What is Backup Withholding?
Backup withholding means the withholding of tax on investments by investee which may be required for several reasons that include cases when payer or investor fails to provide correct tax identification number to investee .
It is the method adopted by the IRS to make sure that investors pay the tax on the income from investments made by them. Investee organization has the responsibility to deduct the tax from income and remitted the same to the government when an investor fails to pay or declare the income. Some payments which are subject to backup withholding are interest income, dividends, and rents, etc. the investor gets the credit of tax while calculating personal income tax. The rate of tax at which tax can be deducted are pre-determined rates and may vary as per the nature of income. There is the nature of incomes that are specifically defined and covered under these rules and also the incomes which are excluded.
- The basic purpose behind it is to prevent revenue loss of the government.
- Also, its purpose is to motivate the investors to declare all income from investments if they want to prevent backup withholding tax.
- It also ensures that proper and correct taxes are paid by cross-checking of correct taxes and income. As per this concept, employers are always required to file a form with IRS, and the IRS cross verifies the information and tax deduction number so that it can ensure that proper and correct income is reported.
How Does Backup Withholding Work?
- Every employer or other specified person has to give information to the IRS in a specified form of the amount they pay to employees or investees as the case may be. IRS then verifies the information with the information contained in the return of employee or Investee and IRS also verifies Tax Identification Number of both the parties cross verified with each other. If the information doesn’t match, then IRS sends the notice to the investor or employee that IRS will begin the backup withholding proceedings.
- If an employee or investor does not provide correct information, then the payer at the instructions of the IRS is required to withhold the tax at the specified rate at present, which is 24%. Payers might also be required to withhold if the IRS informs them that the payee has misreported the income, and the taxpayer will be informed about tax withholding. The IRS will do this only after it has mailed payee four notices over at least 120 days. And finally, the employer or Investee to withholds the tax from the payments due to employee or investor at the specified rates and then remit the same to the IRS or federal or state governments.
Let’s take an example.
Mr. Raja has a monthly salary of $200,000, and subject to rules covered under backup withholding and his employer deducts the amount of $ 15,000 every month as backup withholding tax, contributions to PF and other deductions, etc. and remits $2000 every month to state and federal government on behalf of Mr. Raja. And now both Mr. Raja and Employer have to give information about salary, the amount deducted, etc. to the federal and state government and this information goes to IRS. And IRS cross-verifies the information provided by Raja and Employer if mismatch noticed then notice regarding clarification to be sent to both Raja and employer, and accordingly IRS will initiate with other proceedings.
Backup withholding applies to income like, for example. Interest, dividends, salary, commission, contract income, royalty, winnings from lotteries, gambling income, etc. and payments that are not subject to mandatory withholding are real estate transactions, retirement account distribution, self-employment incomes, etc.
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Investees or employees will get the credit of the tax deducted under backup withholding rules. Investor or employee may be subject to these rules, and the payer must withhold at a flat 24% rate when:
- Investors or Employees don’t give the payer his/her TIN.
- The IRS notifies the payer that the TIN you gave is incorrect or mismatches.
- The IRS notifies the payer to start withholding on interest or dividends because the payee has underreported in an income tax return. The IRS will do this only after it has mailed payee four notices over at least 120 days.
- Payee fails to certify that they are not subject to backup withholding for underreporting of income.
How to Prevent Backup Withholding?
- Providing correct information to the IRS like providing correct TIN;
- By resolving the underreported income by paying the amount owed;
Give proper explanation if the notice receiver doesn’t agree with the notice or liability with evidence.
When is Backup Withholding Required?
When the receiver of notice i.e., employee or investor fails to provide information even after receiving 4 emails from IRS within 120 day period, the IRS will directs the payer to withhold the tax from the amount due to payer and remit the same to a state-federal corporation or state government and inform the same to IRS.
It is the concept of withholding the tax by the payer from the amount due to them of payee and remit the same to the state government or federal corporation on the instructions of the IRS. There are some pre-defined incomes which are subject to backup withholding and if the information provided by payer and payee mismatches then IRS will send the notice to both asking for clarification and if the payer fails to provide information even after notices and warnings from IRS it directs the payee to withhold the tax at the specified rate and remit the same. One can prevent this tax by paying the amount owed and providing correct information.
This has been a guide to what is Backup Withholding and its meaning. Here we discuss how does backup withholding works along with examples and purpose. You can learn more about financing from the following articles –