What Is 1099 Backup Withholding and How Does It Work?

Backup withholding is a process requiring payers to deduct a specific percentage of certain payments and remit it to the Internal Revenue Service (IRS). This applies to income not typically subject to regular payroll withholding, such as payments to independent contractors or for interest and dividends. The system acts as a safeguard, ensuring the IRS can collect taxes on income streams that might otherwise go unreported. The responsibility to withhold the tax falls on the business or person making the payment when specific conditions are not met by the recipient.

Triggers for Backup Withholding

A payer must begin backup withholding at a flat rate of 24% when specific events occur. The most common trigger is the payee’s failure to provide a valid Taxpayer Identification Number (TIN) to the payer. A TIN can be a Social Security Number (SSN), Employer Identification Number (EIN), or an Individual Taxpayer Identification Number (ITIN). Withholding is also required if the payee provides a TIN that is clearly incorrect, such as one with the wrong number of digits.

Withholding can also be triggered if the IRS notifies the payer that the recipient’s TIN is incorrect. This notification is known as a “B notice.” After receiving a B notice, the payer must begin withholding until the issue is resolved, which involves the payee providing the correct TIN.

The IRS can instruct a payer to start backup withholding if it determines the payee has underreported interest or dividend income on their tax return. Before this, the IRS sends four notices to the payee over at least 120 days to provide an opportunity to correct the issue. For interest and dividend accounts, a payee must also certify on Form W-9 that they are not subject to backup withholding for previous underreporting. Failure to make this certification will also trigger withholding.

Payments Subject to Backup Withholding

Backup withholding rules apply to a wide array of payments reported on Form 1099 series returns, which are distinct from employee wages. Common payments subject to withholding include interest (Form 1099-INT), dividends (Form 1099-DIV), and nonemployee compensation for independent contractors (Form 1099-NEC). Other covered payments include rents, royalties (Form 1099-MISC), and certain gambling winnings (Form W-2G).

Conversely, several types of payments are exempt from backup withholding. These include:

• Wages, salaries, and tips subject to regular payroll tax withholding.
• Proceeds from real estate transactions.
• Distributions from retirement accounts like a 401(k) or an IRA.
• Canceled debts.

Payer Responsibilities

A payer’s responsibilities begin before issuing payment. The payer must request a completed Form W-9, Request for Taxpayer Identification Number and Certification, from every payee. This form provides the payee’s correct TIN and the necessary certifications to avoid backup withholding, and should be kept on file.

If a trigger event occurs, the payer must begin withholding 24% from all applicable payments to that payee. These funds must be deposited with the IRS on a set schedule, which can be monthly or semi-weekly depending on the amount. Deposits are generally made through the Electronic Federal Tax Payment System (EFTPS).

At year-end, the payer must report the total amount withheld to the payee. This amount is shown in Box 4 of the relevant Form 1099, such as Form 1099-NEC or 1099-MISC.

The payer must also reconcile the year’s backup withholding with the IRS by filing Form 945, Annual Return of Withheld Federal Income Tax. This form reports total nonpayroll federal income tax withheld and is filed separately from payroll tax forms like Form 941. The total liability on Form 945 should match the deposits made during the year.

Recipient Actions and Tax Reporting

A recipient of a payment can prevent or stop backup withholding by providing a correct TIN to the payer on a Form W-9. If withholding began due to an incorrect TIN, providing the correct one will stop it for future payments. If withholding was triggered by an IRS notice for underreporting income, the recipient must resolve the issue directly with the IRS, which may involve amending a prior tax return.

Backup withholding is not an additional tax or a penalty; it is a prepayment of the recipient’s federal income tax liability. The full amount withheld is a credit that the recipient can claim when filing their annual income tax return.

When filing an income tax return like Form 1040, the recipient must report the total income received and the total federal income tax withheld. The amount withheld via backup withholding, found on the Form 1099, is included on the line for federal income tax withheld. This credit directly reduces the final tax liability and may result in a smaller tax bill or a larger tax refund.