What is 'Backup Withholding'

A backup withholding is a tax that is levied on investment income, at an established tax rate, as the investor withdraws it. Backup withholding helps to ensure that government tax-collecting agencies (such as the IRS or Canada Revenue Agency) will be able to receive income taxes owed to them from investors' earnings.

Backup withholding may be applied when an investor has not met rules regarding taxpayer identification numbers (TIN). At the time the investor withdraws his or her investment income, the amount mandated by the backup withholding tax is remitted to the government, providing the tax-collecting body with the required funds immediately, but leaving the investor with less short-term cash flow.

BREAKING DOWN 'Backup Withholding'

Investors commonly earn income – for example, interest payments, dividends, capital gains – from assets in which they have invested. While this income is taxable at the time it is received, the taxes owed on any calendar year's worth of investment income only come due once every year, during tax season.

Thus, investors could potentially spend all of their investment income before the annual income taxes come due. This could render them unable to pay taxes, leaving the IRS with the difficult and expensive job of collecting the taxes owed. It is primarily this risk that motivates the government to sometimes require backup withholding taxes to be levied by financial institutions at the time investment income is earned.

Ways Backup Withholding Is Triggered

Taxpayers may also be subject to backup withholding if they did not provide the correct TIN or if they did not report dividend, interest, or patronage dividend income to the IRS.

Other types of payments also subject to backup withholding include rents, royalty payments, profits, commissions, fees, and other payment for work as an independent contractor. Gambling winnings may also be subject to backup withholding if they were not subject to standard gambling withholding.

If a contractor or investor does not provide the correct TIN to receive payments that are reportable on Form 1099, the payer is required to withhold at a rate of 24 percent. Payers might also be required to withhold at that rate if the IRS informs them the payee underreported interest or dividends on their income tax return. In such an instance, the tax filer will be notified four times over a 120-day period of the issue and the intent to institute backup withholding.

If a tax filer's 1099 indicates backup withholding, that amount can be applied as credit against an income tax filing for that year.

RELATED TERMS
  1. IRS Publication 515

    A document published by the Internal Revenue Service that provides ...
  2. Retention Tax

    A retention tax is any tax withheld from an employee's paycheck ...
  3. Excess Employer Withholding

    Excess Employer Withholding is extra money that has been withheld ...
  4. IRS Publication 15 - Employer's ...

    The IRS Publication 15- Employer’s Tax Guide is published by ...
  5. W-4 Form

    A form completed by employees to tell employers their tax situation ...
  6. Withholding Allowance

    Withholding allowance refers to an exemption that reduces how ...
Related Articles
  1. Taxes

    Understanding The U.S. Tax Withholding System

    Understanding the origins of our tax withholding system is crucial to getting the most out of it.
  2. Taxes

    Filling out the W-9 form

    Freelancers and independent contractors have to fill out a W-9 for their employers and clients. Here's what to do and how to fill out the form.
  3. Taxes

    The Purpose Of The IRS W-4 Form

    Why do you need to fill out a W-4 form and what does the IRS do with it?
  4. Taxes

    How to Reduce Next Year's Tax Bill

    There are several things you can do throughout the year to lower your tax bill.
  5. Taxes

    How to Fill Out Your W-4 Form

    Your step-by-step guide to making sure your employer reports your tax withholding correctly to the IRS.
  6. Taxes

    Small Business Tax Obligations: Payroll Taxes

    Don't leave it up to your accountant - owners are ultimately responsible for fulfilling tax obligations.
  7. Taxes

    The Impact Of U.S. Corporate Taxation On Investment Decisions And CFC Transfer Pricing

    To avoid taxation, businesses do careful tax planning, taking into consideration more than one country's taxation system.
  8. Taxes

    How to Owe Nothing on Your Federal Tax Return

    You have the control to determine whether you owe in April. Learn how to owe nothing on your federal tax return.
  9. Taxes

    Have Household Help? Don't Get In Tax Trouble

    Hiring household workers can be a complicated process. Know what the government requires so you can prevent penalties and problems down the road.
  10. Taxes

    Estimated Taxes Tripping Up More Filers

    If your working as an independent contractor, making sure you cover your bill for estimated taxes is important for avoiding a tax penalty.
Trading Center