Key Takeaways

  • Backup withholding applies when the IRS requires tax withholding due to missing or incorrect taxpayer information.
  • Exempt payees are entities that are not subject to backup withholding, including corporations, financial institutions, government entities, and some non-profits.
  • W-9 forms help determine exempt payee status and are required for tax reporting.
  • Exempt Payee Status for LLCs depends on whether the LLC is taxed as a corporation, partnership, or disregarded entity.
  • Consequences of Incorrect Exemption Claims include IRS penalties and enforced withholding.
  • IRS Compliance Requirements ensure that businesses verify payee status and avoid penalties.
  • State-Specific Regulations may impact tax treatment of exempt payees.

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 backup 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 backup withholding require that a 1099 form be sent to both the recipient and the IRS.

Backup withholding is necessary only 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.

State-Specific Exempt Payee Regulations

While the IRS governs federal backup withholding rules, individual states may impose additional reporting requirements or exemptions for businesses operating in their jurisdiction.

  • Some states have lower withholding thresholds for non-exempt payees.
  • Certain states require businesses to file state tax forms in addition to the W-9.
  • Exempt payee classifications may differ under state law, particularly for LLCs or nonprofits.

To ensure compliance, businesses and payees should review their state’s Department of Revenue guidelines and consult with a tax advisor for location-specific regulations.

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 provides 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 per section 501(a), or a custodial account 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 per section 584(a)
  • A custodian or nominee investment middleman
  • A trust that is given exemption from tax per section 664 or section 4947
  • Nonprofit LLCs (subject to certain qualifying criteria)

If you are not classified as an exempt payee, 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 letter 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 backup 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.

IRS Compliance and Exempt Payees

Businesses making payments to vendors or independent contractors are responsible for ensuring they collect accurate W-9 forms and verify payee exemption status. To comply with IRS regulations:

  1. Verify tax identification numbers (TINs) of all payees to prevent mismatches with IRS records.
  2. Request updated W-9 forms when changes occur in payee status or business structure.
  3. Maintain accurate records to avoid compliance issues and ensure proper tax reporting.
  4. Report payments on Form 1099-NEC or Form 1099-MISC as required for non-exempt payees.

Failure to meet these requirements can result in IRS-imposed penalties and increased tax liability.

Exempt Payee Status for LLCs

Limited liability companies (LLCs) may or may not qualify as exempt payees, depending on their tax classification. The IRS recognizes three types of LLCs for tax purposes:

  • Single-member LLCs: Typically taxed as sole proprietorships unless they elect corporate taxation. They are not automatically exempt payees.
  • Multi-member LLCs: Default classification is as a partnership, which does not qualify as an exempt payee.
  • LLCs taxed as corporations: If an LLC elects to be taxed as an S-corporation or C-corporation, it can qualify as an exempt payee.

To ensure exemption from backup withholding, an LLC must check the appropriate classification box on Form W-9 and provide a valid Employer Identification Number (EIN).

What Is a W-9 Form?

A W-9 form 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 backup 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 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 backup withholding if the W-9 form is not returned or if you fill in an incorrect taxpayer number. Your organization may also find itself subjected to backup withholding if you fail to provide accurate earnings data on a tax return (for example, missed or incorrect interest and dividends).

Consequences of Incorrect Exemption Claims

Claiming exempt payee status when ineligible can lead to IRS penalties and enforced backup withholding. Some key risks include:

  • IRS-imposed fines for providing false information on Form W-9.
  • 28% withholding rate applied to all payments received if incorrect details are reported.
  • Delays in processing payments from clients or business partners due to compliance issues.
  • Tax audits or increased scrutiny of financial records.

To avoid these issues, businesses should ensure they properly classify their tax status before submitting Form W-9. If unsure, consulting a tax professional or legal expert is advisable.

Frequently Asked Questions

  1. Can an individual be an exempt payee?
    No, individuals typically do not qualify as exempt payees unless they are operating as specific types of non-taxable entities, such as non-profits or retirement accounts.
  2. How does an exempt payee avoid backup withholding?
    By completing Form W-9 correctly and selecting the appropriate exemption code, an exempt payee ensures that the payer does not withhold taxes on payments.
  3. What happens if I incorrectly claim exempt payee status?
    If the IRS determines that the exemption claim was incorrect, they may impose penalties, require backup withholding, and conduct further tax reviews.
  4. Is a nonprofit organization automatically an exempt payee?
    Many 501(c)(3) nonprofit organizations qualify, but they must still provide a valid W-9 form to claim exemption.
  5. How can I verify my exempt payee status?
    You can check IRS Form W-9 instructions, consult with an accountant, or contact the IRS directly to confirm your tax classification.

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 accepts only 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 Airbnb. For the latest legal news and further information on running your business smarter, you can view the UpCounsel legal blog.