds taxes from a paycheck. This system applies to specific types of income where regular wage withholding is not used.

Triggers for Backup Withholding

One of the most common reasons this occurs is the failure to provide a correct Taxpayer Identification Number (TIN) to the payer. A TIN is an individual’s Social Security Number (SSN) or a business’s Employer Identification Number (EIN). When opening an account or setting up payments, you are required to provide this number on a Form W-9, and if you do not, the payer must begin withholding immediately.

Another trigger is an IRS notification to the payer that the TIN you provided is incorrect. This happens when the name and TIN combination on the Form W-9 does not match IRS records. The IRS uses a “B Notice” process to inform the payer of this mismatch, and the payer will then notify you to provide the correct information. Failure to resolve this discrepancy will result in backup withholding.

A less common trigger is when the IRS notifies the payer that you have underreported interest or dividend income on a past tax return. This is known as a “C Notice.” Before this happens, the IRS will send you at least four notices, providing an opportunity to correct your tax return and pay any tax due.

Finally, backup withholding can be initiated due to a payee certification failure on Form W-9. If you fail to certify that your information is correct, the payer is required to withhold tax.

Payments Subject to Backup Withholding

Backup withholding applies to a range of “reportable payments,” which are types of income that payers must report to the IRS. The most common examples include:

• Interest payments (Form 1099-INT), dividends (Form 1099-DIV), and patronage dividends paid in cash
• Payments for rents, royalties, prizes, and awards (Form 1099-MISC)
• Nonemployee compensation paid to independent contractors and freelancers (Form 1099-NEC)
• Gross proceeds from transactions handled by brokers, such as the sale of securities or digital assets
• Certain payments made by government agencies

Certain payments are not subject to backup withholding. Wages and salaries paid to employees are exempt because they are already subject to regular payroll tax withholding. Distributions from retirement accounts like IRAs and 401(k)s are also excluded, as is tax-exempt interest from municipal bonds.

Resolving Backup Withholding Issues

The most direct way to stop backup withholding is to correct the issue that triggered it by providing the correct information to the payer. The primary document for this is Form W-9, which you must accurately complete with your legal name, address, and correct TIN (SSN or EIN). Provide this completed form to the company or person paying you, not the IRS.

By signing and dating the form, you are attesting under penalties of perjury that the TIN you provided is correct and that you are not subject to backup withholding for previously underreporting interest or dividend income. Once the payer receives the properly completed and certified Form W-9, they are required to stop backup withholding, often within 30 days.

If the withholding was started because of a “C Notice” for underreporting interest or dividends, providing a new W-9 will not be sufficient. You must resolve the underlying tax issue directly with the IRS, which may involve filing an amended tax return or paying the back taxes owed. Once the matter is settled, the IRS will provide you with a certification to give to your payers, notifying them to stop withholding.

Claiming Withheld Amounts on Your Tax Return

Money taken out for backup withholding is not lost; it is treated as a federal income tax payment you have made. The total amount withheld by a payer throughout the year is reported to you on an information return. For example, this amount appears in Box 4 of forms like the Form 1099-NEC for nonemployee compensation or Form 1099-MISC for other income.

When you file your annual federal income tax return using Form 1040, you claim credit for the amount withheld in the “Payments” section. The total withheld amount is added to your other tax payments for the year. This total is then subtracted from your overall tax liability, and if your total payments are more than the tax you owe, you will receive a refund; if it is less, the withheld amount reduces the final balance you must pay.