What is Backup Withholding in 2024?

Backup withholding ensures the IRS collects taxes from individuals who may need to report their income correctly or have a history of underreporting. This system helps prevent tax fraud and guarantees that everyone meets their tax obligations. Without it, tax evasion could significantly reduce government revenue, affecting essential public services and benefits.

In this guide, we'll explore about backup tax withholding, its implications, and how to handle it effectively.

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What is backup tax withholding?

Backup withholding is a federal tax withholding applied under certain conditions when a taxpayer receives payments reported on an IRS form, such as 1099 or W-2G. It might be required if an individual:

• Is not able to provide a correct taxpayer identification number (TIN) to the payer
• Underreports interest / dividends on their tax return
• Has received a notice from the IRS requiring them to submit to backup withholding

This measure ensures the government collects taxes from those who might otherwise neglect or evade paying their fair share.

Why is backup withholding necessary?

Backup withholding acts as a safety net for the IRS, ensuring taxes are paid accurately and on time. It also helps prevent tax fraud and ensures that everyone meets their tax obligations fairly. Without it, tax evasion could result in significant revenue loss, jeopardising essential public services.

How does backup withholding work?

When subject to backup withholding:

1. The taxpayer withholds a predetermined percentage (currently 24%) of the payment.
2. This amount is paid directly to the IRS on the recipient's behalf.
3. The taxpayer reports the payment and withholding tax amount on the IRS form (e.g.  1099 or W-2G).
4. The taxpayer receives a copy of this form showing the gross payment and amount withheld.
5. The taxpayer includes both the total payment received and the withholding amount on their tax return.

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Types of payments subject to backup withholding

The IRS can apply backup withholding to various payments, such as:

• Contractor payments, including commissions and fees
• Legal fees
• Interest and dividend payments
• Transactions from payment cards and third-party networks
• Rental income and other profits
• Royalties

This guide primarily focuses on backup withholding related to payments for independent contractors.

Exemptions from backup withholding

Certain independent contractors may be exempt from backup withholding, including:

• Tax-exempt organisations
• Government entities
• Registered corporations

Refer to the IRS Instructions for the Requester of Form W-9 for more details on exemptions.

How to track your global financial payments?

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Determining if you are subject to backup withholding

You will be subject to backup withholding if:

• You receive an IRS notice (CP2100 or CP2100A) stating your TIN is incorrect and fail to correct it.
• You underreport interest or dividends on your tax return.
• You receive a notice from the IRS requiring backup withholding.

Review any IRS notices and your tax records to ensure accurate income reporting.

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Correcting your TIN to avoid backup withholding

If you receive a notice from the IRS that your TIN is incorrect:

1. Review the notice to verify the incorrect TIN.
2. Contact the payer to provide the correct TIN and request they update their records.
3. Submit Form W-9 to the payer to certify your correct TIN.
4. Keep copies of the corrected form and your Form W-9 for your records.
5. If you believe your TIN is correct, contact the IRS to resolve the issue promptly.

Scenario: Incorrect TIN and Backup Withholding

Background:

Jane is a freelance UI/UX designer who works with several clients throughout the year. One of her clients, a marketing firm, is required to report payments made to Jane using a Form 1099-NEC. Jane inadvertently provides an incorrect Taxpayer Identification Number (TIN) to the marketing firm.

Issue:

A few months later, the marketing firm receives a notice from the IRS indicating that Jane's TIN needs to be corrected. As a result, the marketing firm is required to start backup withholding at a rate of 24% on all future payments to Jane until the issue is resolved.

Impact:

Jane usually receives $1,000 per project from this client. With backup withholding, the marketing firm withholds 24% ($240) of each payment and sends it directly to the IRS. Jane now receives only $760 per project instead of the full $1,000.

Resolution:

Jane needs to correct her TIN to stop the backup withholding. Here’s how she does it:

Review the IRS Notice:

1. Jane reviews the notice sent by the IRS to the marketing firm and confirms that her TIN was incorrectly reported.

Contact the Payer:

2. Jane contacts the marketing firm and provides her correct TIN. She asks them to update their records and resubmit the corrected information to the IRS.

Submit Form W-9:

3. Jane completes and submits Form W-9, "Request for Taxpayer Identification Number and Certification," to the marketing firm to certify her correct TIN.

Keep Records:

4. Jane keeps a copy of the corrected Form W-9 and the notice from the IRS for her records.

Verify with the IRS:

5. Jane contacts the IRS to ensure that her correct TIN is on file and that the issue has been resolved.

Outcome:

After the marketing firm updates its records and confirms the correct TIN with the IRS, the backup withholding stops. Jane once again receives the full $1,000 per project. Additionally, when she files her annual tax return, she includes the total payments received and the amounts withheld due to backup withholding. Jane can claim credit for the withheld taxes on her return.

Conclusion:

By promptly addressing the incorrect TIN issue and providing accurate information, Jane was able to stop the backup withholding and ensure that her payments were fully restored. This example illustrates the importance of providing correct TINs and promptly responding to IRS notices to avoid unnecessary withholding.

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Stopping backup withholding

To stop backup withholding:

1. Correct your TIN as described above.
2. Once the payer updates their records, the withholding should stop.
3. If due to underreported interest or dividends, file an amended tax return.
4. Submit necessary documentation to the IRS to show you no longer need backup withholding.

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Tips for compliance

• Always provide your correct TIN to payers.
• Ensure accurate reporting of interest or dividend income on your tax return.
• Keep proper documentation of your TIN, Forms W-9, and any corrections.
• Respond promptly to IRS notices and resolve discrepancies.

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Penalties for non-compliance

Failing to comply with backup withholding regulations can result in penalties, including:

• Fines for under-withholding or not withholding at all.
• Interest charges on underpayments.
• Penalties for incorrect reporting of interest or dividends.
• Potential criminal charges for willful non-compliance.
• IRS enforcement actions, such as audits or additional notices.

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Essential forms for backup withholding compliance

• Form W-9: To provide and certify your correct TIN to the payer.
• Form 1099 series: To report various types of income.
• Form 945: For payers to report total federal income tax withheld from non-wage payments.
• Form 1096: To transmit Form 1099 to the IRS.
• Form 1040 series: To report annual income, deductions, and credits.

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Frequently asked questions

What is the purpose of backup tax withholding?

Backup withholding ensures the government receives the rightful taxes on certain forms of income, such as interest, dividends, and non-wage payments.

How can I avoid backup withholding?

Provide your correct TIN to payers, report interest or dividend income accurately, and respond promptly to IRS notices.

What rate does the IRS use for backup tax withholding?

As of 2023, the backup withholding rate is 24%.

When do I stop backup withholding?

Address and resolve the issue causing the withholding, such as providing a correct TIN or correcting income reporting discrepancies.

Who is responsible for implementing backup withholding?

The payer is primarily responsible for implementing backup withholding, but payees must provide correct TINs and accurately report income.

Who is exempt from backup withholding?

Exemptions apply to certain entities, including government entities, tax-exempt organisations, foreign governments, registered corporations, and retirement accounts.

By understanding and following these guidelines, you can manage backup withholding effectively and ensure compliance with IRS regulations.

If you need more help, check out Inkle Tax. 

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