What is Backup Withholding Tax?

The backup withholding tax applies to certain kinds of income, most of which is reported on an Internal Revenue Service Form 1099. A variety of factors can cause you to have to pay a backup withholding tax. Knowing what some of these are can help you avoid paying backup withholding on your investments.

The Backup Withholding Tax

Certain kinds of income are subject to the backup withholding tax. This tax is a flat percentage of a payment that is held back by the payer to give to the IRS. The current percentage is 28%. In this way, it is similar to the income tax withholding done on an employee’s paycheck. However, the backup withholding tax only applies to certain kinds of income in a very specific set of circumstances. Only payments that are reported on IRS Form 1099 are subject to this kind of tax.

Payments Subject to Backup Withholding

The backup withholding tax may apply to most payments that are reported on Form 1099. These can include things like interest, dividends, patronage dividends (if at least half of the payment is in money), rents, profits, royalty payments, and certain other payments. It may also apply to payments for work done as an independent contractor, including commissions and fees. Gambling winnings may also be subject to backup withholding. Backup withholding is not always required on any of these payments.

Rules for Withholding

When an investor is making an investment, opening a new account, or beginning to receive payments that are reported on some kind of 1099 form, the business or bank will give them a Form W-9. This is a Request of Taxpayer Identification Number (TIN) and Certification. If the investor does not give the payer his or her TIN or gives the wrong TIN, he or she will be subject to the backup withholding tax. In addition, failing to certify that he or she is not subject to the backup withholding tax or underreporting interest or dividends will trigger a withholding order from the IRS.

Preventing or Stopping Withholding

An investor can prevent the backup withholding tax from being applied to them by making sure that they fill in their correct TIN on the W-9 form. The IRS will send at least 4 notifications that the TIN entered is incorrect and, if the error is corrected, this will usually prevent backup withholding from beginning or stop it from being withheld. However, if the backup withholding is due to underreporting interest or dividends, filing corrected taxes with the IRS and paying any back taxes will prevent backup withholding.

Recouping Backup Withholding Tax Money

The backup withholding tax is like the income tax. This means that if income from investments or other sources has been withheld through the backup withholding rule, it can be credited on the tax return for the year in which the investor received the income. The backup withholding tax is a way to make sure that investors pay taxes on profits on investments and other payments. Withholding in excess of the amount of tax actually owed may be refunded when the rest of the taxes are filed.

The backup withholding tax is designed to make sure that investors pay taxes on certain kinds of investments. If you do make sure that you file all the necessary paperwork and report all of your investment income, you can avoid backup withholding.