You may have encountered backup withholding If you’ve ever received a tax form showing money withheld from your investment income or freelance payments. It may sound complicated, but it isn’t really. Backup withholding is simply the IRS’s way of ensuring it collects taxes on certain types of income before you have a chance to spend it.
To avoid unexpected tax complications and ensure you’re meeting all your obligations to the IRS, a lesson in what is backup withholding tax is necessary. Buckle up.
What Is Backup Withholding Tax?
Backup withholding is a federal tax deducted from certain types of income at the time of payment. Currently set at 24%, this withholding is an insurance policy for the IRS, and it’s how they receive taxes owed on income that might otherwise go unreported or unpaid.
Unlike regular income tax withholding from your paycheck, backup withholding typically applies to investment income and payments to independent contractors. The IRS requires payers such as banks, brokerage firms, or clients to withhold this tax before releasing funds to you.
Why Does Backup Withholding Exist?
The IRS implemented backup withholding to address a specific problem: taxpayers earning investment income throughout the year but potentially spending it all before tax season arrives. Without any withholding mechanism, some taxpayers would find themselves unable to pay their tax bills when April rolled around.
A freelance consultant who earns $40,000 in 1099 income throughout the year might, for example, spend that entire amount on living expenses, only to face a $10,000 tax bill they can no longer afford. Backup withholding prevents this scenario by collecting taxes upfront.
Common Situations That Trigger Backup Withholding
Aside from those we’ve covered (investment incomes and freelance payments), you may be subject to backup withholding in several other situations:
Missing or Incorrect Taxpayer Identification Number (TIN)
If you fail to provide your Social Security number or provide an incorrect one to a payer, they’re required to withhold 24% from your payments.
A gig worker who forgets to submit Form W-9 to a new client, for example, should see automatic backup withholding on their payments until they provide the correct information.
Underreporting Income
The IRS will notify payers to begin backup withholding if you’ve underreported interest or dividend income (meaning you earned it but didn’t report it on your tax return) on previous tax returns. For example, the IRS notice for backup withholding may get triggered if your bank says you earned $5,000 in interest, but you only reported $3,00.
The IRS sends you four notices over 120 days, warning about any discrepancy discovered. If you don’t respond or correct the issue, backup withholding begins automatically.
If you ignore all four notices or don’t resolve the issue within that timeframe, the IRS then notifies your payers (banks, brokers, clients, etc.) that they must begin withholding 24% from your future payments. The word “automatically” means it happens without any further action from you. The IRS simply tells your payers to start withholding, and they’re legally required to comply.
IRS Notification
Sometimes the IRS directly informs payers that you’re subject to mandatory backup withholding due to tax compliance issues. This can happen when there’s a history of underreporting or failure to file returns.
Types of Income Subject to Backup Withholding Tax
Backup withholding applies to various income types, including:
- Interest payments from banks and other financial institutions
- Dividend payments from stocks and mutual funds
- Freelance and contractor payments reportable on Form 1099-NEC
- Rental income payments
- Royalty payments
- Broker proceeds from securities transactions
- Certain gambling winnings
- Patronage dividends from cooperatives
Some income types are exempt from backup withholding, notably retirement account distributions and unemployment compensation.
How Backup Withholding Works in Practice
When backup withholding applies, the process is straightforward. The payer deducts 24% from your payment and sends it directly to the IRS on your behalf.
A freelance graphic designer billing a client $5,000 would receive only $3,800 if subject to backup withholding, with the remaining $1,200 sent to the IRS. This withheld amount isn’t actually lost money. It goes toward settling your annual tax liability for when you file your return. If the withholding exceeds what you owe, you’ll receive a refund.
Who Is Exempt from Backup Withholding?
Most U.S. citizens and resident aliens are exempt from backup withholding if they:
- Provide their correct name and Social Security number on Form W-9
- Have not been notified by the IRS about underreporting income
- Certify they’re not subject to backup withholding
- Provide accurate information that matches IRS records
Certain entities, including corporations and tax-exempt organizations, are also typically exempt.
Resolving Backup Withholding Issues
Where you’re subject to backup withholding due to missing or incorrect information
Resolve it quickly by providing the correct tax identification number (TIN) to your payer. Once they verify your information with the IRS, backup withholding should stop.
Where you’re subject to backup withholding because of underreported income
The process is more complex here. You’ll first need to address the underlying tax compliance issue, which may involve filing amended returns, paying back taxes, or working through IRS notices.
The Financial Impact of Backup Withholding
Backup withholding helps the IRS for sure, but it can create cash flow challenges if you’re in a specific situation. Having 24% of your income withheld means less money available for immediate expenses or investment opportunities. For self-employed individuals or those relying on investment income, this reduction in available cash can strain budgets.
The silver lining is that backup withholding counts as a tax payment. When you file your return, the withheld amount reduces your tax bill or increases your refund.
How CuraDebt Can Help with Tax Compliance Issues
Tax complications don’t end with backup withholding. If you have tax debt because of backup withholding due to underreported income, unfiled returns, or other tax debt issues, you may require professional assistance.
CuraDebt specializes in helping individuals and businesses resolve complex tax situations. With over 24 years of experience, we work directly with the IRS to address issues like:
- Filing back taxes that triggered backup withholding
- Negotiating penalty abatements for late filing or payment
- Setting up installment agreements for manageable tax payments
- Resolving outstanding tax debt through Offers in Compromise
- Addressing audit assessments and disputed liabilities
Our team understands that tax problems often stem from circumstances beyond your control. So we create plans tailored to your specific situation, helping you regain control of your finances while ensuring IRS compliance.
If backup withholding has revealed tax debt you can’t afford to pay immediately, don’t wait for penalties and interest to increase. A free consultation can help you understand your options and create a path forward.
Frequently Asked Questions
Is backup withholding the same as regular tax withholding?
No. Regular withholding applies to wages and salaries based on your W-4 elections. Backup withholding is a flat 24% rate that applies to specific types of income, typically when there’s a compliance issue or missing taxpayer information.
Can I get backup withholding refunded?
Yes. Backup withholding is credited against your total tax liability when you file your return. If the withheld amount exceeds what you owe, you’ll receive a refund. If it’s less than you owe, you’ll need to pay the difference.
How do I stop backup withholding?
For withholding due to missing information, provide your correct TIN using Form W-9.
For withholding due to underreported income, you can, through expert help, resolve the underlying compliance issue with the IRS.
What happens if I ignore backup withholding notices?
Bad idea. Ignoring IRS backup withholding notices won’t make the problem disappear. The withholding will continue, and underlying tax issues may escalate to tax debt that’s beyond control. If you need help addressing a backup withholding tax notice, head over to this link to talk to a CuraDebt expert for free.
Does backup withholding apply to all types of income?
No. Backup withholding primarily affects investment income, freelance payments, and certain other payment types. Wages from employment, retirement distributions, and unemployment compensation are generally exempt.
