On October 14, 2020, the IRS posted Tax Tip 2020-136 entitled, “Helpful information for taxpayers on backup withholding.” This particular Tax Tip serves as a great reminder for payers making payments for which backup withholding is required, especially if they are unaware of the troubling consequences of noncompliance.
Backup withholding is imposed at a rate of 24%, and is required when a payer makes a “reportable payment” under Chapter 61 of the Internal Revenue Code but either does not have the payee’s U.S. taxpayer identification number (“TIN”) or fails to obtain the TIN in the manner required at the time the payment is made. Backup withholding can also be required in other circumstances, such as when the IRS notifies the payer through correspondence that either the payee provided an incorrect TIN or that the payee’s name and TIN do not match the name in IRS records. Payers should strive to possess the payee’s correct name and TIN and obtain the TIN in the manner required to avoid backup withholding. A payee’s name and TIN can be confirmed through the IRS TIN Matching System.
What Does Obtaining the TIN “in the Manner Required” Mean?
Depending upon the type of payment, a payer may be required to obtain a certified TIN using a Form W-9 (Request for Taxpayer Identification Number and Certification) or an acceptable substitute Form W-9. TIN certification is accomplished by signing the Form W-9 (or an acceptable substitute) under penalties of perjury as set forth on the form. A certified TIN is generally required with respect to amounts received through payers like financial institutions that make payments to customers arising from investments, such as interest, dividends, and gross proceeds from the sale of securities. Accordingly, banks, savings and loan associations, credit unions, and investment houses generally require the submission of a certified Form W-9 (i.e., a Form W-9 signed under penalties of perjury, etc.) or require the use of their own acceptable substitute forms to obtain the certified TIN.
Payers required to make other types of payments such as payments for royalties, the performance of services, etc. are generally able to obtain a payee’s name and TIN either orally or in writing without obtaining a signature to certify the TIN. Payers should consult the rules to determine whether a certified TIN is required in their particular situation.
Backup Withholding Failures May be Costly
Taxpayers that are required to backup withhold at the time a reportable payment is made but fail to do so become secondarily liable for the unwithheld tax. The consequence of backup withholding failures can be costly, so businesses − regardless of size − should make sure they are in compliance. For example, a business that pays $100,000 to a non-exempt (i.e., an entity not treated as a U.S. corporation) payee for the performance of services for which the payer failed to obtain the TIN in the manner required could be subject to a $24,000 assessment for the unwithheld tax plus penalties and interest.
Payers are required to deposit amounts withheld under the backup withholding rules with the U.S. Treasury and report the withheld amounts on an annual Form 945 (Annual Return of Withheld Federal Income Tax) filed with the IRS. Further, the payer must file an applicable information return reporting the gross payment and the withheld federal tax with the IRS and furnish a copy to the payee.
A reportable payment is defined under section 3406(b) and, as highlighted in Tax Tip 2020-136, includes the following:
- Reportable interest or dividends, and
- any other reportable payment including —
- Payment card and third-party network transactions
- Patronage dividends, but only if at least half the payment is in money
- Rents, profits or other gains
- Commissions, fees or other payments for work done as an independent contractor
- Payments by brokers
- Barter exchanges
- Payments by fishing boat operators, but only the part that is paid in actual money and that represents a share of the proceeds of the catch
- Royalty payments
- Gambling winnings, if not subject to gambling withholding
- Taxable grants
- Agriculture payments
Another noteworthy reportable payment is a payment of gross proceeds made to an attorney or a law firm to settle a dispute. Such payments are required to be reported on box 10 of Form 1099-MISC, and the payer must obtain the attorney’s TIN prior to making payment. Failing to obtain the TIN of the attorney or law firm prior to making payment subjects the payment to backup withholding.
Unfortunately, payers cannot simply obtain the TIN after the fact to cure a failure. Rather, the payer must generally obtain a Form 4669 (Statement of Payments Received) from the payee, which is often easier said than done. Although a valid Form 4669 will result in a credit to offset a backup withholding assessment by the IRS, it generally does not result in the withdrawal of related penalties.
How Would the IRS Know if a Payer did not Possess a TIN at the Time of Payment?
The IRS may ask payers under audit to prove that they possessed TINs for applicable reportable payments prior to making the payment, and the inability to demonstrate possession of the TINs prior to payment may result in an assessment. Examples of proof that the payer possessed a TIN may include the filing of a Form 1099 for the year prior to the year under audit; a TIN that appears on the vendor’s invoice issued prior to payment; a copy of an email or envelope in the payer’s files from a vendor that includes the postmark or email date that establishes the date of transmittal of a Form W-9 or the TIN; a consistent process of date stamping and retention, either electronically or in hard copy format, of all Forms W-9 received by the payer upon receipt (a business record); and the entry of a vendor TIN in an automated financial or accounting system the date of which can be verified through the system.
Where to Look for Additional Federal Guidance
The IRS has published helpful guidance for payers with respect to backup withholding. IRS Publication 1281 (Backup Withholding for Missing and Incorrect Names/TINs) and IRS Publication 1335 (Underreporter Backup Withholding) provide useful guidance. Additional discussion on the topic and links can also be found here.
State Backup Withholding
Backup withholding may also apply at the state level. For example, California imposes backup withholding on nonwage payments at the rate of 7%. Other states that impose some form of backup withholding include, but are not necessarily limited to, Colorado, Georgia, Maine, Minnesota, South Carolina, and Vermont.