Backup Withholding

Backup withholding is a method used by the Internal Revenue Service (IRS) to recover taxes from filers who have been negligent or who have underpaid in the past. If the IRS determines that you owe them more money than you've sent, backup withholding is one method they have at their disposal to recover their losses. Backup withholding is a tax that is levied on investment income at a predetermined tax rate as the investor withdraws it. What this method does is helps ensure that the IRS actually gets to collect the money it has coming.

Taxpayer Identification Numbers

Backup withholding can be applied when an investor has not followed the government's rules regarding TINs or taxpayer identification numbers. When backup withholding is in play, the amount mandated is withheld and handed over to the federal government any time the investor makes a withdrawal. What this accomplishes for the government is that the required funds owed by the taxpayer are collected much more quickly than they might be otherwise. The cost to the investor is substantially impacted cash flow.

Investors can earn income from investments in a number of ways, such as from dividends, average annual return, capital gains, and interest payments. While this income is taxable at the time it is earned, in a normal situation it is only collected once a year, when the investor files federal taxes. The trouble with this as the government sees it is that this investor who already owes them money could potentially spend all of that money by the time tax season comes around. This would put him further in the hole while also costing the government in its own short term cash flow. To remedy this, the government simply takes the tax due on any investment income as soon as it is earned rather than waiting for April 15th. These backup withholding taxes are levied by financial institutions at the behest of the government, so there is little an investor can do about it.

Backup Withholding Applies to Many Payments

Backup withholding payments can apply to pretty much any payment that gets reported on an IRS form 1099. This can include interest payments, payments coming in from brokers, and royalty payments as well. Stock dividends can be subject to backup withholding. Many investors subjected to backup withholding are chagrined to find out that payments made to form 1099 independent contractors including commissions and fees can also be subject to backup withholding.

Exemptions to Backup Withholding

There are also certain scenarios in which exclusions to backup withholding payments apply. This is about the only good news for those among us who ever have to deal with this unfortunate turn of events. Real estate transactions, property foreclosures, cancelled debts, medical care benefits, unemployment compensation, state and local income tax refunds, and distributions from ESOPs (employee stock ownership plans) are all exempt from backup withholding.

The federal government takes the issue of tax payments very seriously. Anyone who has ever experienced tax troubles with the IRS is well aware of this. The concept of backup withholding exists to give the government a leg up in its efforts to collect from taxpayers who might otherwise take a lot longer to come up with the required funds. Consumers who wish to avoid this rather nightmarish scenario must make sure to keep current on all of their tax payments. If you are a 1099 contractor, for example, be sure to set aside enough money to pay all taxes for the year when the time comes. A bit of extra effort and maybe a little sacrifice can help avoid trouble.

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