Is your income subject to something called backup withholding? If you think you may be in this category, it’s important to understand what to expect.
If you think you can avoid payments to the IRS, think again. The Internal Revenue Service has a plethora of tools to make sure taxes are reported correctly and paid to the government. When they’re not, you can be sure the federal government is devising a plan to secure IRS-claimed money.
How Backup Withholding Works
Are you familiar with backup withholding? If not, then learning about this keeps you and the Internal Revenue Service on the same page, and that’s for your benefit and the government’s benefit as well. You see, backup withholding is one of those government tools used to get what’s rightfully owed to the IRS. It’s a federal taxation method that protects earnings due to the United States government after certain taxes aren’t paid correctly or on time.
A simple way to look at backup withholding is through non-conventional employers. Some employers do not take taxes from income, expecting employees to pay taxes at the end of the year. But in some situations, the IRS requires the employers or other financial institutions, being used by the investor, to withhold 24% of your wages or earnings as a backup withholding. This is just in case you do not pay those taxes. This happens more often than you may think.
This procedure is required under Chapter 61 of the Internal Revenue Code, and this same 24% is taken every year so the IRS always gets their portion of taxes due. Payers must file a Form 945 which reports all backup withholdings for the year. They also have an obligation to report these same backup amounts to the payee as well.
Another Circumstance That Triggers a Backup Withholding
Full-time investors and companies are always earning income, and it’s usually large amounts of money. This could be from dividends, capital gains, and interest payments. While taxes are due on these earnings, it doesn’t come due until it’s time to file taxes – all earnings and payments come due in tax season. Most investors pay taxes when the time comes. But you have those few that do not.
If an investor spends all the money they earned during the year, they have none left to pay taxes on those earnings. When this happens, it’s sometimes incredibly difficult for the IRS to get what’s owed to them. And they give the taxpayer 120 days to settle the situation. Notifications are sent out as well, giving individuals or companies time to rectify the situation.
If the government doesn’t receive their share in taxes, they can set a credit against your next income tax return, simply taking what’s owed to them, or as much as they can. This could mean receiving no refund for years to come.
Because of issues like these, the government thinks ahead. Instead of depending on investors to pay taxes as they should, a backup withholding is levied by financial institutions at the time investors are earning income. The government gets their percentage and investors get what remains.
Three Types of Earnings That Cause Backup Withholding
Not all payments, obviously, must have a percentage taken for tax purposes. Only certain conditions and situations are subject to this backup withholding. These reasons include:
- The failure to report dividend income that’s received
- Under-reporting or not reporting interest payments
- Not providing a (TIN) taxpayer identification number or your social security number for filing purposes.
Am I Subject to Backup Withholding?
Maybe you’re wondering if you’re at risk for backup withholding. Well, that depends on the type of income you’re receiving or have received in the recent past. There are many forms of payment subject to this withholding process such as:
- Any government payments that require a 1099-G
- Rent and other property gains
- All Dividends
- Payments from investments
- Money won from gambling
- Barter and broker exchange payments
- Professional fishing boat operators
- Cash payments of original issue discounts
- Independent contractor’s fees, commissions, payments
- Royalty earnings from sales
- Patronage dividends
- Third-party network exchanges or transactions
- Settled disputes with a law firm
Giving the bank your TIN when you first open a business account will help prevent backup withholding as well. Any earnings or payments that require a Form 1099 will benefit greatly by contacting the bank with this information ahead of time. When it comes to dividends and interest, you must certify that you’re not guilty of under-reporting these types of earnings now and in the past. If so, there’s a good chance of backup withholding on investments and dividends in the near future.
Payments That Are Not Subject to Backup Withholding
Just as there are many types of transactions that are affected by backup withholding, there are also numerous payments that are not. Some Income or payments are simply immune to this type of tax law. Those include:
- Income tax refunds
- Various canceled debts
- Retirement account distributions
- Compensation from Unemployment
- School tuition earnings
- Abandoned or foreclosed properties
- Archer MSA distributions
- Cash payments for fish
- Employee stock plan distributions
- Transactions from Real Estate sales
- Care benefits (long-term)
How to Stop Backup Withholding
It isn’t a complicated procedure to stop backup withholding. The ease of putting a stop to these proceedings depends on why the withholding took place. If you’re aware that this is happening because you didn’t provide a TIN or the correct number, simply report the correct TIN or your social security number to halt the process.
If you’ve neglected to report any portion of your income, then remedy this issue by collecting the remainder of your income statements and send them to the IRS.
If you owe the IRS additional money, paying this debt as soon as possible can stop a backup withholding and stop interest and late fees accrued from the debt, which can add up fast.
If there seems to be a missing return, then file one as the return as soon as possible.
Challenging a Backup Withholding Order
You can also challenge or appeal a backup withholding order from the IRS. You simply ask the Internal Revenue Service to review your case for mistakes or missing information. In rare situations, under-reporting never happened, and it was a mistake on the federal level. Again, this is not a common occurrence.
If you were in the process of filing an amended return, the IRS may consider lifting the backup withholding request from the financial institution that’s retaining 24% of your earnings. In other uncommon situations, the Internal Revenue Service may consider that the backup withholding procedure may cause financial hardship for you or any dependents. In this case, the IRS may stop the withholding for that reason as well.
If you succeed in stopping the backup withholding procedure, the IRS will send you a certificate of proof for the corrected situation. They will simultaneously report this new information to any financial institutions implementing the backup withholding.
At this point, no percentage will be taken from your earnings. Also, if any overpayment of backup withholding was paid to the IRS, you will receive a refund of all earnings due to you. However, you will not receive the refund until you file taxes the next year, as any backup withholdings must be reported on a 1099 form.
If you purposely give the wrong information to dodge a backup withholding, you could be subject to criminal and civil penalties. Civil court fines are usually around $500, but if you are tried in criminal court, you could pay $1,000 in fines or serve a year in prison. Criminal penalties are always worse.
Businesses or payers are also subject to penalties if they do not adhere to the backup withholding request. If the business fails to record the payee’s TIN to retain tax payments for the government, they could face a $24,000 assessment. There could also be additional penalties and interest.
Thinking Ahead to Avoid Backup Withholding
As a taxpayer and a citizen of the United States, it’s important to understand tax laws. The government is required to send an initial warning called the ‘B’ notice. This is your notice to get things in order and rectify the situation before it escalates. This is a prime opportunity to take.
Avoiding backup withholding and penalties is the objective. When you understand laws and penalties, then preparing for paying taxes makes the process much smoother. There are so many tax laws that cover various ways of earning money and collecting profits. Understanding these laws prevents mistakes during the year, and also during tax season.
To better prepare, learn the basic laws pertaining to your line of work or investment. If you do this, everything should fall into place when it’s time to pay or calculate taxes on your return. Or better yet, work with a tax professional to help you calculate your true tax liability. Whether you pay quarterly, or during tax season, just make sure to contribute honestly.
And remember, the government will always retain what’s due to them. And it is your responsibility to make sure you pay your part.