Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Backup Withholding

What it is:

Backup withholding is a way for the Internal Revenue Service to withhold taxes from a taxpayer who does not provide or have a taxpayer identification number or Social Security number.

How it works (Example):

In general, the employer or entity that is making payments to the payee must withhold a percentage in federal income taxes (about 28%) from their payments. The employer must then remit this withheld amount to the Internal Revenue Service, pursuant to Section 3406(b) of the Internal Revenue Code.

The working relationship does not have to be strictly employer/employee for backup holding to apply, however. An independent contractor, freelancer, broker, landlord, or anyone receiving royalties, gambling winnings, interest, or dividends (that is, people receiving 1099 forms) may also find that the entities making payments to them are required to obtain backup withholding. There are exceptions. For example, real estate transactions, foreclosures, abandonments and canceled debts are not subject to backup withholding.

The IRS makes this notification via a CP2100 or CP2100A Notice. The notice includes documents attributable to the taxpayer that have errors (i.e., the Social Security number or other information that doesn’t match IRS records), and it informs the recipient the IRS will begin backup withholding.

Why it Matters:

When a person becomes an employee of or does business with another entity, the entity typically gives that person a Form W-9, Request for Taxpayer Identification Number and Certification. The person must enter a taxpayer identification number (usually a Social Security number) on the form and certify that the number is correct.

Most taxpayers are exempt from backup withholding if they properly report their names and social security numbers to the payer (using a Form W-9) and that information matches IRS records. However, if the taxpayer’s name and social security number do not match IRS records, or the taxpayer owes federal income taxes, or the IRS discovers that the taxpayer has not reported all of his income on his tax return, the IRS will typically notify the taxpayer that he or she is required to have backup withholding.