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What Does Backup Withholding Mean?

Nearly everyone is required to file income taxes each year. There are a few reasons you might not need to file a return, but these circumstances are typically pretty rare and only apply to a select few Americans. 

Depending on your specific financial situation, filing your taxes correctly can be challenging and might require additional help from tax experts. It’s important to file your taxes correctly because the IRS could access penalties and interest. 

The IRS has a wide variety of options at its disposal to address the situation. One such option would be to employ a backup withholding tax on your income. 

What Is Backup Withholding?

Backup withholding is a specific type of federal tax applied to someone’s income that might not typically require any withholding under normal circumstances. 

The IRS most commonly uses this tax on individuals who have failed to correctly report their incomes in the past. As a result, the IRS will apply a flat tax rate percentage withheld from businesses or financial institutions for each transfer. 

The tax rate used to be 28% until the Tax Cuts and Jobs Act (TCJA)  was signed into law in 2017. When it took effect in 2018, the TCJA reduced the flat tax rate to 24%, and it remains this percentage today. 

A backup withholding tax is not a fine, fee, or penalty, and it’s not meant to take any more taxes from you than you would typically pay. It’s simply a precaution to make sure that you are paying an accurate percentage of your taxes. 

Because you will be paying taxes on your income throughout the year, you will most likely not owe any additional money when you file your annual tax return. You may even be eligible for a tax refund. 

Why Is Backup Withholding Used?

The IRS typically employs a backup withholding tax on individuals who have made specific mistakes on their tax returns. Sometimes these are nothing more than mistakes, but sometimes they are intentional.

Regardless of the intent, the IRS might apply a backup withholding tax if any of the following are true:

  • You have previously under-reported income, interest payments, or dividends on tax returns. The IRS will generally issue several warnings first as an attempt to avoid backup withholding being used.
  • The taxpayer identification number (TIN) that was provided to the payer was incorrect. You will most likely use your Social Security number (SSN) as your TIN, and the IRS will notify you of any discrepancies before applying a backup withholding tax.

What Types of Income Does Backup Withholding Affect?

Not every type of income is eligible for a backup withholding tax. For example, if you have a job where you file W-2 tax returns, you most likely have a payroll withholding tax. This tax means that your employer will withhold a certain amount of your taxes from every check sent to the IRS to cover your taxes. 

That’s not the same process if you have a job that comes with a 1099 tax return. This type of income will not be taxed during the transfer, and it will be up to you to pay the appropriate taxes whenever you file your annual tax return. If you fail to do so correctly, the IRS might use a backup withholding tax to ensure they are being paid their share of taxes. 

These are a few examples of the types of income that would fall under a 1099 tax return:

  • Commissions or fees paid to an independent contractor or freelancer
  • Interest payments from financial accounts
  • Dividends from shareholdings 
  • Rent payments received from tenants
  • Gambling winnings, prizes, or awards
  • Royalty payments
  • Payments from stockbrokers from exchanges 

Can You Get Backup Withholding Back?

A backup withholding tax is merely a precaution, and the IRS will only keep what you owe. It’s simply a backup plan to ensure that you pay at least a part of your share of taxes. 

A backup withholding tax operates similarly to a payroll withholding tax. Once you have reached the correct payment for your annual taxes, any additional taxes you have overpaid will be refunded to you unless you owe back tax liability for any other prior years. 

It’s important to note that even if you do receive a refund, you might still not be in good standing with the IRS, and the backup withholding tax may continue into the next year. A backup withholding tax can be used in perpetuity if the IRS has reasons to believe that you might be under-reporting your income, underpaying your taxes, or continuously owing taxes every year and not paying. 

The IRS will not remove the backup withholding order unless you reach out to the IRS to resolve the issue and have the tax withholding order lifted.   

How Can You Stop Backup Withholding?

The solution to getting the IRS to stop using a backup tax withholding order will depend on their reason for using it.

The mistake may have happened while filling out your information on Form W-9. These forms are officially titled: Request for Taxpayer Identification Number and Certification and are used by individuals and businesses alike. They will be filled out with accurate and up-to-date information and sent to other individuals, clients, and financial institutions in return for a Form 1099. 

If you didn’t provide an accurate taxpayer identification number/Social Security number, the IRS might issue a  backup withholding tax. Simply fixing the mistake should be enough for the IRS to remove the levy and allow it to remove the backup withholding. 

If it’s related to previously unreported (or under-reported) income, then it can be a little more difficult to fix. Once the IRS has noticed potential irregularities between your returns and their records, they will send four separate notices over 210 days. Unless the issue is resolved, these notices will serve as warnings of impending backup withholding being applied to your income. 

Suppose you have received these notices or are already being subjected to backup withholding. In that case, it might be wise to consult with a tax professional for advice on quickly resolving the situation. They will help you to establish one of the four acceptable circumstances for preventing or ceasing backup withholding:

  • You accurately reported income, interest, or dividends earned on your returns, and the IRS records are wrong.
  • You have a pending review of the alleged under-reporting, and the issue has not yet been sufficiently resolved. 
  • A backup withholding tax will create a financial hardship for you, and you won’t under-report in the future.
  • You filed an updated return that correctly lists all incomes and paid all taxes, penalties, and interest that was due, but the backup withholding is still being applied. 

You must be truthful whenever you are dealing with the IRS and attempting to stop the backup withholding. This backup tax withholding isn’t the worst thing, but lying can be worse and lead to much more severe consequences. 

If you are caught providing false information to avoid backup withholding, it could result in a civil penalty in the form of a $500 fine. If you are convicted of lying in a criminal court case, it could result in a $1,000 fine, a year in prison, or both. 

What Happens If You Don’t Resolve Backup Withholding?

It’s important to resolve whatever issue led to you being subjected to a backup withholding as soon as possible. When the IRS levies a backup withholding tax against you, it’s often just the beginning of their actions. 

The tax is just a precaution to ensure that your future income will be taxed in the appropriate amount. However, that doesn’t mean the IRS is willing to forgive previous income being taxed insufficiently. 

Interest will start to accrue on any unpaid balance that you owe to the IRS. The interest will compound daily from the due date of the return until the balance is paid in full. Typically the failure to pay the penalty will equal 0.5% for every month that the taxes are not paid, which caps at 25%. 

If you have still not resolved your tax issue, the IRS might impose liens and levies against your assets that could potentially result in forfeiture. Although extremely unlikely, depending on the circumstances, it’s possible that the IRS might even take your case to a criminal court on charges of tax evasion.  

The Takeaway

Backup withholding tax is a precautionary measure employed by the IRS to make sure that you are paying at least some of your income taxes. The tax is usually applied due to a simple mistake with your taxpayer identification number or a miscalculation during your tax returns. 

Whatever the issue may be that triggered the IRS to pursue a backup withholding, it’s important that you resolve it as soon as possible. Owing money to the IRS can lead to a whole host of financial penalties and fees and could even end up with jail time. 

If you are being subjected to a backup withholding tax or have received notices from the IRS that warn of an impending tax, you should resolve the issue immediately. Talking with a tax expert at Coast One Tax Group can help you understand why you are in this situation and how you can get out of it as easily as possible. 

Sources:

Form W-9 | Internal Revenue Service 

Do I Need to File an Income Tax Return Every Year? | Investopedia 

For Small Business Week: Backup Withholding Rate Now 24 Percent | Internal Revenue Service

Backup Withholding Definition | Investopedia.

Backup Withholding: What Is It? | The Balance

Payroll Tax Definition: Overview & Examples | Investopedia

Collection Procedural Questions 3 | Internal Revenue Service