Backup Withholding

Backup withholding is a procedure used to ensure that federal income tax is paid on earnings even though the recipient cannot be identified by a Social Security number. Banks, brokers, and other entities report nonwage earnings paid out on IRS Form 1099. When the form cannot be filed because it lacks the taxpayer's Social Security number, 28% (through December 31, 2012) of the interest, dividends, or fees is withheld by the payer and remitted to the federal government.

Definition

Backup withholding is a tax mechanism in the United States designed to ensure that individuals who fail to provide a valid taxpayer identification number (TIN), such as a Social Security Number (SSN), to the payers are still paying taxes on their nonwage income. Incentivizing compliance, the IRS mandates that payers (like banks or brokers) withhold a certain percentage of the payment, typically 24% post-2012 amendments, rising from a previous rate of 28%. The withheld amount must be remitted to the federal government. This withholding requirement is documented on IRS Form 1099, a form used to declare nonwage earnings like interest and dividends.

Examples

  1. Scenario with Interest Payments: A bank pays interest on CDs (Certificates of Deposit) to a customer but does not have the customer’s SSN. The bank would then withhold 24% of the interest payment and submit it to the IRS as backup withholding.

  2. Dividends from Brokerage Accounts: An individual receives dividend payments from their brokerage account but fails to supply a Social Security number. Consequently, the brokerage firm deducts 24% of the dividends for backup withholding.

  3. Freelance Payments: A freelancer is paid by multiple clients totaling more than $600, but neglects to provide an SSN. The clients are required to withhold 24% of the payments for IRS purposes.

Frequently Asked Questions

What triggers backup withholding?

Backup withholding is triggered when a taxpayer fails to provide a correct taxpayer identification number (TIN) or if the IRS notifies the payer that the taxpayer is subject to backup withholding.

What type of income is subject to backup withholding?

Backup withholding generally applies to nonwage income such as interest, dividends, rents, royalties, non-employee compensation, and certain other payments.

How does a payee stop backup withholding?

Once a correct TIN is provided or other corrective actions taken and proper documentation submitted to the IRS, backup withholding can be stopped.

What is IRS Form 1099?

IRS Form 1099 is a series of documents the IRS refers to as “information returns.” Commonly it reports nonwage earnings for taxpayers.

Are there any exceptions to backup withholding?

Yes, exceptions are provided under specific circumstances, such as payments made to corporations, tax-exempt organizations, the United States, a state or local government, or international organizations.

  • TIN (Taxpayer Identification Number): A unique number assigned by the IRS or Social Security Administration used for tax purposes.
  • Form W-9: An IRS form used by taxpayers to confirm their TIN to the entity that will file an information return with the IRS.
  • Nonwage Earnings: Income, other than wages, which includes interest, dividends, rent, royalty, or other income reported on 1099 forms.
  • Withholding Tax: An advance payment on a taxpayer’s income tax liability deducted by the payer and remitted directly to the government.

Online References

  1. IRS Backup Withholding Information
  2. Understanding IRS Form 1099
  3. Federal Backup Withholding Guidelines

Suggested Books for Further Studies

  • “Taxation for Individuals 2021 Edition” by Joseph Bankman, Daniel N. Shaviro, Kirk J. Stark
  • “Individual Income Taxation: An Application Approach” by Marvin A. Chirelstein
  • “Federal Income Taxation, 17th Edition” by Paul R. McDaniel, Martin B. Dickinson, James J. Freeland

Fundamentals of Backup Withholding: Taxation Basics Quiz

### What percentage of payment is generally withheld for backup withholding if a taxpayer fails to provide a TIN? - [ ] 20% - [ ] 25% - [x] 24% - [ ] 28% > **Explanation:** Post-2012 amendments state that 24% of the payment is withheld for backup withholding if a taxpayer fails to provide a TIN. ### Which of the following payments is subject to backup withholding? - [ ] Wage income - [x] Dividend income - [ ] Tax refunds - [ ] Non-taxable benefits > **Explanation:** Dividend income, along with other nonwage incomes like interest, is subject to backup withholding. ### How can a payee stop backup withholding? - [ ] By providing correct personal details - [x] By providing a correct taxpayer identification number (TIN) - [ ] By reporting to the state government - [ ] Through social media declaration > **Explanation:** A correct taxpayer identification number (TIN) must be provided to stop backup withholding. ### Who is responsible for remitting backup withholdings to the IRS? - [ ] The taxpayer - [x] The payer, such as banks or brokers - [ ] The state government - [ ] The Social Security Administration > **Explanation:** Payers, like banks or brokers, are responsible for withholding and remitting the appropriate amount to the IRS. ### What document is used to report nonwage income that may necessitate backup withholding? - [ ] IRS Form W-4 - [ ] IRS Form 1040 - [x] IRS Form 1099 - [ ] IRS Form 940 > **Explanation:** IRS Form 1099 is used to report nonwage income like interest and dividends that may necessitate backup withholding. ### What could trigger backup withholding besides failure to provide a TIN? - [ ] Non-payment of dividends - [ ] Incorrect telephone number - [x] IRS notification of backup withholding status - [ ] Inactive bank account > **Explanation:** Backup withholding can be triggered by an IRS notification indicating that the taxpayer is subject to it. ### Are charitable organizations subject to backup withholding? - [ ] Yes, always - [ ] Only if they receive large payments - [ ] On interest payments only - [x] No, charitable organizations are not subject > **Explanation:** Charitable organizations are typically exempt from backup withholding. ### What is the key IRS form used by taxpayers to confirm their TIN to the payer? - [x] Form W-9 - [ ] Form 1040 - [ ] Form W-2 - [ ] Form 8962 > **Explanation:** IRS Form W9 is used by taxpayers to provide their TIN to the payer. ### Backup withholding applies to which of the following? - [ ] Internal revenue collections - [x] Nonwage income like interest and dividends - [ ] Sales tax - [ ] Unemployment benefits > **Explanation:** Backup withholding applies specifically to nonwage income such as interest and dividends. ### To which entity must the returned amount from backup withholding be remitted? - [ ] State treasury - [ ] Local government - [ ] Federal courts - [x] The IRS > **Explanation:** The withheld amount must be remitted to the IRS.

Thank you for exploring the intricacies of backup withholding with this comprehensive guide and quiz. Aim for excellence in your understanding of taxation!


Wednesday, August 7, 2024

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