What Does It Mean to Be an Exempt Payee?

An exempt payee is an entity or individual not subject to backup withholding, a specific type of tax withholding. The Internal Revenue Service (IRS) requires payers to determine if withholding is necessary when making certain payments. Understanding this status helps ensure proper tax compliance for both the party making a payment and the one receiving it.

Understanding Backup Withholding

Backup withholding is a requirement for a payer to withhold a portion of certain payments and send it to the IRS. This process is not an additional tax but a method of collecting income tax that might otherwise go uncollected. It is triggered when a payee fails to provide a correct Taxpayer Identification Number (TIN). A TIN can be a Social Security Number (SSN) for an individual or an Employer Identification Number (EIN) for a business.

The requirement can also be initiated if the IRS notifies the payer that the provided TIN is incorrect or if the payee fails to report all interest and dividend income. When these conditions are met, the payer must withhold tax at a flat rate of 24%. This rate applies to payments like interest, dividends, rents, royalties, and nonemployee compensation.

Payments subject to this withholding include a wide range of transactions from brokers, barter exchanges, and certain gambling winnings. However, some payments are explicitly excluded, such as distributions from retirement accounts, unemployment compensation, and real estate transactions.

The amount withheld is remitted to the IRS by the payer. For the payee, the withheld amount is treated as a tax payment and can be claimed as a credit on their annual income tax return.

Who Qualifies as an Exempt Payee

Certain types of payees are automatically exempt from backup withholding. These are primarily entities, as individuals and sole proprietors are not exempt. The IRS provides a list of organizations that do not have to worry about withholding on payments like interest and dividends, provided they properly certify their status.

A primary category of exempt payees is corporations. This includes both C corporations and S corporations, which are exempt from backup withholding for certain payments like interest and dividends. However, this exemption does not apply to payments for medical and health care services reported on Form 1099-MISC.

Governmental bodies are another major group of exempt payees. This includes the United States government and any of its agencies or instrumentalities. State governments, the District of Columbia, U.S. commonwealths or possessions, and their political subdivisions are also exempt.

Tax-exempt organizations also qualify. Any organization that is exempt from tax under Internal Revenue Code Section 501 is considered an exempt payee. This includes most charities, churches, and other nonprofit organizations, as well as Individual Retirement Arrangements (IRAs).

Being an “exempt payee” for backup withholding is a separate concept from being exempt from income tax, although many organizations that are tax-exempt also qualify as exempt payees.

Other qualifying entities include financial institutions, real estate investment trusts (REITs), and entities registered under the Investment Company Act of 1940. Dealers in securities or commodities who are registered in the U.S. are also on the list.

How to Certify Your Exempt Status

To avoid backup withholding, a qualifying entity must certify its exempt status to the payer. This is accomplished by properly completing and submitting IRS Form W-9, Request for Taxpayer Identification Number and Certification. This form serves as the official document for a payee to provide their TIN and attest to their tax status.

Before filling out the form, the payee needs to gather specific information. This includes the exact legal name as shown on tax documents, any business or “doing business as” name, the correct entity type, address, and the appropriate TIN. For a business entity, the TIN is the Employer Identification Number (EIN).

The “Exemptions” section of the form contains a box for an “Exempt payee code.” If an entity qualifies for an exemption, it must enter the appropriate code in this box. The instructions for Form W-9 provide a list of codes that correspond to the different categories of exempt payees.

For example, a corporation would enter code “5,” while a tax-exempt organization would enter code “1.” By entering the correct code, the payee is certifying under penalties of perjury that they are an exempt payee and are not subject to backup withholding.

Submitting Form W-9 and Responsibilities

After correctly filling out Form W-9, including the exempt payee code if applicable, the form must be delivered to the requester. This is the person or business that will be making payments to you. The completed Form W-9 is not sent to the IRS; the payer keeps it for their records to justify not applying backup withholding.

The information provided on Form W-9 must be kept current. If any of the critical information changes, such as the legal name, TIN, address, or exempt status, the payee must provide a new, updated Form W-9 to every payer. Failure to provide an updated Form W-9 when information changes could lead to the implementation of backup withholding on future payments.

This ongoing responsibility ensures that the payer has accurate information for their tax reporting obligations. It also ensures the payee remains in compliance with IRS regulations.