Backup withholding is federal income tax withheld directly by payers from payments to payees subject to IRS backup withholding rules.
What is Backup Withholding?
Backup withholding is a type of U.S. federal income tax that is deducted by payers when their 1099 or W-2G payee has failed to provide a valid TIN number or show that they are exempt from backup withholding. Backup withholding is calculated using IRS tax rates of 24% for U.S. citizens and resident aliens, or 30% or 10% for non-resident foreign persons, depending on the types of income.
Tax treaties can reduce or exempt amounts of required backup withholding for foreign persons.
Understanding Backup Withholding
Payers report backup withholding amounts on 1099 forms for each payee and submit amounts deducted for backup withholding to the IRS. When payees file their tax returns, backup withholding amounts already paid through these payment deductions reduce their actual federal income tax amount payable to the IRS, which may result in tax refunds.
Which IRS Forms Relate to Backup Withholding?
U.S. persons submit a Form W-9 to the payer with their name and taxpayer identification number, which the payer uses to complete a 1099 information return submitted to the payee, the IRS, and any state tax authority. W-9 vs 1099 forms have some differences.
The IRS has rules specifying who gets a 1099 form, which includes many types. Self-employed independent contractors received Form 1099-NEC for Nonemployee Compensation. Others receive 1099-MISC to report Miscellaneous Income. Financial institutions, including banks, credit unions, and brokerage firms, file forms 1099-INT and 1099-DIV for interest and dividend income paid to recipients, and 1099-B for proceeds from broker and barter exchange transactions.
Foreign persons can submit IRS Form W-8BEN for Individuals or W-8BEN-E for Entities to claim a reduced rate or exemption from backup withholding. The title of W-8 BEN and W-8-BEN-E forms is Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting. Form W-8BEN is for Individuals and Form W-8BEN-E is for Entities, which is included in parenthesis in the form titles.
The IRS specifies which forms foreign person payees should furnish the payer instead of a W9 form. For example, Form W-8ECI is furnished to U.S. payers by foreign persons with income effectively connected with a trade or business in the U.S. The title of Form W-8ECI is Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States.
What Types of 1099 Income are Subject to Backup Withholding?
According to the IRS in its Topic No. 307, Backup Withholding explainer, certain types of payments are subject to backup withholding.
“Payments subject to backup withholding: Backup withholding can apply to most kinds of payments reported on Form 1099, including:
- Interest payments (Form 1099-INT);
- Certain government payments (Form 1099-G);
- Dividends (Form 1099-DIV);
- Patronage dividends, but only if at least half of the payment is in money (Form 1099-PATR);
- Rents, profits, or other income (Form 1099-MISC);
- Commissions, fees, or other payments for work performed as an independent contractor (Form 1099-NEC);
- Payments by brokers and barter exchange transactions (Form 1099-B);
- Payments by fishing boat operators, but only the part that’s in money and that represents a share of the proceeds of the catch (Form 1099-MISC);
- Payment Card and Third-Party Network Transactions (Form 1099-K);
- Royalty payments (Form 1099-MISC); and
- Original issue discount, but limited to the amount of cash paid (Form 1099-OID).
Backup withholding also may apply to gambling winnings (Form W-2G) that aren’t subject to regular gambling withholding.”
From the IRS Instructions for Form W-8BEN-E for foreign persons:
“Foreign persons are subject to U.S. tax at a 30% rate on income they receive from U.S. sources that consists of:
- Interest (including certain original issue discount (OID));
- Compensation for, or in expectation of, services performed;
- Substitute payments in a securities lending transaction; or
- Other fixed or determinable annual or periodical gains, profits, or income.”
The Tax Cut and Jobs Act of 2017 instituted a 10% backup withholding rate for gains from the transfer (beginning January 1, 2023) of an interest in a publicly traded partnership (PTP) effectively conducted with the conduct of a trade or business within the United States. (See Form W-8ECI, line 12).
Which Payment Types are Excluded from Backup Withholding?
According to the IRS, some payment types are excluded from backup withholding.
“Payments that are excluded from backup withholding:
- Real estate transactions
- Foreclosures and abandonments
- Cancelled debts
- Distributions from Archer MSAs
- Long term care benefits
- Distributions from any retirement account
- Distributions from an employee stock ownership plan
- Fish purchases for cash
- Unemployment compensation
- State or local income tax refunds
- Qualified tuition program earnings”
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Am I Subject to Backup Withholding?
Although most taxpayers aren’t subject to backup withholding, IRS backup withholding rules, tax treaties, or IRS notifications determine who will have backup withholding deducted from their income payments. Different rules and rates apply to U.S. persons and foreign persons needing to pay U.S. taxes.
The Internal Revenue Service (IRS) defines United States (U.S.) persons and foreign persons in its Classification of Taxpayers for U.S. Tax Purposes. Note that U.S. persons and foreign persons include legal entities besides individuals.
