Exempt Payee

An exempt payee is a company that is exempt from backup withholding. This article will tell you everything that you need to know about exempt payees and the criteria which is used to determine if an organization qualifies for this status.

What is Backup Withholding?

It is important to understand backup withholding to fully understand what an exempt payee is. Backup withholding relates to a certain amount of money that is withheld by an individual for tax purposes. The money will then be paid to the Internal Revenue Service (IRS).

Any organization that is operating in business-to-business transactions, and earns money for their services in these transactions, may be subject to back up withholding for their taxes unless they are classified as an exempt payee.

There are several different payment types that can be subject to back up withholding. These include dividends, interest, rent, royalties, patronage dividends, and non-employee compensation. Any payments that are subject to back up withholding require that a 1099 form be sent to both the recipient and the IRS.

Backup withholding is only necessary in the following circumstances:

  • The payee does not give the payer his name or taxpayer number.
  • The taxpayer did not report all of the dividends, interest, or other payments on their tax return.
  • The taxpayer owes federal income tax.
  • The taxpayer's identification number on the W-9 form does not match the IRS records.

What Does Exempt Payee Mean?

An exempt payee is a company for whom backup withholding is not necessary, even in circumstances where this would typically be required. It should be noted that sole proprietors and individuals are usually not exempt from backup withholding, and therefore are not exempt payees.

The conditions for qualifying as an exempt payee are outlined in the instructions that the IRS provide for completing a standard W-9 form.

To qualify as exempt for W-9 purposes, the payee must be one of the following:

  • Any IRA, an organization exempt from tax as per section 501(a), or a custodial account as per section 403(b)(7) if said account meets the criteria of section 401(f)(2)
  • Corporation
  • Financial institution
  • The U.S. government or its associated third parties
  • A real estate investment trust
  • The District of Columbia, a U.S. state, a U.S. commonwealth or possession, or any of their subdivisions and third-party authorities acting on their behalf
  • An overseas government or its acting authorities and subdivisions
  • A dealer of commodities or securities that is required to be registered in the U.S., a U.S. commonwealth or the District of Columbia
  • Commodity Futures Trading Commission registered futures commission merchants
  • An organization that is registered under the Investment Company Act of 1940 throughout the entirety of the tax year
  • A trust fund as per section 584(a)
  • A custodian or nominee investment middleman
  • A trust that is given exemption from tax as per section 664 or section 4947
  • Nonprofit LLCs (subject to certain qualifying criteria)

If you are not classified as an exempt payee, then you can still be given exemption from the withholding provided that your W-9 is correct and completed, and that either the IRS has never contacted you to advise that you are subject to back up withholding, or if they have, they sent you a notice later to advise that you are no longer subject to the withholding.

If you do not believe that you will owe income tax due to the fact that you will not earn as much as your filing threshold, you could be an exempt payee. Note that the filing threshold changes annually and can be checked via the IRS website.

For payees who are not eligible to be an exempt payee, the law states that the payer must withhold 28 percent of all payments to cover federal taxes.

It is important to note that there are a number of variables that can affect state taxes, and the rules vary depending on the state of residence. All companies can get a refund if too much tax is withheld, whether they are an exempt payee or not.

It is worthwhile to consider seeking the assistance of a tax professional or an accountant in order to determine whether or not you are subject to back up withholding and if you are eligible for exemption or not. Penalties may be incurred in the instance of individuals who falsely claim exemption when they do owe taxes, so it is important to be clear.

What is a W-9 Form?

A W-9 form is a form that is completed by those who provide services to businesses without being an employee of the organization, or as a contractor (for example, freelancers or those who have earned an amount of income via investments). The organization requesting the services should provide a W-9 form for completion in the first instance.

The secondary purpose for the form is that it acts as a declaration as to whether an individual is an exempt payee or not (i.e., they are not obligated to back up withholding). Exempt payees can check the relevant box on the form if applicable. If the box is not checked, it is automatically assumed that you are nonexempt and therefore that backup withholding is a requirement.

A W-9 certifies an individual's taxpayer identification number (i.e., Social Security number). Any payments made to you that exceed the sum of $600 will subsequently be reported to the IRS.

Completing the form does not typically result in you having any withholding tax subtracted from your received payments. However, you may be subjected to back up withholding if the W-9 form is not returned, or you fill in an incorrect taxpayer number. Your organization may also find itself subjected to back up withholding if you fail to provide accurate earnings data on a tax return (for example, missed or incorrect interest and dividends).

Additional Information and Help

If you are currently dealing with a situation where you are uncertain as to whether or not you qualify as an exempt payee and you need further advice, you can post your legal need on UpCounsel's Marketplace. UpCounsel only accept the top 5 percent of lawyers to its site, and they come from schools such as Harvard Law or Yale. Our lawyers have an average of 14 years of legal experience that includes working with prestigious companies like Google and Twilio. For the latest legal news and further information on running your business smarter, you can view the UpCounsel legal blog.