Backup WithholdingDefined along with Examples

Written By:
Lisa Borga

What is Backup Withholding?

Backup withholding is a certain percentage of tax that is withheld on certain types of income, particularly investment income.

Backup withholding is used by the Internal Revenue Service (IRS) to ensure that all taxes that are owed on these types of income are received before they are spent by the individual receiving them.

Backup withholding is only used on types of income that are not subject to required federal tax withholding, such as transactions that are reported on varieties of Form 1099.

Some common reasons that this withholding may be applied by the IRS include when a taxpayer has provided incorrect identifying information, previously under-reported earnings, or failed to certify that they are not subject to backup withholding.

The payer will directly remit the withheld amount to the government at the time they pay the taxpayer.

For the tax years 2018 to 2025, the backup withholding amount is a flat rate of 24%.

Understanding Backup Withholding

Backup withholding is applied by the IRS to ensure that taxes on certain types of income are paid before being spent by the taxpayer.

This is primarily applied to types of income that would be reported on variants of the IRS Form 1099, such as interest, rent payments, dividends, royalties, and more.

This is because, for these types of incomes, the amount paid is taxable at the time it is received, but the tax payment is only due at one point in the year.

As a result, by the time the tax bill is due, the taxpayer could have spent all of the income earned, leaving them unable to make the necessary payment.

This could leave the IRS in a difficult position when it comes to collecting the amount due.

As a result, if certain conditions give the IRS reason to be uncertain that a taxpayer may be trusted to remit the payments, they will apply a backup withholding.

However, a significant portion of taxpayers, including citizens and resident aliens of the United States, are exempt so long as they correctly submit their name and TIN or Social Security number with their Form W-9, and this information matches the information on the IRS’s own records.

Taxpayers are also exempt unless they have been notified that they are subject to backup withholding.

Causes of Backup Withholding

A taxpayer may become subject to backup withholding for several reasons.

Likely the most common is because they failed to provide a TIN or Social Security number that matched what the IRS has on file for the taxpayer on the Form W-9.

When this occurs, the IRS will provide a “B” notice to the payer of the income, which should then be forwarded to the taxpayer stating that the provided information does not match their records.

In this case, backup withholding can be prevented by providing the correct information.

If a second notice is received, the taxpayer can still stop the withholding by providing proof of the correct information, which may include a tax return with the correct information or a Social Security card.

Backup withholding also may occur if the taxpayer is under-reported or fails to report interest or dividend income.

In this case, the IRS will provide the taxpayer with a series of four notices concerning the failure to report under-reported income through the mail over a 210 day period.

A taxpayer still may be able to stop the backup withholding if they can establish any of the following situations:

• That the income in question was not under-reported.
• That the taxpayer has a dispute with the IRS regarding whether an underreporting occurred.
• That backup withholding would create an undue hardship, and that underreporting of interest and/or dividends is unlikely to occur in the future.
• That the underreporting has already been corrected by either filing an original return for the income or by filing an amended return and paying all required taxes, penalties, and interest for the underreported income.

If the IRS decides to cease the backup withholding, it will provide certification of the decision to the taxpayer and notify any payers that were notified to withhold income that it is no longer required.

Example of Backup Withholding

John is a taxpayer with investments in three different corporations, which earn him dividends of $5,000, $7,000, and $20,000, respectively.

John forgets to report the income of $5,000 to the IRS and fails to receive the subsequent notices from the IRS.

As a result, the IRS alerts payers to initiate backup withholding on the income, meaning that they will withhold 24% of the investment income John otherwise would have received.

In order to stop the backup withholding, John will have to file an amended tax return with the IRS and pay taxes and penalties on the underreported income from the $5,000 in dividends.

Key Takeaways

• Backup Withholding is a strategy used by the IRS to ensure taxes on certain types of income, including investments, gambling winnings, interest, and others, are paid.
• For tax years 2018 to 2025, the backup withholding amount is a flat rate of 24%.
• Common reasons for backup withholding to be applied include supplying an incorrect Social Security number or taxpayer ID number or under-reporting income in prior tax years.
• The majority of taxpayers are exempt from backup withholding so long as they correctly report information that matches the records held by the IRS.