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Backup withholding: what is it and when is it required?

Tax law is full of terms of art.

Some of them are very technical, such as the word "basis" when it refers to the price to be used when calculating increases in value of an asset.

Others are not quite so technical, but still may not be entirely clear to many taxpayers.

In this post, we will discuss one such term: backup withholding.

Withholding is of course a fairly broad term. It generally refers to keeping back payments of taxes so that they can be paid at a later time to tax authorities. This form of withholding is a basic component of the payroll tax process.

A form of withholding also occurs in the offshore account context. As we discussed in our December 24 post last year, under the Foreign Account Tax Compliance Act (FATCA), foreign financial institutions (FFIs) are subject to various withholding requirements if they do not register with the IRS to exchange information with U.S. authorities about account holders who are U.S. taxpayers.

Backup withholding, however, is somewhat different. It refers to banks or businesses who, in some circumstances, may need to withhold income tax from certain payments that they make.

Normally, when a business pays a contractor or a bank pays out interest, nothing is withheld. The business or bank merely sends out a 1099 form to reflect the payment. As we discussed in our March 12 post, these forms are commonly used with independent contractors.

So when is backup withholding required?

One way this comes into play is when the taxpayer has not provided a Taxpayer Identification Number (TIN) to the payer. The IRS also insists on backup withholding when the TIN for a taxpayer turns out to be incorrect.

Source: IRS.gov, "Backup withholding," Accessed May 2, 2014

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