What Does it Mean to be Exempt from Backup Withholding?

Most taxpayers in the United States are exempt from backup withholding taxes. However, there are a few ways that you can become subject to backup withholding, so it is important to know a little bit about how backup withholding works and what you can do about it if it happens to you.

Investments that May be Subject to Backup Withholding

A variety of different investments may be subject to backup withholding. All of them are reported to the taxpayer and the IRS using different versions of the 1099 Form. These income types include interest, dividends, royalty payments, rent, gambling winnings, and certain other payments. In addition, independent contractors may have to backup withholding on commissions and fees that they receive. Payments from brokers for stock or bond transactions may also be subject to withholding.

W-9 Regulations

The IRS requires backup withholding in specific situations where a taxpayer has accidentally or deliberately made an error in paperwork. This paperwork, IRS Form W-9, is used when an investor opens a new account, makes an investment, or begins to receive payments that are reported on a 1099. The W-9 requires the investor to provide his or her Taxpayer Identification Number (TIN) and certify that he or she is not subject to backup withholding. If the TIN provided matches the TIN the IRS has on record, then the taxpayer is exempt from backup withholding.

When is Backup Withholding Applied?

Backup withholding is applied when an individual does not supply a TIN or supplies the wrong TIN or a TIN that does not match the one in the IRS’s database. Forgetting to certify that they are exempt from backup withholding or falsely certifying that they are exempt from backup withholding will trigger a back withholding order. In addition, if the taxpayer did not report all income from dividends, interest, or other 1099 sources on taxes for the previous year, the IRS may order backup withholding.

Exempt from Backup Withholding

Most United States citizens are exempt from backup withholding, unless they have violated any of the rules outlined above. In addition, if a violation has accidentally occurred, it is usually fairly straightforward to correct it. The IRS sends repeated written notifications to the taxpayer and to the bank or company that is making the payments to warn of a violation and request that it be fixed. This can often be done by providing a corrected TIN or, if the problem is underreporting income, by correcting the error and paying any taxes that are due.

Other Exempt Entities

Besides citizens who have a correct W-9 form, there are other groups that are exempt from backup withholding. These include tax-exempt organizations, partnerships, corporations, companies, or associations that have been created or organized in the U.S. or under U.S. laws. It also includes domestic trusts and domestic estates. These groups must show proof of their status in order to be exempt, so a payee may not be an exempt corporation just because it uses the term “Company” in its name.

Although most people are exempt from backup withholding, it is important to know what it is, why the IRS might order it, and how to stop it so that you can make good investing decisions. Make sure you ask your tax professional or an IRS agent if you have any questions about backup withholding.