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Backup withholding

Backup withholding is a tax term that it pays to understand. Bankrate explains it.

What is backup withholding?

Backup withholding provides a way for the IRS to make sure it receives the taxes owed on any investment income you make. Normally, tax on investment income is due once a year, during tax season. Sometimes the government requires financial institutions to withhold 28 percent of certain investment income payments.

Deeper definition

The IRS requires backup withholding when you fail to provide the correct taxpayer identification number to the bank or if you fail to report any income from interest, dividends or patronage dividend income. Certain other payments might require backup withholding, as well. These usually include income reported on a Form 1099 and include:

  • Commissions, fees and other payments for work as an independent contractor.
  • Dividends
  • Interest payments.
  • Patronage dividends where at least half of the payment is in cash.
  • Payments by brokers, including barter exchange transactions.
  • Payments by fishing boat operators, but only cash received as a share of the catch.
  • Payment card or other third-party network transactions.
  • Rents, profits, or other income.
  • Royalty payments.

In order to stop backup withholding by a financial institution, you need to rectify the situation that triggered it. This includes providing the correct taxpayer ID number to the financial institution, paying any taxes owed for under-reported income, and filing any missing paperwork, as needed.

You can also repeal a ruling for backup withholding by a financial institution. The request to the IRS to review your case must show that either no under-reporting occurred, any backup withholding could cause an undue hardship, the IRS was wrong about you under-reporting, or you have corrected any under-reporting by filing the required return or an amended return.

If successful, the IRS should provide you with a certification showing you have corrected the situation and notify the particular financial institutions.

Examples of backup withholding

Most often, backup withholding is triggered when you:

  • Fail to give the financial institution your taxpayer ID number.
  • The IRS notifies the financial institution that the taxpayer ID number you gave is wrong.
  • The IRS reported to the financial institution that you under-reported income from interest or dividends on your tax return.
  • You fail to provide certification that you are not subject to backup withholding for previously under-reporting income from interest or dividends to the IRS.

The financial institution that takes out the backup withholding reports the amount to you and the IRS using a Form 1099. In turn, when you file your taxes for the year, you report the amount withheld on your tax return.

If you give false information in attempt to avoid backup withholding, you could face civil and criminal penalties. The civil penalty for lying to avoid backup payment is usually a fine of $500. If convicted in criminal court, the penalties are much steeper. You could face a fine of up to $1,000 or face imprisonment for up to one year, or both.

Use our calculator to determine which tax bracket you are in. 

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