What is Backup Withholding?
Backup withholding refers to the withholding of a certain percentage of the investment income earned by an investor. Many reasons could trigger backup withholding as it is a method used by a tax body like the Internal Revenue Service (IRS) to receive taxes.
For instance, when an investor fails to provide the correct tax identification number (TIN) to the authorities, it may lead to a withholding case.
- Backup withholding refers to the withholding of a certain percentage of the investment income earned by an investor.
- Many reasons could trigger backup withholding as it is a method used by a tax body like the Internal Revenue Service (IRS) to receive taxes.
- For instance, when an investor fails to provide the correct tax identification number (TIN) to the authorities, it may lead to a withholding case.
Understanding the Meaning of Backup Withholding
If you are wondering what this concept involves, we got you covered! Simply speaking, backup withholding occurs when the authorities do not pay a certain amount of investment income to an investor.
What causes such a withholding?
We have already mentioned that a missing TIN makes an individual liable for withholding deductions. But two critical reasons could also lead to such withholding. They are listed below.
- Investors usually earn investment income in the form of interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. , dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company., and rents, etc. The tax on such income is usually not charged at the time of their payment.
- What will happen if the investors spend all of their investment income in expenses before the taxes are deducted from them?
- Then there are times when investors forget to declare that they have earned an investment income.
How will a tax body collect taxes in such cases? That is why entities like IRS instructs financial institutions to deduct a certain amount of tax from the investment income when an investor fails to pay or declare the income. The deducted amount is remitted to the government.
- The primary purpose is that it prevents the revenue loss of the government.
- In addition, it motivates investors to declare all the income earned from investments.
- It also ensures that the correct amount of tax is received from the taxpayers. For this, the IRS employs a cross-verification approach.
How Does Backup Withholding Work?
Let us take you through a detailed explanation of how this works.
- So, how exactly does IRS ensure that the correct amount of tax is received from the taxpayers? Simple, it employs a sort of cross-verification approach.
- In this approach, employers and financial bodies are required to file a special form with the IRS. The form specifies the amount of money they have paid to the employees and investors respectively.
- On the other hand, the employees or investors declare their earned income and taxes deducted while filing their tax returns.
- IRS checks if the TIN provided by them is the same as those given by employers and financial institutions.
- After that, the IRS does some further cross-verification. Based on the tax data received from taxpayers/investors and employers/financial institutions, the IRS looks for any discrepancies.
- If the information fails to match, then the IRS sends the notice to investor/employee or employee/financial institution that it will be initiating the backup withholding proceedings.
- It is important to note that the rate of backup withholding tax are pre-determined and may vary as per the nature of the income. The rate is currently 24%.
- The tax provision contains all the rules, types of income to be taxed, and the income that is excluded from taxation.
- The IRS will undertake backup withholding only after sending four notices to the payee within 120 days.
- After this stage, the employer or the financial institution will need to deduct the tax from any future payments made to the employee or the investor.
- After deduction, they will be required to remit the collected tax to a state-federal corporation or a state government and inform the IRS.
We have put together an example to help explain the concept more practically.
George has a monthly salary of $200,000. The deductions made by his employer are as follows.
- Backup withholding tax
- Contributions to PF
- Other deductions
The sum of three comes to $15,000 every month. The employer remits $2000 every month to the state and federal government on behalf of him. George and his employer declare the information about the salary, earning and the deducted amount in the income tax form. This information is sent to the IRS.
While cross-verifying, the IRS notices a mismatch and initiates a proceeding.
Income covered under the backup withholding
It applies to income like interest, dividends, salary, commission, contract income, royalty, winnings from lotteries, gambling income, etc. The exempted income not subjected to withholding are real estate transactions, retirement account distribution, self-employment incomes, etc.
How to Prevent it?
This part of the article will explain any possible exemption or way out of backup withholding.
- It can be prevented if a payee specifies that they are not subjected to deductions for underreporting of income in the current fiscal.
- Providing IRS with correct information like correct TIN will surely prevent such an action.
- It can also be prevented by paying the amount owed when the income has been underreported.
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 –