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What You Need to Know About Backup Withholding

It’s essential to know about backup withholding. This is true if you’re the one doing the hiring or the one getting hired. Let’s go over what to know about backup withholding for small businesses and independent contractors.

What are backup withholdings?

Ordinarily, when you hire an independent contractor, you don’t have to withhold any tax from the money you pay the worker. All you need do is report the payments you make to the worker on Form 1099-MISC. This only applies if you pay the person $600 or more during the year.

Yet, some people work in the underground economy. They are paid in cash and never pay any taxes or file tax returns. The IRS may not even know they exist.

These people often work as independent contractors. The IRS requires anyone who hires an independent contractor to get the person’s taxpayer identification number (TIN). You then must provide it to the IRS when reporting payments made to the worker on Form 1099-MISC.

The IRS requires you to withhold 24 percent of the payments over $600 you make to an independent contractor during the year if:

  • The worker fails to provide you with his or her TIN
  • The TIN provided is clearly erroneous it has more or less than nine numbers, or has an alpha character in one of the nine positions
  • The IRS notifies you that the TIN provided by the worker is incorrect

This backup withholding ensures that the IRS receives its share of taxes. There can be penalties for not backup withholding. The IRS will impose an assessment against you.

How to avoid backup withholding

Backup withholding can be a bookkeeping burden. Fortunately, you can prevent it by obtaining an independent contractor’s TIN. Make sure the number is correct before you pay them.

Have the independent contractor fill out and sign IRS Form W-9. Retain it in your files. You can download copies of the form from the IRS website.

You don’t have to file the W-9 with the IRS. This form merely requires the independent contractor to list his or her name and address and TIN. Most independent contractors are sole proprietors without employees. Their TIN is their Social Security number.

Corporations, multi-member limited liability companies, partnerships and sole proprietors with employees must have a federal employer identification number (“EIN”). They get this from the IRS.

If they don’t already have an EIN, but promises to obtain one, you don’t have to backup withhold for 60 days after they apply for one. Have them put “Applied For” on the W-9 form under the ID number space. If you don’t receive the independent contractor’s ID number within 60 days, start backup withholding.

It’s a good idea to check whether the TIN a worker provides you is correct before you submit a 1099-MISC. Use the IRS’s online TIN matching service, which matches the name and number the worker gives you against IRS records.

To use the service, you must enroll in the IRS e-Services program and have filed at least one 1099-MISC during the previous two years. For more information, refer to IRS Publication 2108-A, On-Line Taxpayer Identification Number (TIN) Matching Program, available at www.irs.gov.

Backup withholding procedure

If you are unable to obtain an independent contractor’s TIN or the IRS informs you that the number the independent contractor gave you is incorrect, you’ll have to do backup withholding. Backup withholding must begin after you pay an IC $600 or more during the year. You need not backup withhold on payments totaling less than $600.

For this procedure, you withhold 24 percent of the independent contractor’s compensation and deposit it every quarter with the IRS. You must make these deposits separately from the payroll tax deposits you make for employees. Report the amounts withheld on IRS Form 945, Annual Return of Withheld Federal Income Tax. This is an annual return you must file by January 31 of the following year. (See the instructions to Form 945 for details.)

Special rules for electronic payments

If you pay an independent contractor electronically by credit or debit card, or by using a third party settlement organization (TPSO) like PayPal or Payable, you need not obtain the independent contractor’s TIN or backup withhold from the worker’s pay if you fail to do so. The third party payment processor must obtain this information. If the independent contractor fails to provide it, the processor must backup withhold from the independent contractor’s payments. You make your full payment to the payment processor, and it handles the backup withholding.

It’s the third party payment processor’s duty to obtain this information. If the independent contractor fails to provide it, the processor must backup withhold from the independent contractor’s payments. You make your full payment to the payment processor, and it handles the backup withholding.

About the author

Stephen Fishman

Stephen Fishman is a self-employed tax expert who has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for entrepreneurs, independent contractors, freelancers and other self-employed people.

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The Growth Center does not constitute professional tax or financial advice. You should contact your own tax or financial professional to discuss your situation.