What Is Backup Tax Withholding and How to Stop It?

Backup withholding is a mechanism the Internal Revenue Service (IRS) uses to ensure federal income tax is collected on certain types of income. This process begins when the IRS identifies issues with a taxpayer’s identification information or income reporting. It serves as a method for tax collection rather than a penalty.

When Backup Withholding Applies

Backup withholding can be imposed under several specific conditions related to a taxpayer’s information or reporting. One common trigger occurs when a taxpayer fails to provide a valid Taxpayer Identification Number (TIN) to the entity making a payment, such as a bank or a business. A TIN can be a Social Security Number (SSN), an Employer Identification Number (EIN), or an Individual Taxpayer Identification Number (ITIN). Providing an incorrect TIN to the payer also initiates backup withholding. This includes instances where the name and TIN on file do not match IRS records.

The IRS may also notify a payer that the TIN provided by a payee is incorrect. This notification, often referred to as a “B-Notice” (such as a CP2100 or CP2100A), requires the payer to begin backup withholding if the issue is not resolved. Another situation arises if the IRS notifies a taxpayer that they have underreported interest or dividend income on their tax return. This notification, frequently a CP2000 notice, indicates a discrepancy between income reported by third parties to the IRS and what the taxpayer reported.

Backup withholding can also be triggered if a taxpayer fails to certify that they are not subject to it when opening new accounts or investments that generate interest or dividends. This certification is made on Form W-9, Request for Taxpayer Identification Number and Certification. If a taxpayer mistakenly marks themselves as subject to backup withholding on this form, it can also lead to its imposition.

How Backup Withholding Functions

When backup withholding is triggered, a flat tax rate is applied to certain payments made to the taxpayer. Currently, the backup withholding rate is 24% for most reportable payments. The payer, such as a financial institution or a business, is responsible for deducting this amount from the payments.

A wide range of payments can be subject to backup withholding, including:

• Interest payments
• Dividends and patronage dividends
• Rental income
• Royalties
• Nonemployee compensation paid to independent contractors
• Broker and barter exchange transactions
• Certain government payments
• Gambling winnings

However, some payments, such as retirement benefits, unemployment compensation, and real estate transactions, are generally exempt.

The payer remits the withheld amounts directly to the IRS. This process functions similarly to regular wage withholding, where taxes are collected throughout the year. The amounts withheld under backup withholding are credited against the taxpayer’s total income tax liability for the year. At year-end, the taxpayer receives documentation, typically a Form 1099, which shows both the total amount of income paid and the amount of federal income tax that was withheld due to backup withholding. This form allows the taxpayer to account for the withheld funds when filing their annual tax return.

Resolving Backup Withholding Issues

Taxpayers can take specific steps to resolve backup withholding issues once they arise or to prevent them from starting. If backup withholding began due to a missing or incorrect Taxpayer Identification Number (TIN), the primary action is to provide the correct TIN to the payer. This is often done by submitting a new, properly completed Form W-9 to the entity making the payments. The payer will then update their records, which should lead to the cessation of backup withholding.

Should the IRS notify the payer that the TIN provided is incorrect (a “B-Notice”), the taxpayer must address this issue directly. The payer will send a notice to the taxpayer requesting a corrected TIN and often includes a Form W-9. The taxpayer should promptly complete and return the corrected Form W-9 to the payer. If it is a second B-Notice within a three-year period for the same reason, the taxpayer may be required to contact the IRS directly to resolve the discrepancy and receive official validation before the payer can stop withholding.

For issues stemming from underreported interest or dividend income, which may result in a CP2000 notice from the IRS, the taxpayer must resolve the underlying underreporting with the IRS. This could involve paying any additional taxes, penalties, and interest owed. The IRS sends multiple notices over a period of several months before initiating backup withholding for underreporting. Once the issue is resolved, the IRS will notify the payer to cease backup withholding.