For U.S. citizens and resident aliens included in the IRS definition of U.S. persons, you may be subject to backup withholding of U.S federal taxes at 24 percent of gross payments for specific reasons shown in the table below.
|U.S. PersonsBackup Withholding Reason
|You received an IRS notification stating you’re subject to backup withholding.
|You didn’t furnish a taxpayer identification number (TIN).
|You furnished a wrong taxpayer identification number instead of the correct TIN, or the taxpayer name/TIN doesn’t match the IRS database.
|You haven’t been reporting, or you’re underreporting reportable interest income, dividend income, or reportable patronage dividends income on your tax return. The IRS notifies you to start backup withholding on interest and dividends after mailing you four notices over 120 days.
|You didn’t certify that you’re not subject to backup withholding for underreporting interest and dividends.
|You haven’t filed all your federal income tax returns.
U.S. persons, including individuals and entities, submit a Form W-9 to the payer with their name and taxpayer identification number. The payer uses the W-9 to complete a 1099 information return submitted to the payee, the IRS, and any applicable state tax authority.
The IRS has a TIN Matching service. Payers can verify that the payee’s name and TIN number are correct and match the IRS database before filing 1099 forms with the IRS. IRS Publication 1281 explains procedures and specifies the 24% rate of Backup Withholding for Missing and Incorrect Name/TIN(S).
Types of taxpayer identification numbers (TIN) include:
- Social Security Number (SSN)
- Employer identification number (EIN)
- Individual Taxpayer Identification Number (ITIN)
- Taxpayer Identification Number for Pending U.S. Adoptions (ATIN)
- Preparer Taxpayer Identification Number (PTIN)
Foreign Persons Subject to U.S. Taxes
For foreign persons, including non-resident aliens, included in the IRS definition of foreign persons, you may be subject to backup withholding of U.S federal taxes on certain types of gross payment amounts at the specific rates shown in the table below. A foreign person fills out IRS Form W-8BEN for Individuals or Form W-8-BEN-E for Entities, or possibly other types of W-8 forms instead of a W-9.
|Foreign PersonsBackup Withholding Reason
|Foreign PersonsBackup Withholding Rate
|Specified types of 1099 income
|30% or reduced amount per tax treaty or exemption from backup withholding (IRS Form W-8BEN-E to claim)
|Disposition of partnership interest for a gain that is effectively connected with conducting a trade or business within the United States
|10% backup withholding under IRS section 1446(f)
“This tax is imposed on the gross amount paid and is generally collected by withholding under section 1441 or 1442 on that amount. A payment is considered to have been made whether it is made directly to the beneficial owner or to another person, such as an intermediary, agent, or partnership, for the benefit of the beneficial owner.
Section 1446(a) requires a partnership conducting a trade or business in the United States to withhold tax on a foreign partner’s allocable share of the partnership’s effectively connected taxable income. In addition, section 1446(f) generally requires a transferee of a partnership interest (or a broker in the case of a transfer of a PTP interest) to withhold on the amount realized from the transfer when any portion of the gain from the transfer is treated as effectively connected gain under section 864(c)(8).”
How To Avoid Backup Withholding
Avoiding backup withholding is possible by filing correct information, including a correct taxpayer identification number (TIN) with a legal name that matches, reporting all taxable interest income and dividend income, or as a foreign person, claiming an allowable exemption from backup withholding.
You can avoid or stop backup withholding by correcting the reason for the backup withholding. Report your correct taxpayer identification number (TIN) to the payer. Resolve the underreported income and pay amounts owed. File any missing tax return(s).
Backup Withholding Example
In April 2023, Rebecca Jordan, a payee who resides in San Diego, California, forgets to include $640 in taxable interest income from one 2022 tax year 1099-INT form she received. Rebecca’s life is chaotic, and she’s very disorganized. Rebecca doesn’t respond to four IRS notifications sent to her (within four months) about underreporting interest income. The IRS notifies Rebecca that she’s subject to backup withholding.
In November 2023, Rebecca opened a new brokerage account with Charles Schwab and submitted a W-9 form as one of the documents required to open her account. Because she’s subject to backup withholding per the IRS notification, Becky remembered to scratch out Line 2 in Part II – Certifications section of Form W-9.
Line 2 on Form W-9 is:
“2. I am not subject to backup withholding because: (a) I am exempt from backup withholding, or (b) I have not been notified by the Internal Revenue Service (IRS) that I am subject to backup withholding as a result of a failure to report all interest or dividends, or (c) the IRS has notified me that I am no longer subject to backup withholding”
Form W-9 Certification instructions applying to line 2 state:
“You must cross out item 2 above if you have been notified by the IRS that you are currently subject to backup withholding because you have failed to report all interest and dividends on your tax return. For real estate transactions, item 2 does not apply….”
Charles Schwab reviews the W-9 and sets up backup withholding at 24% on Rebecca’s payments received. On Rebecca Jordan’s Form 1099 for the calendar year 2023 payments, Charles Schwab indicates the amount of Federal income tax withheld (backup withholding) on Line 4. Copies of the 1099 form are distributed to Rebecca Jordan (the payee), the IRS, and to California’s state tax authority.
When Rebecca files her 2023 tax return with the IRS, she reports the backup withholding as federal income tax withheld, which will reduce the amount of income taxes still payable. If she owes less in taxes than the backup withholding of federal income taxes at 24%, Rebecca may be entitled to a backup withholding tax refund.
Importance of Backup Withholding
Backup withholding (federal income tax withheld) is important because it ensures the IRS can collect federal taxes owed. Backup withholding reduces the amount of income paid to any payees subject to backup withholding. To improve global supplier payments, read the white paper.