What Does Exempt From Backup Withholding Mean?
Learn what exemption from backup withholding entails. Understand how this impacts certain income payments and your tax obligations.
“Exempt from backup withholding” means that certain payments you receive will not have federal income tax automatically deducted by the payer before you receive them. This concept is relevant for various types of income, such as interest, dividends, or payments for contract work.
What is Backup Withholding
Backup withholding is a mechanism the Internal Revenue Service (IRS) uses to collect federal income tax on certain payments when there’s a concern that the income might not be properly reported by the recipient. This applies to various payments, including interest, dividends, royalties, rents, and nonemployee compensation. The goal is to ensure tax compliance and minimize underreported income.
The current backup withholding rate is 24% of the payment. It is triggered when a payee fails to provide a correct Taxpayer Identification Number (TIN) to the payer. An incorrect or missing Social Security Number (SSN) or Employer Identification Number (EIN) can also lead to this withholding. Additionally, the IRS may notify a payer to begin backup withholding if the payee has underreported interest or dividend income on past tax returns.
Categories of Exempt Payees
Certain individuals and entities are exempt from backup withholding because their income is subject to different tax reporting and collection rules. Corporations, for instance, are often exempt from backup withholding on certain payments like interest and dividends. This exemption for corporations does not extend to payments made in settlement of payment card transactions or for attorney’s fees.
Organizations recognized as tax-exempt under Internal Revenue Code Section 501(a) are also exempt from backup withholding. This includes many non-profit organizations. Governmental units, such as the United States government, states, the District of Columbia, or their political subdivisions, are also considered exempt payees.
Other categories of exempt payees include individual retirement arrangements (IRAs), certain financial institutions, and specific trusts. This also extends to entities like registered securities dealers, futures commission merchants, and real estate investment trusts.
How to Claim Exemption
To claim an exemption from backup withholding, a payee communicates their status to the payer using Form W-9, Request for Taxpayer Identification Number and Certification. This form provides an accurate Taxpayer Identification Number (TIN) and includes claims for exemption. The completed Form W-9 is provided directly to the payer, not submitted to the IRS.
On Form W-9, specifically on Line 4, an exempt payee enters an “Exempt payee code” that corresponds to their specific exemption reason, such as being a corporation or a tax-exempt organization. Completing and signing this form certifies their exempt status to the payer, allowing the payer to process payments without applying backup withholding.
Practical Effects of Being Exempt
When a payee is exempt from backup withholding, the payer will not deduct the 24% federal income tax from the payments. This means the payee receives the full amount of the payment, rather than a reduced sum. For example, if an exempt corporation receives a $1,000 payment for services, they will receive the entire $1,000 instead of $760. This direct receipt of the full payment can improve cash flow for the exempt entity or individual.
Being exempt from backup withholding does not mean the income is tax-exempt. The income received is still taxable income, and the exempt payee remains responsible for reporting it on their income tax return. The exemption only removes the obligation for the payer to withhold tax at the source. Providing a correct Taxpayer Identification Number (TIN) to all payers is still required to ensure accurate income reporting to the IRS.