What is Backup Withholding ? Who are Exempt from it?

What is backup withholding?  is a good and common question for many. It is nothing but the tax deduction at source by the payer off certain kinds of payments. Under the Internal Revenue Code, persons making certain payments are required to pay only after withholding to 28% of such payments and depositing with IRS. This is the action of tax deduction at source by the payer is called “backup withholding.”

What Payments Subject to Backup Withholding

Payments that may be subject to backup withholding include

1. interest,
2. tax-exempt interest,
3. dividends,
4. broker and
5. barter exchange transactions,
6. rents,
7. royalties,
8. nonemployee pay,
9. payments made in settlement of payment card and third party network transactions, and
10. certain payments from fishing boat operators.

How to prevent backup withholding?

Let us understand what makes it certain that the payments you receive will be subject to backup withholding. As per the IRS rule, in following conditions backup withholding is compulsory by the payer if:

1. You do not furnish your TIN to the requester,
2. You do not certify your TIN when required (see the instructions for Part II for details),
3.  The IRS tells the requester that you furnished an incorrect TIN,
4. You do not certify to the requester that you are not subject to backup withholding under 4 above (for reportable interest and dividend accounts opened after 1983 only).
5.  If you do not report all your taxable interest and dividends on your tax return, IRS may notify you for backup withholding on payments of taxable interest and dividends.

Therefore, if you give the requester your correct TIN, make the proper certifications, and Are You exempt from tax withholding?

Are you as a payee exempt from withholding?

Under the US Tax 26 , certain payees and payments are exempt from backup withholding. If you fall under any of the following List – 1, you are exempt from backup withholding from  list given in (List 2)

List -1 – Payees Exempt

1. An organization exempt from tax under section 501(a), any IRA, or a custodial account under section 403(b)(7) if the account satisfies the requirements of section 401(f)(2)
2. The United States or any of its agencies or instrumentalities
3. A state, the District of Columbia, a U.S. commonwealth or possession, or any of their political subdivisions or instrumentalities
4. A foreign government or any of its political subdivisions, agencies, or instrumentalities
5. A corporation
6. A dealer in securities or commodities required to register in the United States, the District of Columbia, or a U.S. commonwealth or possession
7. A futures commission merchant registered with the Commodity Futures Trading Commission
8. A real estate investment trust
9. An entity registered at all times during the tax year under the Investment Company Act of 1940
10. A common trust fund operated by a bank under section 584(a)
11. A financial institution
12. A middleman known in the investment community as a nominee or custodian
13. A trust exempt from tax under section 664 or described in section 4947

Form W-9 (Rev. 11-2017) Page 4

List -2 Types of Payments Exempt from Tax Withholding?

The following types of payments that may be exempt from backup withholding. The chart applies to the exempt payees listed above, 1 through 13.
IF the payment is for . . .

1. Interest and dividend payments – All exempt payees except for 7
2. Broker transactions Exempt payees 1 through 4 and 6 through 11 and all C corporations. S corporations must not enter an exempt payee code because they are exempt only for sales of noncovered securities acquired prior to 2012.
3. Barter exchange transactions and patronage dividends Exempt payees 1 through 4
4. Payments over $600 required to be reported and
5. direct sales over $5,0001 Generally, exempt payees 1 through 5
6. Payments made in settlement of payment card or third party network transactions
   Exempt payees 1 through 4

See Form 1099-MISC, Miscellaneous Income, and its instructions.

Exception to List- 2

The following payments made to a corporation and reportable on Form 1099-MISC are not exempt from backup withholding:

• medical and health care payments,
• attorneys’ fees,
• gross proceeds paid to an attorney reportable under section 6045(f), and
• payments for services paid by a federal executive agency.

IRS Backup Withholding B-Notice & C-Notices . What are they and how to deal with it?

When IRS finds some error or mismatch in the data that you filed with them , they send you notices CP2100 or CP2100A Notice. IRS sends you a “B” notice stating that the non-employee’s taxpayer ID number is either missing or incorrect. When you receive the first IRS notice, you must continue withholding of tax until you are informed by the IRS to stop it. Here are some actions necessary on your part :

1. First, send a copy of the “B” notice to the individual and ask them to sign a new W-9 form.
2. If the IRS says the taxpayer ID is missing, immediately start withholding taxes at the rate of 24% from that non-employees pay, no later than 30 days after you receive the notice.
3. If you receive a new W-9 form from the person, you can stop backup withholding .
4. If you do not find the taxpayer or the taxpayer refuses to provide you a correct Form W-9, or the person ignores your intimations , you must start backup withholding from the payments made to that person.

What is a Second B-Notice

In this case , an employer does not need to take any action and continue to withhold income tax from the taxpayer’s payments until you receive a new W-9 form from the individual.The second B notice is meant for the individual taxpayer . It tells hm/her to contact the IRS or Social Security Administration to obtain a correct Taxpayer ID Number.

What Is a Backup Withholding C-Notice

IRS sends a backup withholding notice “C” when it finds that the non-employee has understated income and is subject to backup withholding. Therefore ,once you receive C-notice , you should :

1. Immediately start withholding taxes at the rate of 24% (effective 2018 and beyond) from that non-employee’s pay, no later than 30 days after you receive the notice
2. Send or give a copy of the “C” notice to the individual.

When in doubt as to what to do, always start backup withholding on payment made to an individual (at the current rate of 24%). Let the taxpayer sort out the taxpayer ID problem with the IRS.

How to Report and Pay Backup Withholding to the IRS

 When you withhold backup withholding from a person’s income, you must pay IRS payments separately, using electronic funds transfer (EFT) as under: 

• If withholding payments is less than $2,500 for the year, you may make payments along with the annual report form (IRS Form 945) .
• If the total is more than $2,500, use either the semi-weekly or the monthly schedule. 

Remember , the back up withholding tax is not related to employee, so it should not be included with those for an employee to determine which schedule to use.

How to Report Backup Withholding Payments 

Use Form 945, Annual Return of Withheld Federal Income Tax for reporting backup withholdings.  Form 945 is due by January 31 of the year after the tax year. See the Instructions for Form 945 for more information. It is also important that you provide Form 1099-MISC that shows the total backup withholding payments for that person and also file it with the IRS by January 31 of the following year.